In search of a perfect peg...

Prelude: Sa-dhan's Quick Report 2007 spells out a data of about 129 MFIs. DER of total industry assuming that there are only these 129 major MFIs, comes out to be around 12:1. Is this healthy from both lenders as well as owner's perspective? Write up below is just a penning down or playing-around with some ratios which concludes with a question, open for all bloggers of this BottomOfPyramid Blog to comment.


To calculate the return on equity using the DuPont model, multiply the three components (net profit margin, asset turnover, and equity multiplier.)

• Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

[Equity multiplier is calculated as Assets/Equity; Equity is Networth]

Du Pont observes that Return on Equity is a product between Profitability, Asset Efficiency and Financial Leverage.

Using Equity Multiplier, one can clearly say how much of the return has actually come out of debt.

This is how it is...

Equity Multiplier = A/E; Where A = Assets and E = Equity

Say EM = 10

==> 10 = (D+E)/E
==> 10E = D+ E
==> 9E = D
==> 9 = D/E
==> Debt-Equity Ratio = 9
This shows that if EM is n, then DER is n-1

Now, at different levels of EM, the DER, Proportion of Equity and Proportion of Debt are as follows:

EM (n)	1	2	3	5	10	20	50	100
DER (n-1)	0	1	2	4	9	19	49	99
% of Equity (1/n)	100%	50%	33%	20%	10%	5%	2%	1%
% of Debt (1-(1/n))	0%	50%	67%	80%	90%	95%	98%	99%

The above table gives some valuable insights:

1. EM is a leverage ratio
2. As EM tends to infinity, proportion of equity tends to zero.

Further, its important to understand that the EM is a multiple of ROE (as referred above) and therefore highly significant increase in EM can alarm both the creditors as well as its owners. Creditors will be worried about their own funds more at stake than owner's equity and therefore there is a likelihood of the cost of borrowings going high. Similarly, if the owners also perceive risk, they also raise their expected return, and thereby increasing the cost of equity. Overall, an increased EM will increase Average Cost of Capital and thereby reduce profitability. Sometimes, a very low EM can also be costly as expected return on equity by shareholders will be high, and thereby increase the overall cost of capital.

So my question to the reader is: When do I say EM is optimal? or, When do I say EM of an average MFI is optimal? or more precisely, What levels of DER is more optimal?