RIFT VALLEY UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

DETERMINANTS OF MICRO FINANCE INSTITUTION

PROFITABILITY IN ETHIOPIA

A PROPOSAL THESIS SUBMITTED TO THE DEPARTMENT OF

ACCOUNTING AND FINANCE COLLEGE OF BUSINESS AND
ECONOMICS RIFT VALLE UNIVERSITY IN PARTIAL
FULFILLMENT OF THE REQUIREMENTS FOR THE MASTERS
OF ART (MBA) DEGREE IN BUSSINES ADMINSTRATION.

BY:
DANGE TESHOMA

Advisor: TEMIRU KUMSA

JAN 2025
Addis Ababa, Ethiopia

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 RIFT VALLEY UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ACCOUNTING AND FINANCE
MBA DEGREE IN BUSSINES ADIMINSTRATION

APPROVAL SHEET

Submitted by:

DANGE TESHOMA _______________ ___________

PG Candidates Signature Date

Approved by:

______________________ ________________ ___________

Advisor Signature Date

_______________________ __________________ ____________

Head Dep. of Accounting and Finance signature Date

________________________ _________________ __________

Dean of College of Bus & Econ signature Date

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Abstract
Microfinance institutions provide financial services to lower income borrowers and micro and
small enterprises in areas where urban and other rural poor people are excluded from the
financial sector. The main objective of this study is to examines the factor determining
profitability of microfinance institution in Ethiopia using balanced panel data covering the
period of 2013 to 2023 from 21 MFIs, are select purposively based on data availability. The
study is based on secondary data, whereas, the secondary data is collecting from the audited
annual financial reports of microfinance institutions in National Bank of Ethiopia and
association of Ethiopian microfinance institution. The study will be employed apply explanatory
research design and data are analyzing through multiple linear regression analysis models of
the MFI’s rate of asset (ROA). Random effect regression model are applying to analyze the effect
of loan period, collateral, capital adequacy, liquidity, Interest rate, inflation and exchange rate
on lending decision of microfinance institution in Ethiopia. Whereas, Interest rate, inflation and
exchange rate have insignificant effect on profitability of microfinance institution in Ethiopia.

Keywords: ROA, Profitability, Determinants of profitability, Microfinance institutions.

Table of Contents

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Abstract_____________________________________________________________________________iii
Table of Contents______________________________________________________________________iv
Acronyms and Abbreviations_____________________________________________________________vi
List of Tables_________________________________________________________________________vii
CHAPTER ONE_______________________________________________________________________1
1. INTRODUCTION___________________________________________________________________1
1.1. Background of study________________________________________________________________1
1.2. Statement of the Problem_____________________________________________________________3
1.3. Objectives of the study______________________________________________________________6
1.3.1. General objectives_________________________________________________________________6
1.3.2. Specific Objectives________________________________________________________________6
1.4. Research questions__________________________________________________________________6
1.5. Hypotheses of the study______________________________________________________________6
1.6. Significant of the study______________________________________________________________7
1.7. Scope of the study__________________________________________________________________7
1.8. Potential Limitation of the study_______________________________________________________7
1.9. Organization of the study.____________________________________________________________8
CHAPTER TWO______________________________________________________________________9
2. REVIEW OF LITERATURE____________________________________________________________9
2.1. Theoretical Literature Review_________________________________________________________9
2.1.1. Microfinance_____________________________________________________________________9
2.1.2. Characteristics of Microfinance._____________________________________________________11
2.1.3. History of Microfinance___________________________________________________________11
2.1.4. History of Microfinance in Ethiopia__________________________________________________12
2.1.5. Difference between microfinance and traditional banking services__________________________13
2.1.6. The Need for Microfinance_________________________________________________________14
2.1.7. Liquidity Preference Theory________________________________________________________15
2.1.8. The Theory of Inflation Rate_______________________________________________________16
2.1.9. Traditional theory of capital structure________________________________________________16
2.1.10. Pricing Theory_________________________________________________________________17
2.1.11. Theory of Multiple-Lending_______________________________________________________17
2.1.12. Challenges of Microfinance Institutions in Ethiopia____________________________________17
2.1.13. Determinants of MFI’s Profitability.________________________________________________18
2.1.14. Financial services of microfinance institutions________________________________________22
2.2. Empirical Literature Review_________________________________________________________23
2.3. Research Gap_____________________________________________________________________25
2.4. Conceptual Framework_____________________________________________________________25
CHAPTER THREE___________________________________________________________________26
3. RESEARCH METHODOLOGY_______________________________________________________26
3.1 Research design___________________________________________________________________26
3.3. Research methods_________________________________________________________________28
3.3.1 Target population_________________________________________________________________28

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3.3.2 Sample size and Sample Technique___________________________________________________28
3.3.3 Data type and Source______________________________________________________________29
3.3.4 Methods of Data Analysis__________________________________________________________29
3.4. Model Specification________________________________________________________________30
3.5. Definition and Measurement of Variables_______________________________________________31
3.5.1. Dependent Variables______________________________________________________________31
4. TIME AND COST BUDGET SCHEDULE_______________________________________________35
4.1 Time Budget Schedule______________________________________________________________35
4.2 Cost Budget Schedule_______________________________________________________________35
4.3 Bibliography______________________________________________________________________37

Acronyms and Abbreviations

AEMFI: Association of Ethiopian Microfinance Institution

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CAP: Capital asset ratio

CEO: Chief executive officer

CGAP: Consultative Group to Assist the Poor

GDP: Gross Domestic Product

IFC: International Financial Corporation

INFL: Inflation

Liq Liquidity

MFI: Microfinance Institution

MFIs: Micro Finance Institutions

MIX: Microfinance Information Exchange

NBE: National Bank of Ethiopia

NGO: Non-Government Organization

OLS: Ordinary Least Square

ROA: Return on Assets

ROE: Return on Equity

List of Tables
Table 3.1 List of sample MFIs in Ethiopia included in the study.---------------------------------------------------28
Table 4.1 Work plan-------------------------------------------------------------------------------------------------------------35
Table 4.2.Cost budget schedule----------------------------------------------------------------------------------------------36

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 CHAPTER ONE

1. INTRODUCTION

1.1. Background of study

Microfinance institutions provide variety of financial services to lower income borrowers and
micro and small enterprises in areas where urban and other rural poor people are excluded from
the financial sector. According to (Yunus, 2004) microfinance provides access to finance to low-
income or jobless people who do not have access to traditional financial institutions, and it has
proven to be one of the most effective tools for poverty alleviation in many developing countries,
particularly in Africa and Asia. Many development experts agree that microfinance, when
properly harnessed and supported, can economically empower individuals and small enterprises
and enable them to contribute to and benefit from economic development. Having access to
financial services helps people improve their lives and work their way out of poverty (UN,
2013).

In Ethiopia, financial institutions such as banks operate mostly in urban areas, excluding the rural
poor from financial services for many years. As a result, micro-credit began as a government and
NGO-driven initiative. According to (Alemayehu, 2008), even if in a very limited and not
sustained manner, many NGOs started to offer micro-credit along with other relief activities
following the 1984/85 severe drought and famine. Aware of this fact, (Rosenberg, 2009) also
stated that the poor are generally excluded from the financial services and hence, microfinance
institutions have emerged to bridge the gap. Ethiopian MFIs were formally established following
proclamation no. 40/1996, which was then amended by proclamations no. 626/2009 and
1164/2019, with the amendment of some restrictions that had been influencing MFI activities.

According to the World Bank reports, an estimated that many people in developing countries
have little or no access to formal financial services that can help them increase their incomes and
improve their lives. Access to a range of microfinance services savings, loans, micro insurance,
and money transfers enable the poor families to invest in enterprises and in better nutrition,
improved living conditions and the health and education of their children. The evolution of the
industry has been driven by many factors which include the transformation of microfinance
providers, the sizeable supply gap for basic financial services, the expansion of financing
services supporting the industry and the use of technology. As the industry, has developed, there
has been a shift from specialized NGOs to an increasing number of regulated and licensed MFIs
which stress that sustainability and impact go hand in hand (IFC., 2019)

Micro finance institutions play a great role in supporting the economic activities of the rural and
urban poor in developing countries. Studies show that African MFIs are important actors in the
financial sector, and they are well positioned to grow and reach the millions of potential clients
who currently do not have access to mainstream financial services (Yilma, 2017), Although the
provision of financial services to the underserved or non-served poor peoples is the primary
objectives of microfinances, an increasing rate of defaulters with large amount of outstanding
loan is still the challenges of most microfinance institutions that are operating in Ethiopia. In
most of the developing countries, most of its nationals have no access with formal banking
services hence requires the individuals to rely heavily on the financial services provided by
MFIs. In boosting the income that later on support creation of jobs, increasing entrepreneurs,
innovators, improving living standards and creating successful business practitioners. For
instance, in Uganda majority of entrepreneurs were impeded with the lack of enough capital to
run their businesses. The same applied to microfinance institutions that were hindered by high
operating expenses that hindered properly provision of monetary services to the nationals. Thus
presence of clear laws, rules and regulations on operating and formalizing the microfinance,
Uganda has witnessed the gradual growth and sustainability of MFIs (Issangu, 2020)

The Microfinance industry, along with all the players in it, is quickly changing. Today, the
microfinance industry has become both more crowded and complex. First of all, the concept of
microfinance no longer just covers microcredit only, but also includes the possibilities of saving,
insurance and money transfer. Although MFIs are characterized as one type when it comes to
financial services, there is a great variety of MFI‟s in terms of legal form, profit status, degree of
sustainability and funding sources (Gislaw, 2018)

One of the methodologies of MFIs is group lending. In group lending, the group obtains a loan
under joint liability, so each member is made responsible for repayment of loans of his or her
peers. The success of MFIs is because, in group based programs, the function of screening,
monitoring and enforcement of repayment are to a large extent transferred from the bank to
borrowers. The main argument is that, compared to the physically distant banks, group members

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can obtain at low cost, information regarding the reputation, indebtedness and wealth of the loan
applicant and about his or her effort to ensure the repayment of the loan (Yitbarek, 2022)

Therefore, scholars must periodically examine determinants of MFIs Profitability to maintain

their wonderful contribution to low-income and unemployed people and make them a reliable
source of finance in developing nations in the current dynamic macroeconomic environment. As
a result, understanding the determinants of MFI's Profitability is vital to address preserving
MFI's performance so that it can reach out to more underserved societies in a financially
sustainable manner. The objective of this study is focused on identifying factors of micro finance
profitability which contribute for the sustainability of the MFIs and make them a reliable source
of finance for the poor, by taking into account some selected or nominated MFIs operating in
Ethiopia. Data from 21 MFIs in Ethiopia and eleventh years from 2013 to 2023 are used for this
analysis.

