Trainer: At this stage the Trainer will now begin to discuss each particular indicator in detail. The discussion should start with a definition of each ratio, what it means, where to find the data, and how to calculate it. A subsequent section will cover how to interpret it, and then to score it.

Introduction and Why Portfolio Quality is Important

Trainer: The Trainer should repeat why portfolio quality is important.

Portfolio quality is critical to the sustainability of the MFI/NGO, both in terms of (i) recycling the funds available for lending and (ii) ensuring the ongoing sustainability of the institution by re-investing retained earnings.

Secondly, it is important that the value assets are protected, and that they are correctly valued in the Balance Sheet.

Thirdly, the loan portfolio probably will represent the majority of assets of the MFI/NGO.

Fourthly, the measurement of the level of protection is measured by the adequacy of the loan loss allowance.

The indicators/ ratios used for measuring both the quality and the level of protection of the portfolio are:

• The Portfolio at risk (PAR) ratio.
  
• The Loan Loss Allowance.

Trainer: The Trainer here should stress why there are two ratios.

The two ratios are interconnected.

Trainer: The Trainer should ask the attendees what the PAR ratio measures.

The PAR ratio measures the likely future losses that the MFI/NGO could suffer, based on those borrowers who are having difficulty in meeting their repayment installments. This difficulty in repayment is measured by having one or more loan repayment installments that are due, but are unpaid. As such, it is a predictor of potential future losses.

Trainer: The Trainer should ask attendees what does the Loan Loss Allowance ratio measure.

The loan loss allowance ratio measures whether you have established a sufficiently large allowance to cover those potential future losses that have been identified by the PAR ratio. Furthermore, it shows whether the loan portfolio is included in the balance sheet at its correct value, namely the value of the portfolio that will be repaid.

It also permits the MFI/NGO to charge the expense of the loss against income when that loss is incurred, rather than being charged against future earnings.

THE RESULT OF THESE TWO RATIOS, THEREFORE, IS

The PAR ratio identifies and quantifies the likely amount of future losses.

The loan loss allowance ratio shows whether these potential losses have been correctly entered into the financial statements.