1.2. Statement of the Problem

The main goal of MFIs is to offer credit and savings to the poor in order to ease their financial
burdens and contribute to the reduction of poverty. Most of the people in urban and rural areas
who cannot afford collateral to obtain loans from banks are served by microfinance institutions.
In Ethiopia, there is a significant urban concentration in the financial services sector.
Microfinance institutions offer credit to the poor who cannot obtain official credit from financial
institutions in order to fill this gap. The borrowers' loan performance is one metric used to
identify efficient MFIs. The advantages for MFIs and borrowers alike are connected to high
payback rates. Good communication between MFIs and their consumers will result from a high
payback rate. A poor payback rate, however, will have a negative impact on both borrowers and
MFIs. So, if the MFIs are not viable due to a default issue, borrowers would not have access to
loans and suffer from poverty, which has an impact on the overall growth of the nation.

(Belay, 2021) asserts that MFIs have a significant positive impact on Ethiopia's national
economy through the creation of jobs and reduction of poverty. A significant strategy for
alleviating poverty over time is to expand people's access to financial services, which helps to
create jobs, raise incomes, and increase consumption. By alleviating production's liquidity
limitations, providing cash for new business ventures or the adoption of cutting-edge technology,
and assisting producers in assuming production risk, access to financial services for the

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underprivileged promotes economic growth. The lower-income people's ability to finance their
financial demands is severely constrained by Ethiopia's traditional banking system. Due to this,
microfinance is now receiving increasing attention as a means of financial intermediation for
low-income individuals and unemployed get access to financial services (Getachew, 2017)
In Ethiopia, reducing poverty is essentially the sole goal of all microfinance institutions. They
must be sustainable and commercially viable in order to accomplish this goal. Microfinance
institutions, in particular for the rural and urban poor, notably in Ethiopia, where many people
live on the border of hunger, are crucial exit points from the poverty trap, according to (Ebisa, &
Mitiku, 2013). Ethiopia's microfinance market is expanding despite the deepening concerns
about inflation that are endangering the financial stability and survival of MFIs. In this regard,
the performance of microfinance institutions in Ethiopia has drawn the attention of numerous
scholars.
(Gashaw, 2022) to examine the relationship between metrics like debt to equity, age of MFI,
number of borrowers, liquidity, portfolio at risk, operating expense to loan, percentage of women
borrowers, financial self-sufficiency, operational self-sufficiency, gross domestic product,
inflation, and financial performance of Microfinance Institutions, which is gauged by return on
asset and return on equity.
Government, non-governmental organizations (NGOs), banks, and public deposits are the main
sources of funding for microfinance institutions in Ethiopia. Good lending decisions are
necessary as a result of public deposits. Although there is no Deposit Insurance Plan in Ethiopia,
good corporate governance is even more crucial. Furthermore, in order to reduce agency conflict,
the industry needs governance that acts in the best interests of shareholders. Due to these
realities, there is no empirical research on the lending decisions of Microfinance Institutions
(MFIs) in Ethiopia, and it is difficult to locate empirical literature that is supported by
documentation.
Commercial banks' lending activities are influenced by a variety of internal and external factors.
According to (Olokoyo, 2011; (Olumuyiwa, 2012; and Malede, 2014), internal factors of
commercial banks' lending are under the management of the bank, whereas external factors came
from the macroeconomic factors, the regulatory body of central banks, and other regulatory
authorities in the financial sector of the economy. As a result, it becomes crucial for many
Researchers to investigate these key variables that affect commercial banks' lending activity.

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Return on equity and interest rates have a negligible impact on the lending decisions made by
private commercial banks (Abay, 2021). (Olokoyo, 2011) discovered that the banks' lending
decisions and adherence to the guidelines issued by the National Bank are not negatively
impacted by the liquidity ratio.
There are a number of articles in the area, even though most of the researches are conducted in
commercial banks and insurance companies. Consequently, in Ethiopia, empirical studies on
lending decision of Microfinance Institutions (MFIs) are not enough and finding documented
empirical literature on the topic is difficult. It is built up on the findings of prior researches, but
it has its own identity as it is conducted in the Ethiopian context by using different variables.
While the microfinance sector in the country is large, it has been under little international
influence and only Ethiopians are allowed as shareholders in microfinance institutions.

Generally, researches conducted in the area are limited in spite of the research needs of the
financial sector. It is the belief of the researcher that the concept of lending decision of
microfinance institution in Ethiopia is not well developed and studies have not been conducted in
sufficient depth. In this regard, it would have been worth studying the factors affecting lending
decision of microfinance institutions in Ethiopia. What motivated the researcher to conduct the
study on the selected topic is that prior researchers concentrate on commercial banks and
insurance companies. Researches which are conducted on microfinance institutions take limited
number of lending decision variables as it has been tried to show above.
Therefore, this study will be tried to fill these research gaps. To do so, it has tried to examine the
factors that determinants of microfinance institutions profitability in Ethiopia by identifying
some selected determinant variables (methods of lending, loan period, collateral, capital
adequacy, liquidity, Interest rate, inflation and exchange rate) which are believed to have direct
relationship with on loan and advance of microfinance institutions in Ethiopia, typically on
microfinance institutions through reviewing the recent reports of MFI recorded in the form of
financial reports from National Bank of Ethiopia. This study is different as it uses panel data
covering 21 Ethiopian microfinance institutions over the period of 2013 to 2023 G.C.

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1.3. Objectives of the study

1.3.1. General objectives

The main objective of this study is to examining the factors determining of Profitability of
microfinance institution in Ethiopia.

1.3.2. Specific Objectives

Under the above general objective, the study’s specific objectives will be focused on:
i. To investigate the main factors that size affect the Profitability microfinance
ii. To investigate the main factors that Age affect the Profitability microfinance
iii. To investigate the main factors that credit risk management affect the Profitability
microfinance
iv. To investigate the main factors that liquidity affect the Profitability microfinance
v. To investigate the main factors that interest rate affect the Profitability microfinance
vi. To examine the external factors that inflation determines microfinance Profitability
vii. To examine the external factors that exchange rate determines microfinance Profitability

1.4. Research questions

By reviewing literature concerning the topic, the following research questions are
useful in tackling the above objectives:

1. What are the main factors that affect the Micro finance profitability such as capital
adequacy ratio, deposit, liquidity and interest rate of microfinance institutions?
2. What are the external factors affecting on Profitability of microfinance like inflation
and exchange rate of microfinance institutions?

1.5. Hypotheses of the study

To achieve the objectives of the study and to answer clearly research questions, the following
null hypotheses have been developed to estimate the relationship between internal and external
factor with lending decision.

Based on the objectives of the study researcher develops the following arguments.

H1: Size of microfinance has positive and significant effect on profitability of MFI.

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H2: Credit risk management has positive and significant effect on MFI’s profitability.

H3: Liquidity has positive and significant effect on MFI’s profitability.

H4: Inflation has negative and significant effect on MFI’s profitability.

H5: Interest rate has Negative and significant effect on MFI’s profitability.

H6: Age of firm has positive and significant effect on MFI’s profitability.

H7: Exchange rate has Negative and significant effect on MFI’s profitability.

1.6. Significant of the study

Microfinances are one of the most important financial institutions for country’s economic
development through lending money to consumer and the business community. Lending also
has important function for MFIs. Its significance to asset and income portfolio is very high in
MFIs. So understanding the determinants of lending decision plays crucial role

 The study thus would help management of MFIs to make them aware and to give due
attention about the key determinants of profitability.
 The study would also contribute to the existing body of knowledge in the area of
determinants of profitability in MFIs in Ethiopia.

Finally, this study will also be using as a basis for any further research that will need to explore
on some other concerns which is not covered by this research.

1.7. Scope of the study

The scope of the study is limited to the internal and external determinants of the lending decision
of MFIs in Ethiopia by using eleventh years from 2013 to 2023 of financial data from each of
selecting of 21 MFIs operating in Ethiopia. The study is using examine the factors affecting on
profitability of MFIs in Ethiopia, and eight explanatory variables such as methods of lending,
loan period, collateral, capital adequacy, liquidity, Interest rate, inflation and exchange rate as the
determinants of profitability of MFIs in Ethiopia.

1.8. Potential Limitation of the study

This study focuses on attempt to known the determinants of microfinance institution profitabilty
in Ethiopia by taking twenty one microfinance institutions as a case. In addition the study is

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based entirely on secondary sources of data due to lack of primary data factors which determine
the profitability of MFIs constraints. However, the researcher believes that this study will be
stronger if it is support by additional qualitative factors that affect the profitability of
microfinance institutions. The researcher limits the scope only to the available secondary data for
11 years and twenty one MFIs. Except the above mentioned limitations, the study is believed to
represent the true determinants of profitability of the microfinance institutions.

1.9. Organization of the study.

This research proposal consists of four chapters. The first chapter will present back ground of
the study, statement of the problem, research questions, objective of the study, significance of the
study, scope of the study, limitation of the study and organization of the paper. Chapter two
focuses on theoretical and empirical review literature studies related to determinants of
microfinance institution profitability in Ethiopia, summary of research gab and Conceptual
frameworks. Chapter three deals with research methodology, the fourth chapter presents the plan
and budgets of the study.

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 CHAPTER TWO

2. REVIEW OF LITERATURE

This chapter contains a review of literature presented by various authors and scholars based on
the objectives of the study. The literature review provides an explanation of theoretical rationale
of the problem being study as well as what research has been done and how the Findings relate to
the problem at hand. The chapter discusses the Theoretical review, literature Review, empirical
review, gab of the study and conceptual framework.

2.1. Theoretical Literature Review

2.1.1. Microfinance

Microfinance is a type of banking service which provides access to financial and non financial
services to low income or unemployed people. Microfinance is a powerful tool to self empower the
poor people especially low income at world level and especially in developing countries. While
describe microfinance as small financial transactions with low income household and micro
enterprises, using non standard methodologies such as character-based lending, group guarantees
and short term loans.The definitions of microfinance given by different scholars contain some
similar pointes. They describe microfinance as provision of a small amount of loan for the poor,
specifically the rural poor living in developing country. Some microfinance institutions provide non
financial services for their clients. But in our case, most of the microfinances are known by the
provision of a small amount of credit and saving services (Altessa, 2019)

Microfinance is considered providing financial services to people with low income groups or
poor people, the original center of micro finance was on the stipulation micro-credit little credits
generally for short periods to finance operational assets for small enterprises usually poor people,
conversely the subject of microfinance has expand importantly credit, savings, insurance,
remittances and other expenditure all of which have a great impact on the lives of the poor
(Bourreau & Valletti , 2015)

According to (Ngumo & David, 2020) Microfinance is defined as a growth instrument which
contributions or supply financial services such as little loan, investments, insurance and cash
transfer to help the very low income group grow or start their businesses.

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The thought of microfinance was based on the feeling that people with low income economic
development, sustainably life and receiving infrastructure to understand opening new enterprises
dreams or develop accessible businesses and thus try to improve their economic condition on
their own (Dutta, & Banerjee, 2018) Microfinance is the provisions of little level of economic
services to low income client parts, which has no right to use financial services provided by the
formal sector (Boateng, & Bampoe,, 2015)

Different authors and organizations have defined Microfinance institutions in different ways.
However, the essence of the definitions is usually the same in which microfinance refers to the
provision of financial services; primarily savings and credit to the poor and low-income
households that don’t have access to commercial banks define it as the provision of financial
services generally saving and credit to low-income clients.

According to Amanu & Gebissa (2021) small scale financial services primarily credit and
savings provided to people who farm or fish or herd; who operate small enterprises or micro-
enterprises where goods are produced, recycled, repaired, or sold; who provide services; who
work for wage and commission; who gain income from renting out a small amount of land,
vehicles, draft animals, or machinery tools; and other individual and groups at the local level of
developing countries both rural and urban area. But for this case, the definition given by the
MIX (Microfinance information exchange) is more appealing than the rest provided in the above
paragraph. The MIX defines microfinance institutions as a variety of financial services that target
low-income clients, particularly women. Since the clients of microfinance institutions have lower
incomes and often have limited access to other financial services, microfinance products tend to
be for smaller monetary amounts than traditional financial services. These services include loans,
savings, insurance, and remittances. Microloans are given for a variety of purposes, frequently
for micro-enterprise development. The diversity of products and services offered reflects the fact
that the financial needs of individuals, households, and enterprises can change significantly over
time, especially for those who live in poverty. Because of these varied needs, and because of the
industries' focus on the poor, MFIs often use non-traditional methodologies, such as group
lending or other forms of collateral not employed by the formal financial sector (Battaggia, 2021)

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2.1.2. Characteristics of Microfinance.

Microfinance came into being from the appreciation that micro-entrepreneurs and some poorer
clients can be ‘bankable’, that is, they can repay, both the principal and interest, on time and also
make savings, provided financial services are tailored to suit their needs. Microfinance as a
discipline has created financial products and services that together have enabled low-income
people to become clients of a banking intermediary. The characteristics of microfinance products
include: little amounts of loans and savings, Short- terms loan usually up to the term of one year,
Payment schedules attribute frequent installments or frequent deposits, Installments made up
from both principal and interest, which amortized in course of time, Higher interest rates on
credit higher than commercial bank rates but lower than loan shark rates, which reflect the labor-
intensive work associated with making small loans and allowing the microfinance intermediary
to become sustainable over time, Easy entrance to the microfinance intermediary saves the time
and money of the client and permits the intermediary to have a better idea about the clients’
financial and social status and No collateral is required contrary to formal banking practices.
Instead of collateral, microfinance intermediaries use alternative methods, like, the assessments
of clients’ repayment potential by running cash flow analyses, which is based on the stream of
cash flows, generated by the activities for which loans are taken (Adugna, 2014).

2.1.3. History of Microfinance

The history of micro financing can be traced back to the middle of the 1800s when the theorist
Lysander Spooner was writing about the benefits of small credits to entrepreneurs and farmers as
a way of getting people out of poverty. But it was at the end of World war II with the Marshall
plan the concept had a big impact. There have been informal and formal credit and savings
institutions for the poor around the world for centuries, one of the earliest and longer-lived
microcredit organizations, which provided small loans to rural poor without collateral, were the
Irish loan fund system, founded by author and nationalist Jonathan Swift at the beginning of the
eighteenth century. In the 19th century, a wide range of larger and more savings and credit
institutions started to emerge in Europe. These institutions which were organized primarily
among the rural and urban poor were known as people’s Banks savings and credit co-operatives
and credit unions (Tesfaye, 2021).

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Today use of microfinance has its roots in the 1970s when organizations, such as Grameen Bank
of Bangladesh with the microfinance pioneer Mohammed Yunus, were starting and shaping the
modern industry of micro financing. Another pioneer in this sector is Akhtar Hammed Khan. At
that time a new wave of microfinance initiatives introduced many innovations into the sector.
Many pioneering enterprises began experimenting with loaning to underserved people. The main
reason why microfinance is dated to the 1970s is that the program could show that people can
rely on to repay their loans and that it is possible to provide financial services to poor people
through market-based enterprises without subsidiaries (Scheyvens, 2015)

2.1.4. History of Microfinance in Ethiopia

Following the 1984/85 severe drought and famine, many NGOs started to offer micro-credit
along with their relief activities although this was on a limited scale and not in a sustained
manner. However, the microcredit sector in Ethiopia has been strictly regulated since 1996.
Following an assessment of revolving funds managed in the framework of NGO development
projects, a piece of law was promulgated to professionalize the sector by reducing imprudent
lending practices, lenient financial discipline, and distortions due to unrealistic interest rates
(Kiros, 2020).

(Habtewold, 2022) Formal microfinance in Ethiopia started in 1994/5. In particular, the Licensing
and Supervision of Microfinance Institution Proclamation of the government during 1996
encouraged the spread of Microfinance Institutions in both rural and urban areas as it authorized
them among other things, to legally accept deposits from the general public, to draw and accept
drafts, and to manage funds for the micro-financing business. Following the commencement of
formal microfinance service in Ethiopia in 1994/5, the Licensing and Supervision of
Microfinance Institution Proclamation of the government during 1996 encouraged the spread of
Microfinance Institutions in both rural and urban areas as it authorized them among other things,
to legally accept deposits from the general public (hence diversify sources of funds), to draw and
accept drafts, and to manage funds for the micro-financing business. Although the development
of microfinance institutions in Ethiopia started very recently, the industry has shown remarkable
growth in terms of outreach, particularly in the number of clients. Since the issuance of
Proclamation 40/1996, which provides the establishment of microfinance institutions, forty-one

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microfinance institutions (MFIs) have been legally registered by the National Bank of Ethiopia
(NBE) and started delivering service (www.nbe.gov.et)

2.1.5. Difference between microfinance and traditional banking services

Many microfinance institutions operate very similarly to commercial banks. They are started
with equity capital; they borrow debt typically from banks, depositors and aid organizations.
They lend as much as they can for the best terms possible amount, interest rate, payback
schedule without being beyond the risk threshold set by some combination of their board of
directors, management, and lenders of violating local banking regulations. Operationally, they
have branch offices with credit officers who have relationships with community members and
discuss the MFI’s loan products with them, also retrieving interest and principal repayments if
borrowers must in cash and lack the means to bring it to branch offices. Non-profit MFIs exist,
but they grow to be exception rather than the norm, many MFIs started as non-profit have
converted to for profits. The CEOs and CFOs of large MFIs are not that different in mindset than
managers at similarly sized banks. Below are factors differentiating MFIs from traditional
commercial banks. Specifically greater leverage than traditional banks and Lower costs of capital
relative to risks can make MFIs more lucrative than traditional banks.

a. Target market: MFIs focus on lending to unbanked low-income families. This doesn’t make
them more charitable though since they are charging these families’ higher interest rates than
comparable people in those communities with higher income and/or securable assets houses,
motorbikes, etc. Also, assets aside lower income borrowers are not necessarily much riskier for
loans proportionally sized to their incomes as long as they have steady incomes. Frequently loans
also increase family income i.e. when they used to buy inventory for a store or seed so they can
participate in the next harvest. MFI borrowers can be just as likely as their richer community
members to be diligent workers perhaps with small businesses road side restaurants or stands,
farms etc. or secure jobs in agriculture, retail, garment manufacturing, etc. and they could have
just as much drive to find new jobs as if they lose their current jobs. They could be just as
motivated to improve opportunities for their families and maintain reputation as honest,
upstanding community members.

13
b. No collateral: Whereas traditional bank lending is often secured by assets (house, motorbikes
etc., microfinance lending tends to be unsecured. Thus, the MFI does not take the borrower’s
assets if he/she fails to return the loan.

c. Greater leverage than traditional banks.

d. Lower costs of capital relative to risks.

e. Group lending: some MFIs offer group lending product. For example, 10 a person group of
community members may borrow individual loans and guarantee each other’s. Thus, they are
reflectively borrowing the loans together since if one person cannot pay back his or her loan, the
others have to pay it back or they all risk defaulting and never borrowing from the MFI again.
The benefits of this model are social pressure and communal assistance, but it has been phasing
out because in many cases the operating costs associated with its implementation make it less
profitable than individual loans.

2.1.6. The Need for Microfinance

In the development process, microfinance institutions play several roles. The need for
microfinance institutions is also enhancing in many nations. Microfinance institutions can
accomplish several roles such as financer economic choices of people, spreading household
income, making household less vulnerable to recession in the economy or individual,
smoothening income flows of the household, increase quality of life throughout the year and
strengthen the economic position of women so that they can act better control of decisions and
actions in their lives. In addition to this microfinance helps in the course of household asset
building. Microfinance also delivers savings service, permitting poor households to accumulate
safe, but flexible cash accounts to draw on when needed (Ullah, I.& Khan, M., 2017).

Microfinance institution services lead to women enablement by positively impacting women’s

decision making power at household level and their general socioeconomic status. Microfinance
institution services had touched over 79 million of the poorest of the world in the last 20000. As
such it has the capacity to make an important involvement to gender equality and promote
sustainable livelihood and better working condition for women (Gupta,& Tabassum, 2017).

The problem poorness is a rotation that continues itself. When there is lack of money, there is a
lack of basic needs such as food, water and shelter. The pain of people by famine leads them to

14
fewer likely to work. A nonexistence of healthy makes the possible of illness that inhibits
working days. A microfinance institution changes these conditions by creating more money
accessible. Families can capitalize into better wells, better sanitation, and afford the time it may
take to access the health care they need at the time of meting their basic needs. People can stay
more productive when they are safe and healthy. When better health care can be obtained, they
make them a proportional average family size since there are more assurances of existence in
their residence. And when that happens, the possibilities of future investments will occur because
there is more confidence in being able to meet basic needs (Rashid, 2018)

Microfinance is a policy to improve the life of the poor people in terms of generating income to
cover the required cost and institutions meet the demand. Micro finances help the procedure of
development by altering the situation of the poor through facilitating several services which are
essential for poor.

2.1.7. Liquidity Preference Theory

The concept was first developed by Keynes in 1936. Keynes stated that the demand for money is
expressed as a function of level of income and interest rate. MD=(Y, r) where: MD = money
demanded: Y =Level of income r = interest rate. This framework holds that the interest rate is
determined by the interaction of supply and demand of money stock. The liquidity preference
approach views interest rates from the supply and demand of the stock of money in the financial
system. According to Keynes money is demanded mainly for the following motives; transaction,
precautionary and speculative motive. Keynes further stated that investors will always prefer
short term securities to long term securities.

To encourage the investors hold long term bonds, long term securities should yield higher
interests than short term bonds. Therefore, the yield curve will always be upward sloping. It is
based on the observation that, all else being equal, people prefer to hold on to cash liquidity and
that they will demand a premium for investing in non-liquid assets such as bonds, stocks, and
real estate. The theory suggests that the premium demanded for parting with cash increases as the
term for getting the cash back increases. The study seeks to identify the rationale of the liquidity
preference theory on the relationship between the money supply in form of loans by MFIs in
times of rising and or falling lending rate and the sustainability of the lender.

15
2.1.8. The Theory of Inflation Rate

In 1930 the theory was developed and states by Fisher that an increase in the growth rate of the
money supply will result in an increase in inflation and an increase in the nominal interest rate,
which will match the increase in the inflation rate. The Theory of Interest explains the
relationship between inflation and the real and nominal interest rates. Fisher first put forward that
the relationship between interest rates and inflation is termed as the Fisher Effect. It states that
the nominal interest rate in any period is equal to the sum of the real interest rate and the
expected rate of inflation. Fisher studied that the nominal interest rate could be decomposed into
two components, a real rate plus an expected inflation rate. Fisher indicated that there exist a one
tone relationship between the inflation and interest rates in a perfect world, with real interest
rates being unrelated to the expected rate of inflation and determined entirely by the real factors
in an economy, such as the productivity of capital and investor time preference (Muchiri, 2017).

The fisher effect theory has the same conclusions with the International Fischer Effect (IFE). IFE
theory suggests that foreign currencies with relatively high interest rates will tend to depreciate
because the high nominal interest rates reflect expected rate of inflation. This theory also
proposed that changes in the inflation rate between countries will also tend to equate the
differences in their nominal interest rates. Fisher’s rate of interest is important because it
provides a basis for the idea that monetary policy should be concerned mainly with managing
inflation expectations in order to keep real interest rates at a stable level that promotes saving and
investment in the economy. However, an increase in inflation rate discourages saving and
investment (Kathomi, 2017).

2.1.9. Traditional theory of capital structure

This theory states that a high market value of assets is obtained only when the WACC (Weighted
Average Cost of Capital) is minimum only then can an optimal capital structure exists. It is
reached by consuming a combination capital that includes both equity and debt. The firm has the
opportunity to increase or decrease its leverage when the marginal cost of debt and equity are
calculated including another mix of debt and equity financing that is not calculated. According to
this theory, the value of the firm begins to increase to definite level of debt capital then remains
constant before beginning to descend if the amount of borrowing is high. Overleveraging leads to
the decrease in value of the firm after the debt’s tipping point. But a firm with no leverage will

16
have its WACC value the same as its equity financing and can deduct the WACC by an addition
debt to reach a point where the marginal cost of debt is similar to the marginal cost of equity
financing. The firm will encounter an exchange of the values of increased leverage versus the
increasing cost of debt, due to the fact that borrowing costs rise to cancel out the increased value.
Above that point additional debt will lead to an increase in the market value, which will increase
the capital cost. Therefore a combination of debt and equity financing could lead to a firm’s
optimum capital structure.

2.1.10. Loan Pricing Theory

Microfinance institution cannot always set high interest rates, e.g. trying to earn maximum
interest income. Microfinance institution should consider the problems of adverse selection and
moral hazard since it is very difficult to forecast the borrower type at the start of the banking
relationship. If banks set interest rates too high, they may induce adverse selection problems
because high-risk borrowers are willing to accept these high rates. Once these borrowers receive
the loans, they may develop moral hazard behavior or so called borrower moral hazard since they
are likely to 14 take on highly risky projects or investments. From the reasoning of Stiglitz and
Weiss, it is usual that in some cases we may not find that the interest rate set by Microfinance
institution is commensurate with the risk of the borrowers (Mhlanga, 2021).

2.1.11. Theory of Multiple-Lending

According to these theories, when all other factors are equal, there will be fewer borrowing
relationships for tiny, high-quality, information opaque and constrained enterprises. According to
the research, banks should be less likely to participate in loan syndication when there are strong
equity markets present and following a process consolidation. MFIs' lending capacities are
increased by both outside equity and mergers and acquisitions, which lessens their requirement
for increased diversity and oversight through share lending (Olusanya, 2012)

2.1.12. Challenges of Microfinance Institutions in Ethiopia

The stated below are some challenges faced by MFIs. Internal challenges such as deficiency of
loan able funds for additional enlargement, high turnover of employees, lowly customer
treatment, poor documentation, poor management system, not use computerized system, no
training given by the microfinance institutions, the institutions couldn’t assume the customer

17
objections and don’t take corrective decisions; and external challenges such as high credit risk
due to poor loan repayment, high competition with conventional banks and improper interference
of third party in the decision of loan approval. Restricted in product development and inventions
due to the regulatory framework affecting the kind and development products; the owner (mother
NGO, government or shareholders) not clear defining the products; lack of competition; high risk
and high cost developing new products; and limited capacity of the institutions to develop
financial products (Francis, 2022)

According to Geographic factors are the challenges faced by MFIs. Most MFIs approve that the
environmental factors make it hard to connect with customers of far areas which create a
problem in growth and expansion of the organization. The other difficulties for MFIs are
different business models. Assisting the very wide variety of attributes and lending activities is
difficult and necessitates a considerable amount of cost and efforts. In addition, high transaction
cost is a big challenge for microfinance institutions. The size of transactions is very small, while
the fixed cost of those transactions is very high. Rural agriculture related constraints due to
seasonality environment of the agricultural loans are creating stresses on the markets; lack of
well-developed small, medium or large scale irrigation practices. In addition, major challenges
that affect microfinance institutions are default risk inherited from borrowers, insufficient donor
funding and lack of understanding of the definition and concept of microfinance institutions by
the client (Mtawali, 2018)

2.1.13. Determinants of MFI’s Profitability.

i. Size of Microfinance

Another factor that can affect the financial performance of an MFI is its size. The size of an MFI
is measured by the value of its assets (Hermes etal., 2008). According to Cull etal. (2007), the
size of an MFI is significantly positively linked to its financial performance. This variable is
included to capture the economies or diseconomies of scale.

There is consensus in academic literature that economies of scale and synergies arise up to a
certain level of size. Beyond that level, financial organizations become too complex to manage
and diseconomies of scale arise. Total asset of MFIs is used as a proxy of size. It is argued that
failure to become profitable in microfinance is partly due to lack of economies of scale Muriu
(2011). This implies that profitable MFIs in Cameroon have a greater control of the domestic
18
market, and therefore lending rates may remain high while deposit rates remain lower since
larger MFIs may be perceived to be safer, therefore this high interest rate spread translates to and
sustains higher profits margins. Cull etal. (2007) point out that the size of MFIs and financial
performance are significantly related but loan size is negatively related to financial performance.
This means that controlling for other relevant factors; institutions that make smaller loans are not
necessarily less profitable. But the result showed that larger loan sizes are associated with lower
average costs for both individual-based lenders and solidarity group lenders. Since larger loan
size is often taken to imply less outreach to the poor, the result could have negative implications.

viii. Credit Risk management

Credit risk is one of the factors that affect the health of an individual bank. The extent of the
credit risk depends on the quality of assets held by an individual bank. The quality of assets held
by a bank depends on exposure to specific risks, trends in non-performing loans, and the health
and profitability of bank borrowers (Baral, 2005). Credit risk indicator can be represented by
different measurements including loans loss provision to total loans ratio as well as growth in
bank deposits. Higher provisions for loan losses could signals a possibility of future loss on
loans, and could also be a sign of a timely recognition of bad loan by cautious banks
(Munyambonera, 2011). A higher ratio of nonperforming loans to total loans and an absolute
deterioration of credit portfolio quality negatively affect commercial bank’s profitability (Roman
and Tomuleasa, 2013). The study of Dietrich et al. (2011) on the performance of banks in
Switzerland is particularly interesting because the authors study the impact of many variables on
the performance of both pre crisis and during the crisis. Sometimes they notice changes in these
impacts with the arrival of the crisis, and this is especially the case for credit quality.

iii. Capital adequacy

Capital to asset ratio is a measure of solvency of MFIs. This ratio supports MFIs assess their
ability to achieve their obligations and absorb unexpected loss. An acceptable capital to asset
ratio level of determination is generally based on an assessment of microfinance institution
expected losses as well as its financial strength and ability to absorb such losses. The expected
losses of microfinance institutions have to generally be covered through provisioning by the
accounting policies, which eliminates expected losses from both assets and equity. According to

19
the amount of capital needed to cover additional unexpected losses is measured by the ratio to
substantiate that the MFI is well capitalized for potential shocks (Berassa, 2018)

A studied on determinants of profitability of MFIs employing a panel data set of 210

microfinance institutions; he revealed that capital adequacy had robust and significant positive
association with MFI profitability. It was described by the comparatively high coefficient of the
equity to assets ratio through the specifications. The influence remains the same even after the
inclusion of the outside indicators. Intuitively, it had been a sign that well capitalized MFIs are
further flexible in dealing with problems ascending from unexpected losses and witnessed a
reduced cost of funding or lower external funding, found a positive impact of capital ratio on the
financial performance of MFI measured by the ratio of operational self-sufficiency (Remer, &
Kattilakoski, 2021)

ix. Liquidity ratio

Liquidity can be referred to as a state in which an asset can be readily converted into cash. A
bank may be solvent by having enough assets to cover its liabilities but may remain illiquid. This
may be due to a mismatch between its assets and liabilities. This occurred due to the fact that
banks transform the customers deposit to long term loans and advances. Thus, the transformation
function and the demands by customers in terms of withdrawals from their deposits have to be
met instantaneously. Commercial banks, therefore, have to stock reasonable quantity of cash to
meet their customer’s demands. Because, bank’s ability to grant loans and advances is checked
by the available cash in its vault and indeed, a commercial bank cannot afford to grant loans and
advances in excess of its cashing ability. Therefore, the issue of liquidity in bank operations also
affects the lending of commercial banks. Consequently, liquidity ratio is seen as an important
variable in determining the supply of loans and advances (Tsegaye, 2022).

x. Interest Rate

Bank lending rates are mostly seen as being rigid for the reason that they do not move in tandem
with the markets. A number of explanations have been suggested to account for the rigidity in
bank lending rates. In the case of loans, the rigidity has been as a result of the rationing of credit
to borrowers owing to the fact that there are problems of asymmetric information Blinder and
Stieglitz. Indeed, financial markets are not perfect; in the presence of adverse selection and moral
hazard issues, banks are more likely to opt for credit rationing than to adjust their lending rates in

20
a situation where there has been an upward adjustment of interest rates by the central bank. It
may also be possible that when large banks capture large market share, the impact of tight
monetary policy on bank lending will be minimal. However, Berger and Udall could not find
concrete support for the rationing of credit as a reason for the rigidity of lending rate. Therefore,
if central bank reduces the rate, banks become reluctant to provide loan to firms and vice versa.
This variable is expected to have a negative relationship with commercial banks’ lending
(Yitayaw, 2021)

xi. Inflation rate

Another important external condition which may affect both the costs and revenues of MFIs is
the inflation rate. High inflation is related with higher costs as well as higher income. According
to inflation can hamper the microfinance lending mission and may also effect on microfinance
cost of funds and borrowers’ incentives for defaults. The study used annual inflation rate to
express the inflation for microfinance institutions. (Jensen, 2018).

The other study undertaken by in the banking industry that is determinants of profitability in
commercial banks also show that high inflation rate is associated with higher costs as well as
higher income. If a bank’s revenue increases more quickly than its costs, inflation is expected to
exert a positive effect on profitability. On the other hand, if its costs increase faster than its
revenue a negative coefficient is expected on profitability (Tewodros & Gedion, 2019).

xii. Exchange Rate

The Exchange Rate Parity theory was first developed by Stephen Ross in 1976. The theory states
that exchange rate differentials between two different countries will be reflected in the premium
or discount for the forward rate on the foreign currency. The theory of exchange rate parity,
relates to the difference between foreign and domestic exchange rates with the difference in spot
and future rates. This parity condition states that the domestic exchange rate should equal the
foreign exchange rate plus the expected change of the rates. The exchange rate differential
between domestic country and world is equal to the expected change in the domestic rate. The
theory further states that the size of the forward premium or discount on a foreign currency
should be equal to the exchange rate differentials between the countries in comparison. However
an increase in exchange rate implies a decrease in general investment. If investors are risk-

21
neutral and have rational expectations, the future exchange rate should perfectly adjust given the
present rate differential ( Lambe & Salifa, 2019).

xiii. Age.

Examining the relation between firm age and financial performance would seem to be relevant
for both theory and practice. If performance declines as firms grow older, it could explain why
most of them are eventually taken over (Loderer, Neusser, and Waelchli, 2009).Age could
actually help firms become more efficient. However, old age may also make knowledge,
abilities, and skills obsolete and induce organizational decay (Agarwal and Gort, 2002).
Sorensen & Stuart (2000) argued that companies age affect the firm’s performance. They further
argued that organizational inertia operating in old firms tend to make them inflexible and unable
to appreciate changes in the environment. Liargovas and Skandalis (2008) reported that older
firms are more skilled since they have enjoyed the benefits of learning and not prone to the
liabilities of newness, hence they have a superior performance. Loderer et al, (2009) found a
positive and significant relationship between the age of a company and profitability. Malik
(2011) in his Pakistan study found that there is significantly positive relationship between
company size and profitability.

2.1.14. Financial services of microfinance institutions

A. Credit services

The best common credit services in MFIs are microcredit and micro leasing. Micro credits are
loans of small size that can help poor to escape their Micro leasing is a low value contract with
which one party of MFI the lessor, in exchange for the payment of a regular installment,
concedes to another party of customer the lessee the use of equipment, however the ownership of
the asset remains to the lessor of MFI. Low income clients are usually unable to find the tool and
therefore MFIs allow them to obtain the availability of the asset without having to tie up capital
equal to the whole leased asset. Credit facility can be used in different ways such as source of
meeting consumption needs, source of short term working capital, and source of long term
investment capital (Abbas, 2020)

B. Saving’s services

22
Almost all poor need to save in order to protect themselves against periods of low income or
specific emergencies and to store the value of excess income for future investments. There are
two broad forms for which MFIs collect savings, compulsory savings and voluntary
savings .Obligatory saving products comprise of methods of mandatory saving, which indicate
that some percentage of the provided loan is detained back and placed in a fund that acts as a
guarantee. The customers can assess the amount at the end of the loan cycle. Nevertheless, the
low income people normally choose charitable saving products. These are volunteer ways of
saving gathering that permit the investor to deposit and withdraw, with varying frequency and
expiry dates, according to the products‟ liquidity. Hence micro saving deposits provide facilities
for safe keeping of savings, consumption smoothing emergencies and accumulation of resources
as well as self-financing of investments (Nguyen, 2020)

C. Insurance services

Micro insurance products drawn up to reduce doubt and its effects represent an important tool in
microfinance. The micro insurance services include specialized insurance services such as life,
health, accident or livestock insurance and non-specialized facilities that deliver social safeguard
through available to a client’s savings or credit in cases of emergency for risk management,
social security and loan protection. This kind of delivering financial service is not common in
Tanzania. Payment services

This is the service that allows poor to transfer money through secure channels. So far, MFIs that
give payment services are not numerous since of the difficulty of the infrastructure and the
technology that payment system require. This payment service in mainly used by banks which
force MFIs to use affiliated banks to transfer money. In this circumstance, MFIs should develop
good relationship and partnership with banks (Ayenew, 2019)

2.2. Empirical Literature Review

Various studies have been conducted on determinants of commercial bank lending in many
countries around the world. Most of the studies consider internal and external factors of
commercial banks’ lending by focusing on demand side.

For instance (Bhattarai, 2019) has studied the determinants of commercial banks’ lending in the
Ethiopian using panel data of eight banks. The finding of the study indicate that banks size,

23
credit risk, GDP growth and liquidity ratios have a significant effect on commercial banks’
lending. Whereas, volume of deposit, investments portfolios, cash reserve requirements and
interest rates has insignificant effect on commercial banks’ lending activities.

According to (Ayieyo, 2016) has examined the effects of interest rates, lending and collateral
requirement in the loan decision making. From the study it has been observed that commercial
banks have to give strong attention to their loan pricing strategy since they cannot charge price
too low since low interest rates may not be sufficient to cover the cost of deposits, administrative
expenses and losses arising from NPL. Besides, charging very high lending interest rate might
also lead to the problem of adverse selection and moral hazard.

(Amano, 2014), Studied the determinants of commercial banks’ lending behavior in the Ethiopian
Using panel data regression analysis. The study aimed to test the determinants of commercial
banks’ lending behavior and how it affects the lending behavior of commercial banks in
Ethiopia. The results of the study indicate that bank size, volume of deposit, cash reserve
requirement and Inflation rate had positive and significant effect on commercial banks ‘lending,
Whereas interest rate and Liquidity ratio had significant effect on commercial banks’ lending
negatively.

(Zelalem, 2019), has investigated the determinants of commercial banks’ lending in the Ethiopian.
The results of the study indicate that, commercial banks’ lending in Ethiopian is positively
influenced by bank size, volume of deposit and GDP growth, whereas cash reserve requirement
and liquidity ratio affects negatively. On the other hand, Average lending interest rate, credit
risk, and inflation do not significantly effect on Ethiopian commercial banks’ lending.

(Dereje, 2018), has investigated the determinants of commercial banks’ lending in the private
commercial banks in Ethiopia. The regression result concluded that bank size, investment
portfolio, volume of deposit, liquidity ratio, GDP, inflation rate and exchange rate were
significant in determining lending decision of private commercial banks Ethiopian, on the other
hand asset quality and cash reserve requirement ratio was not significant at all.

(Taye, 2020) studied the determinants of private commercial banks’ lending and conclude that
capital adequacy ratio, volume of deposit and return on asset has positive and significant effect
on the bank’s lending, on the other hand, lending interest rate has positive but insignificant effect
on banks’ lending.

24
(Abay, 2021) studied the determinants of lending decision of private commercial banks in Ethiopia
credit risk, cash reserve requirement rate and liquidity ratio has. Negative and significant effect
on the lending decision, besides Liquidity ratio found to have negative and significant
relationship with the lending of private commercial banks in Ethiopia.

2.3. Research Gap

The MFIs profitability can be affected by different factors such as internal and external factors
while this study is focused on some of the internal and external factors affecting of microfinance
institution profitability in Ethiopia. Most of the literature reviewed in this study focused on the
developed countries‟ banking sector and microfinance institution. Although such types of
research were done in developing countries limited literatures were available for this research.
To the knowledge of the researcher there is no empirical studies done regarding to determinants
microfinance institution profitability in Ethiopia and previous related studied focused. Since the
banking industry is in the growth stage with opening of new banks and the absence of active
secondary stock exchange in the country, it is important to notify the important determinants of
MFIs’ profitability by making empirical investigation to already established MFIs. Therefore,
this study filled the gap by giving more emphasis on the size, credit risk management, collateral,
capital adequacy, liquidity, Interest rate, inflation and exchange rate have a great impact on the
profitability of the microfinance institutions that have statistically significant.

2.4. Conceptual Framework

Independent Variables

Internal factors
Size of microfinance
Credit risk management Dependent variables
 Age
liquidity
Interest rate PROFITABILITY

External factors
Inflation
Exchange rate
Source: constructed by the researcher from different literature

Figure 2.1 Conceptual framework

25
 CHAPTER THREE

3. RESEARCH METHODOLOGY

This chapter presents the research design, research approach, study population and sampling
techniques, methods of data collection and techniques of data analysis

3.1 Research design

Research designs are plans and the procedures for research that span the decisions from broad
assumptions to detailed methods of data collection and analysis (Creswell, 2013); there are
descriptive research design and explanatory research design. Descriptive research design aims to
provide an accurate and valid representation of variables that are relevant to the research
question. Therefore, given the nature of the problem and the research perspective, this study
employed an explanatory research design to achieve the goal stated in the preceding section. To
achieve this objective the study adopted an explanatory research design to examine the cause and
effect relationships between the independent and dependent variables. In this study the
explanatory research design is employed to examine the relationship of the stated variables.
Hence, study uses explanatory research design using panel research design so as to achieve
stated objectives of study. The reason of selecting panel data is that the data consists both time
and cross sectional data for which single time series and cross sectional data cannot provide,
besides, it controls for individual heterogeneity effect, less co linearity variables and tracks
trends in the data. In explanatory research design, the main aim is to identify any causal links
between the factors or variables that pertain to the research problem. Since the main objective of
this study will be to examine the cause and effect relationship between the determinants of
profitability i.e. Size of microfinance, Credit risk management, Age, capital adequacy, liquidity,
Interest rate, inflation and exchange rate. So, the explanatory and descriptive research design will
be employed for this study.

3.2. Research Approach

According to (Cresswell, 2014), there are three approaches to research; those are qualitative,
quantitative, and mixed approaches.

26
A qualitative research approach is an approach used for exploring and understanding the
meaning individuals or groups ascribe to a social or human problem. The process of research
involves emerging questions and procedures, data typically collected in the participant’s setting,
data analysis inductively building from particulars to general themes, and the researcher making
interpretations of the meaning of the data. The final written report has a flexible structure. Those
who engage in this form of inquiry support a way of looking at research that honors an inductive
style, a focus on individual meaning, and the importance of rendering the complexity of a
situation. In this approach, the researcher's intention is theory development, by analyzing the
situation from particular to general activities (Cresswell, 2014).

A quantitative research approach is an approach for testing theories by examining the

relationship among variables. These variables can be measured, typically on instruments, so that
numbered data can be analyzed using statistical procedures. The final written report has a set
structure consisting of an introduction, literature, theory, methods, results, and discussion. Unlike
qualitative researchers, the ones who engage in this form of approach have assumptions about
testing theories deductively, building in protections against bias, controlling for alternative
explanations, and being able to generalize and replicate the findings. It is also called the theory
testing approaches, instead of the theory developing approach (Cresswell, 2014).

The mixed methods research approach is an approach to an inquiry involving the collection of
both quantitative and qualitative data, integrating both two forms of data, and using unique
designs that may involve philosophical assumptions and theoretical frameworks. The core
concept of this form of inquiry is that the combination of the two approaches that are qualitative
and quantitative gives the best and most complete understanding of a research problem than
either approach alone

In order to achieve the objectives of this study and thereby to give answer to its problems,
quantitative research approach will be used by the researcher for the sake of appropriateness. By
using such research approach, the researcher will be able to establish a cause-effect relationship
between the independent and dependent variables of the study.

27
3.3. Research methods

3.3.1 Target population

The target populations for this particular study are all audited microfinance institutions currently
operating in the country. According to the recently recorded data extracted from the NBE
website, 41 microfinance institutions are operating in the country by the end of 2023 which are
providing a microfinance service to the poor society in Ethiopia on the current period.

3.3.2 Sample size and Sample Technique

For this study, it is found appropriate to use a purposive sampling technique from which 21
microfinance institutions, which are can provide sufficient for panel data set and the length of
time in this study has eleventh year from (2013-2023)financial statements that are working in
Ethiopia are selecting. According to (Kothari, 2004), purposive sampling involves selecting
people who fit the criteria of desirable participants based on their experience or knowledge. In
other words, it is a sampling technique the researcher consciously decides who to include in the
sample.

The researcher considered 21 microfinance institutions out of the total population of Ethiopian
MFIs. Hence, the data included in the study is the 21 MFIs' 11-years data, which will be audited
from the year 2013 to 2023. Therefore, this provides a total of 221 (21MFIs * 11 years)
observations. The sample size is chosen purposively from the whole population based on the
availability of complete 11 years of data beginning in 2013. In addition to the eleventh-year data
availability criteria, the researcher wants to analyze recent data. Because most MFIs did not
submit their 2023 reports to the national bank or AEMFI, and because most MFIs' reports
contained missing numbers, the sample used for this study consisted of only 21 MFIs with
complete data from 2013 to 2023. Thus, from the total population of all the microfinance
institutions in Ethiopia, sample size of this study is 21 microfinances, which is 51% (21/41) of
the total MFIs based on the availability of the audited financial data.

Table 3.1 List of sample of MFIs in Ethiopia included in the study.

No Name of MFI Date of Establishment:
1 Addis credit and saving institution S.Co 09/04/97
2 African Microfinance Institution S.Co 17/06/98

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3 Aggar Microfinance Institution S.Co 29/10/04
4 Benishangul Microfinance Institution S.Co 09/04/9
5 Digaf Microfinance Institution S.Co 28/07/05
6 Dire Microfinance Institution S.Co 02/05/03
7 Dynamic Microfinance Institution S.Co 12/05/09
8 ESHET Microfinance Institution S.Co 09/04/97
9 Gambella Microfinance Institution S.Co 18/12/08
10 Gasha Microfinance Institution S.Co 15/05/98
11 Harbu Microfinance Institution S.Co 09/04/97
12 Kandil Microfinance Institution S.Co 07/02/01
13 Mekelit Microfinance Institution S.Co 16/02/00
14 Metemamen Microfinance Institution S.Co 09/04/97
15 One Microfinance Institution S.Co 29/10/04
16 Peace Microfinance Institution S.Co 18/11/99
17 Specialized Microfinance Institution S.Co 25/11/97
18 Somalia Microfinance Institution S.Co 31/01/11
19 Tefta Microfinance Institution S.Co 03/01/08
20 Vision Found Microfinance Institution S.Co 17/06/98
21 Wasasa Microfinance Institution S.Co 09/04/97

Source:-Website of the National Bank of Ethiopia

3.3.3 Data type and Source

The data using for this study is purely secondary data that taken from the national bank of
Ethiopia. Although, there are 41 MFIs in Ethiopia, only 21 audited MFIs are considered in this
research study in order to get the reliable and valid data. Accordingly, financial data for twenty
one MFIs and ten years for the period of 2013-2023 are collecting from the NBE.

3.3.4 Methods of Data Analysis

The study will be used secondary data of audited financial statements of sampled microfinance
institutions ten consecutive years which will been collecting from National Bank of Ethiopia and

29
website of the selected MFIs. After the data are edited in the appropriate form the study are run
by using STATA package14 software to be able to interpret and analyze. The data used panel
data from 2013-2023 which contains both a cross sectional and time series. Different diagnostic
tests like, hetroscedasticity, multicollinearity, normality and autocorrelation will be carried out
for the purpose of the adopted model

3.4. Model Specification

In order to test the hypotheses of the study multiple regression models is formulated. In this
research, the general multiple linear regression model is adopted to examine the relationship
between the dependent variable of the study is loan and advances whereas explanatory variables
methods of lending, loan period, collateral, capital adequacy, liquidity, Interest rate, inflation and
exchange rate on MFI lending decision. The regression model is stated as shown on the equation
below.

LOA=f (CAR, LIR, LR, LRP, CO, IN, EXR, MOL) _________________________ (1)

The model applied for this study becomes

LOAit = α0 + β1CAR + β2LIR + β3In + β4EXR + β5Ag + β6LRP + β7IN +Β8ExrL +µ________________ (2)

Where;

α = Intercept of the regression line β1, β2, β3, β4, β5, β6, β7, β8 = are coefficient of each
explanatory variables.

µ= error term

ROA: Rate of MFI

CAR: Capital Adequacy ratio of MFI

LR: Liquidity Ratio of MFI of

ExR: Exchange rate of MFI

LRP: Size of MFI

Ag: Age

CO: Credit risk management

30
IN: Inflation of MFI

In: Interest rate.

Accordingly, descriptive and regression results of the variables are presented in a tabular form in
the discussion and analysis chapter, as generated from STATA 14 software, and the required
interpretation for the statistical results is given. Moreover, based on the Classical Linear
Regression Model (CLRM) assumptions, the most widely used diagnostic tests, like normality,
autocorrelation, multicollinearity, and heteroscedasticity tests are conducting to attest the model
used in the study fulfilled the required assumptions.

3.5. Definition and Measurement of Variables

This section explains the variables used as dependent and independent explanatory variables in
this study. The definitions and measurements used for these variables are described in the
following.

3.5.1. Dependent Variables

The dependent variables in this section are the factors affecting of microfinance institution
profitability.

It is particularly assumed that to decrease poverty by getting higher their outreach, MFIs should
be profitable. The existing literatures give details about profitability of a financial intermediary
as the return on assets (ROA) or the return on equity (ROE). This is measured and/or expressed
as a function of internal as well as external factors. Those factors which are influenced by
management decisions or within the direct control of firm management are called internal
factors. Such factors include firm size, capital adequacy, credit risk provisioning and efficiency
in the management of operating expenses. The external determinants which cannot be directly
influenced by the firm's internal management (out of the control of the firm’s management)
include macroeconomic and industry specific factors which reflect the economic, legal and
business frame works surrounded by the financial institutions function.

3.5.2. Independent Variable

The independent variables used to determine the factors affecting the MFIs profitability in
Ethiopia are methods of Size of microfinance, credit risk management, Age, capital adequacy,

31
liquidity, Interest rate, inflation and exchange rate. The following presents the definition and
measurements of the independent variables used for this study.

I. Capital adequacy

According to lending activity is made possible only if the banks can mobilize enough funds from
their customers. Since commercial banks depend on depositor’s money as a source of funds, it
means that there are some relationships between the ability of the banks to mobilize deposits and
the amount of credit granted to the customers. As total deposit increases the total advance and
loan increases proportionally. An increase in deposit of a bank is likely to improve its ability to
lend more funds to its customers. Lending and deposits move together because faster deposit
growth signals growing demand for loans. We expect a positive relationship (Mukhanyi, 2016)

Paid up capital
Capital adequacy ratio =
Total assets

H5: Capital Adequacy Ratio has positive effect on MFIs‟ loan and advance

II. Interest rate

This is measured as the difference between interest charged on loans advanced and interest
charged on deposits (Mwita, 2019). A decline in the interest rate spread therefore lowers the total
lending and advances through decreased supply from the lending institutions. We expect to have
a positive effect on the total loans advanced by commercial banks.

H6: Interest rate has negative effect on MFIs‟ loans and advances

III. Collateral

Collateral refers to security provided by a borrower to offset the apparent weaknesses of a loan.
Collateral should be considered as a protection rather than as a source of repayment. As
mentioned earlier, when a lending customer run into difficulties, a banker should not try to seek
its collateral in the first place but instead should try to help the customer through a restructuring,
percentage change of the average consumer cost in acquiring a basket of goods and services over
the interval time (Haile, 2021).

IV. Size of microfinance

32
The size of an MFI is measured by the value of its assets (Hermes etal., 2008). According to Cull
etal. (2007), the size of an MFI is significantly positively linked to its financial performance.
This variable is included to capture the economies or diseconomies of scale.

There is consensus in academic literature that economies of scale and synergies arise up to a
certain level of size. Beyond that level, financial organizations become too complex to manage
and diseconomies of scale arise. Total asset of MFIs is used as a proxy of size. It is argued that
failure to become profitable in microfinance is partly due to lack of economies of scale Muriu
(2011). This implies that profitable MFIs in Cameroon have a greater control of the domestic
market, and therefore lending rates may remain high while deposit rates remain lower since
larger MFIs may be perceived to be safer, therefore this high interest rate spread translates to and
sustains higher profits margins.

IV. Liquidity

Liquidity ratios are a set of ratios or figures that measure a company's ability to pay off its short-
term debt obligations. This is done by measuring a company's liquid assets including those that
might easily be converted into cash against its short-term liabilities. There are some different
liquidity ratios, which each measure slightly different types of assets when calculating the ratio.
The greater the coverage of liquid assets to short-term liabilities, the more likely it is that a
business will be able to pay debts as they become due while still funding ongoing operations.
The computation is liquidity ratio is a current asset over short-term liability (AEMFI, 2021).

Current Assets
V. Liquidity =
Current liabilities

H3: Liquidity ratio has positive effect on banks‟ loan and advance

VI. Inflation

The dictionary of economics said “inflation is measured by the proportional changes over time in
some appropriate price index, commonly a consumer price index or a GDP deflator” inflation
occurs when the general price level is rising. As it is defined in the world development indicator
the calculation of inflation is measured by the consumer price index which indicates the annual.

33
 VII. Exchange Rate

Prevailing exchange rate is another macroeconomic factor that influences lending behavior of
microfinance institution. Evidences obtained from accessible literatures on the area suggest that
change in exchange rate is another macroeconomic factor that influences the determinants of
lending decision of microfinance institution in Ethiopia. If MFIs are exposed to short term
liabilities in foreign currencies, then such liabilities will be amplified to the tune of the extent of
depreciation of the local currency and any other associated costs, thus, dampening their potential
to create lending. This is similar with the idea of who that exchange rate depreciation will affect
MFI lending behavior in a developing and open economy.

34
 CHAPTER FOUR

DISSCUSION AND ANALYSIS

This chapter consists of two main sections, namely descriptive statistics and econometric
analysis results. In the first section, descriptive statistical results and the econometric analysis
section, on the other hand, focused on the analysis of data using econometric software model
results for determinants of micro finance institution profitability in Ethiopia.

4.1. Descriptive Statistics Result

Table 4.1 below presents a summary of the data used in the study and provides statistical
descriptions such as: mean, standard deviation, maximum, and minimum of the variables
considered in this study. Then, this was generated to give overall description about data used in
the model.

ROA infl exc size credit age liquidit Interest

y rate
Mean 0.1584 17.129 29.592 19.958 23.354 12.761 0.4571 21.698
Maximum 0.5062 34.04 51.543 25.404 25.278 22 0.8049 24.542
Minimum -0.0709 7.39 18.941 2 20.811 4 0.2278 18.589
Std. Dev. 0.1317 9.718 11.316 2.9421 3.8616 0.1316 1.3633
Observati 231 231 231 231 231 231 231 231
ons

Source: Author’s own computation by STATA on available data (2024)

As it is shown above table, profitability of Ethiopian MFIs measured in terms of ROA for the
total 231 observations during the study period (2013-2023), with a maximum value of 50.6% and
a minimum of -7.09%. This indicates the profitable MFIs earned 50.6 cents of profit after tax for
a single Birr investment they made on total asset. On the other hand, not profitable MFIs lost 7
cents from profit for 1Birr investment made on total assets of the firm. The standard deviation
statistics for ROA was 0.1317 indicating that the profit variation between the selected micro
finance institutions was slightly lower compared to other variables. The overall statistical result

35
for ROA implies the MFIs in Ethiopia need to efficiently utilize their assets to increase their
profitability.

The second columns of the above table 4.1 reveals that inflation rate that measured consumer
price index was during the study years 2013-2023 the mean 17.1291 and the standard deviation
of the variable is 9.7184 as well as the maximum and minimum inflation rate of Ethiopia during
2013-2023 was 34.04001 and 7.3905 respectively. The country has is also characterized high
inflation rate difference among the years of study.

The fourth columns of the above table shows that size of macro finance institution during in
study years for the mean of 19.958 and the standard deviation of variable is 2.9421, and the
maximum and minimum of size for 231 observations are 25.4036 and 2, in Ethiopian MFI
respectively. The country has is also characterized by a high size difference among them.

4.2.1 Trends of ROA, inflation and exchange rate of Ethiopia during (2013-2023).

The trends of ROA, inflation and exchange rate in selected micro finance institutions were
reported in figures 4.1, 4.2, and 4.3, respectively. As can be seen in Figure 4.1, the ROA selected
MFI across periods is negligible in terms of ROA. If we look at the last time span considered, on
average previous period.
Figure 4.1: Trends of ROA selected MFI in Ethiopia (2013-2023)

ROA
0.175
0.17
0.165
0.16
0.155
0.15 Series1
0.145
0.14
0.135
0.13
1 2 3 4 5 6 7 8 9 10 11

Source: Author’s own computation

36
From the above figure which displays the trends of ROA selected MFI in Ethiopian countries,
there are the values of ROA on the Y-axis and the X-axis year of the series starting from 2013 to
2023. The code of micro finance institutions and which country it represented were reported in
Appendix (1).

4.2.2 Trends of inflation rate Ethiopian economy in (2013-2023)

The trends of inflation and in selected micro finance institutions in Ethiopia were reported in
below figures 4.2. As can be seen inflation rate was measured consumer price index across
periods is negligible.

Figure 4.1: Trends of inflation in Ethiopia (2013-2023)

40
35
30
25
20
Series1
15
10
5
0
1 2 3 4 5 6 7 8 9 10 11

Source: Author’s own computation

From the above figure which displays the trends of inflation in Ethiopian economy, there are the
values of inflation on the Y-axis and the X-axis year of the series starting from 2013 to 2023.
The code of micro finance institutions and which country it represented were reported in
Appendix (1).

4.3 Econometric Analysis

It is clear that the objective of this study is to identify the internal and external determinants of
profitability of micro finance institutions in Ethiopia. The secondary data for the analysis
purpose are collected through structured documentary review from performance analysis report
published by NBE and MFIs. Then before analysis econometric Diagnostic Test like correlation
analysis, Homogeneity Test, Heteroskedasticity, Normality Test and multicollinarity analysis. As

37
it is mentioned in methodology part, diagnostic tests were carried out to confirm that the data fits
the basic panel data model. Hence, the results for model misspecification tests are presented as
follows:

4.4.1 Test for Hetroscedasticity

The heteroskedasticity test is used to ensure that the standard errors are not wrong and that any
inferences made are not misleading or deceptive. It is assumed that the variance of errors is
constant, which means the errors are homoscedastic. In this case, the null hypothesis is that the
error terms are homoscedastic. Therefore, the Breusch Pagan-Godfrey test has been made to
ensure the presence of heteroskedasticity.
Hypothesis; H0: error variances are all equal H1: The error variances are multiplicative of
functions of one or more variables. Based on the Table below the p-value of both F-statistic and
χ2 test statistics and the p-value of scaled explained SS must be greater than 0.05 to reject the
null hypothesis of heteroskedasticity.
Table 4. Heteroskedasticity Tests: Breusch-Pagan-Godfrey
F-statistic 1.3241 Pro. F(8,32) 0.2673
Obs*R-squared 10.1665 Pro. Chi-Square(8) 0.2515
Scaled explained SS 3.5316 Pro. Chi-Square(8) 0.8967
Source: Author’s own computation via E-views 8.1
4.4.2 Test for Autocorrelation
To identify determinants or Ethiopian micro finance profitability 231(11*21) observations were
used in the model. The study tested the autocorrelation assumptions that imply zero covariance
or error terms. That means errors associated with one observation are uncorrelated with the
errors of any other observation. Since the null hypothesis (Ho) is that the residuals are serially
uncorrelated, the Fstatistic p-value of 0.3598 indicates that we will fail to reject this null
hypothesis from So we conclude that residuals are serially uncorrelated or it specifies that we no
longer have a problem with serial correlation.

Source: Author’s own computation via E-views 8.1

38
4.4.3 Test for normality

The normality test for this study is shown in figure below. If the residuals are normally
distributed, the histogram should be bell-shaped and the Bera-Jarque statistic would not be
significant meaning disturbance to be normally distributed around the mean. This means that the
p-value given at the bottom of the normality test screen should be bigger than 0.05 to not reject
the null of normality at the 5% level
4.4.4 Test for Multicollinearity

An implicit assumption that is made when using the panel LS estimation method is that the
explanatory variables (independent variable) are not correlated with one another. If there is no
relationship between the explanatory variables (independent variable), they would be said to be
orthogonal to one another. If the explanatory variables were orthogonal to one another, adding or
removing a variable from a regression equation would not cause the values of the coefficients on
the other variables to change (Brooks, 2008). According to Gujarati, (2004) multicollinearity
could only be a problem if the pair-wise correlation coefficient among regressors is above 0.90
(Hailer et al, 2006) cited in Birhanu, (2012) which is not more or less the case in the study
variables.

Figure 4: Correlation matrixes of independent variables

Source: Author’s own computation

39
4.5 Result of Regression Analysis
The key factor to consider when determining between a random effect model and a fixed effect
model is whether it is reasonable to assume that the unobserved effect α, is un- correlated with
all of the explanatory variables (Wooldridge, 2008:2009). Elaborating the argument we find it
unlikely that this is the case. Potential correlation might be found in differing regulation
standards in terms of capital flow in and out of the observed countries, where this could affect
the availability to credit thus limiting the MFIs ability to leverage their business. Consequently,
higher leverage among MFIs might in part be attributed to less restrictive capital control. The
fixed effect model allows correlation between α, and the explanatory variable for any t which
eliminates the possibility to include any time constant variable (ibid). Consequently the legal
status dummy indicating institution type will be omitted in the fixed effect model as it does not
vary over the observed period. Whereas this opportunity is still possible under a random effect
model we do not find it reasonable to assume there is no correlation between the time-constant
unobserved effect and the entire explanatory variable. Therefore, we assume the fixed effects
model to be better suited for this study.
Therefore, the regression results of fixed effect model that was made to examine the
determinants of profitability or MFIs in Ethiopia.
Table 4. 6 Regression Results

Source: Author’s own computation

40
Thus, the model used to examine the determinants of profitability of MFIs in Ethiopia in this
study was:
ROAit=β0+β1SIZ+ β2 LIQ+ β3INT+ β4INFL+B5EXCH+B6CRED+B7AGE+ ɛit

Size of the institution: from the above table 4.4 reveal that coefficient of the size of the
selected microfinance the institution, the coefficient was negative (-0.009487) and was statically
insignificant level (P-value of 0.1490). The result is opposite with Sima (2013) and similar to
Melkamu (2012), Muriu (2011), Fikremariam (2015), Letenah (2009) and Cull et al. (2007).
Accordingly, the hypothesis which says, there is a significant positive effect between size and
profitability of MFIs is rejected. Off course, the real practice in Ethiopia shows that the large
MFIs constitute the largest portion of the market share from the industry; this study found that
size was not a key determinant of profitability of Ethiopian MFIs.

Inflation The other macroeconomic factor included in the study was inflation as measured with
consumer price index. Had a positive coefficient of (0.054297) and it was statistically significant
at 5% significance level (P-value of 0.0245). Inflation depicting that during the study period of
2004-2016 inflation was a key determinant of profitability of Ethiopian MFIs. Accordingly, the
hypothesis saying, there is a significant positive effect between inflation and profitability of
Ethiopian MFIs not rejected as per the findings of the study. The result is opposite with the
findings of Muriu (20 11) and. Jordan (2008) & Fikremariam (2015).

Age The researcher included this variable to check whether there is a learning effect in the
operations of the MFIs in Ethiopia. The coefficient was positive (0.010716) and it is statistically
significant at 1% significance level (P-value of 0.0000). This indicates the fact that age was a key
determinant of profitability of Ethiopian MFIs having a direct relationship with ROA.
Accordingly, the study failed to reject the formulated hypothesis which says, there is a
significant positive effect between age and profitability of MFIs during the study period of 2004
up to 2016. The finding is similar with Sima (2013), Fikremariam (2015), Joergenson (2012) and
Yonas (2012).

Capital to Asset ratio The coefficient of the capital to asset ratio (CAP) is negative (-0.137158)
and it is statistically significant variable even at 1% significance level (P-value 0.0000) This
confirms that for the study period 2004 up to 2016 capital strength of Ethiopian MFIs have a

41
negative relationship with their profitability or holding constant all other variables, increasing
CAP by one unit causes to decrease the ROA nearly 0.137158 Birr. Hence, the hypothesis saying
there is a significant negative effect between capital adequacy and profitability of MFIs is not
rejected or data did support the hypothesis. The result of this study is similar to the findings of
Muriu (2011), Jorgenson (2012) and Ayayi (2009) but opposite to Sima (2013) & Fikremariam
(2015). In general, capital strength can affect profitability; the current study proved that there is
significant effect between the two.

Portfolio quality Loan overdue greater than 30 days to gross loan portfolio was used to measure
the quality of portfolio of Ethiopian MFIs. The ratio was used to check whether there is a
relationship between quality of portfolio and profitability. The negative coefficient of the ratio (-
0.112544) was in line with the prior expectations of the study and also the theory which indicates
negative relationship between profitability and portfolio quality. The coefficient was statistically
insignificant level (P-value of 0.0617). The result is opposite to Muriu, (2011), Yonas, (2012),
Sima, (2013) but inconsistent with Dissanayake, (2012) finding & Fikremariam (2015). In
general, it can be said that the quality of portfolio was not a key determinant of profitability of
Ethiopian MFIs. Therefore, this study fails to reject the hypothesis which says there is a
significant negative effect between profitability and portfolio quality of Ethiopian MFIs.

Operating efficiency Operational Efficiency is performance measure that shows how well MFIs
is streamlining or reforms its operations and takes in to account the cost of the input and/or the
price of output. And Efficiency of the MFIs management measured in terms of adjusted
operating expense to adjusted average gross loan portfolio. By taking the above formula as the
tool to calculate, the current study which covers the time period from 2004 to 2016 indicates that
coefficient of (-0.238537) and it was statistically significant at 1% significance level (P- value
0.0001) this result shows that holding constant all other variables, increasing operational expense
in one unit on gross loan portfolio cause to decrease ROA nearly by 0.238537 birr it is an
indication that MFIs should give great attention in cost minimization technique. The result
indicated that there was a negative relationship between efficiency and profitability of Ethiopian
MFIs during the study period. The result confirms the common rule of thumb that the higher our
expense the lower our profitability. Based on the finding the study fails to reject null hypothesis
namely there is a negative effect between Operational efficiency and MFIs profitability in

42
Ethiopia because the result supports the expectation. Generally operational efficiency was a key
determinant of profitability of Ethiopian MFIs for the study period 2004-2016 The perception of
managers towards operational efficiency result supports the regression finding which is
minimizing expense to loan portfolio have a significant role to achieve the profitability of their
MFI. The result was consistent with findings many research like, Dissanayake, (2012), Muriu,
(2011), Sima, (2013) & Fikremaremariam (2015) but inconsistent with Jorgensen, (2011).

Gearing ratio/Debt to Equity ratio The debt to equity ratio is a common measure used to
assess a firm’s leverage, or in other words the extent to which it relies on debt as a source of
financing. The ratio showed up a negative coefficient (-0.007180) and it was statistically
significant at 5% significance level (P-value 0.0129). This implies that for the study period
(2004-2016) the significant correlation between profitability and gearing ratio. The result is
inconsistent with Dissanayake, (2012) and Muriu, (2011) that is perhaps more debt relative to
equity is used to finance microfinance activities and that long term borrowings impact positively
on profitability by accelerating MFIs growth than it would have been without debt financing.
The result is consistent with Melkamu, (2012). Therefore, based on the regression result from the
study, the study failed to reject the hypothesis namely gearing ratio has negative relationship
with profitability of Ethiopian MFIs which was formulated to show the significant effect
between debt to equity ratio and profitability of Ethiopian microfinance institutions.

GDP Economic growth (GDP) is among the most commonly used macroeconomic indicators, as
it is a measure of total economic activity within an economy and the study used real GDP growth
as a proxy of the macroeconomic environment. The Result shows that a negative coefficient of (-
0.138595) but it was statistically insignificant (P-value 0.5546) which indicates that
improvement in economic conditions did not significantly affect profitability of Ethiopian MFIs
during the study period 2004-2016. The result was consistent with Muriu, (2011), Jordan (2008)
and Sima (2013) but inconsistent with Fikremariam (2015). Therefore, the current study found
that real GDP growth is not positively affect the profitability of MFIs in Ethiopia. Therefore, the
study rejects the hypothesis namely real GDP has positive effect with profitability of Ethiopian
MFIs because the data did not support the result.

Market Concentration (CONS) According to Herfindahl-Hirschman (H-H) index, market

concentration is measured with the sum of the square of market share of the sample banks

43
included in the particular study and the researcher adopt from different literatures in the banking
industry and look MFIs market concentration in the same fashion. The banking theories on
market concentration argue that if the size and firm distribution of a specific sector is
concentrated, the profitability of firms becomes high because they could get monopoly power to
set the price of their products/service and determine their desired level of profit. This empirical
results show that market concentration affects MFIs profitability positively (0.150058), but the
effect was statistically insignificant (p-value 0.1616). The study is consistent with banking sector
result Athanasoglou, (2005) Birhanu(2012) but inconsistent with Belayineh, (2011) and
Habtamu, (2012).Therefore, the study rejects the hypothesis namely Market concentration has
negative effect with profitability of Ethiopian MFIs because the data did not support the result.

44
 CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATIONS
The previous chapter analyzed the results detected in the study and accordingly tested the
formulated hypotheses for validity. And also, the researcher separated the significant
determinants of profitability of Ethiopian MFls from the insignificant ones for the study period.
This chapter presents the conclusions attained and the recommendations forwarded by the
researcher as per the findings detected and finally the chapter raises issues for further study in the
subject matter.

5.1 Conclusions

The main objective of this study was to examine the internal and external factors affecting
profitability of Ethiopian MFIs. Even though previous studies in relation to MFIs profitability are
scant, the study reviewed the available studies and used commercial banking theories as a base
ground, presuming they are also workable for MFIs. Profitability is anticipated to be highly
dependent on internal (firm specific) factors, external factors can also contribute to the
profitability of a given firm. The internal factors include, capital adequacy, portfolio quality,
efficiency, size, Age, gearing and other variables which are under the control of the managerial
organ of the firm. External factors include macro- economic conditions like GDP, inflation and
other industry specific factors like market concentrations.

Based on the previous studies the study examined the effect of internal and external factors of
profitability of Ethiopian MFIs for the study period of 2004-2016, The firm specific factors
included in this study were gearing (Debt to Equity), capital adequacy, portfolio quality,
efficiency, size and age of MFIs. The external macroeconomic variables included in the study
were GDP and inflation and also industry specific factor include market concentration.

To accomplish the stated objective of the study, quantitative research method was adopted. The
data for the study were gathered from performance analysis report annual bulletins by AEMFI
and MFIs for the internal factors and industrial factor for the selected 19 MFIs; and the

45
macroeconomic factors were extracted from the annual reports of NBE and MOFEC. As per the
collected quantitative data, multiple regression analysis was run to test the different hypotheses
formulated in the study. The empirical findings of the study provided the following conclusions.

Gearing showed a negative coefficient against ROA, which is in line with prior expectations and
the variable was statistically significant; indicating that the increment in the debt to equity
decrease the profitability of Ethiopian MFIs. Portfolio quality showed up a negative coefficient
against ROA which is in accordance with prior expectations and also the variable was
statistically insignificant. Thus the result was not similar to prior expectations and also with
relative market power theory and scale efficiency theory.

The outcome of the study showed that size was a negative coefficient and statistically
insignificant variable. Thus the result was not similar to prior expectations and also with relative
market power theory and scale efficiency theory. Efficiency as measured in terms of operating
expense to gross loan portfolio showed a negative coefficient against ROA and the variable was
statistically significant as it was predicted. This depicts that the higher the cost the lower the
profitability of Ethiopian MFIs.

Age of MFIs as measured with the number of years a MFI is under operation showed a positive
coefficient and statistically significant variable as it was expected; implying that the more the
maturity of the MFIs the more the profitability will be get. Rate of inflation showed a positive
coefficient against ROA which is in line with prior expectations and the variable was statistically
significant; implying that the increment of rate of inflation is increases the profitability of
Ethiopian MFIs.

Capital adequacy of Ethiopian MFIs showed on average a result greater than the statuary
requirement set by NBE which is 12%, as the study verifies on average 39.11% of the MFIs asset
is funded by owners’ equity and the fund found that capital adequacy is a statistically significant
profitability determinant of Ethiopian MFIs during the study period of 2004-2016. The other
variables included in the study, GDP and Market concentrations were found to be statistically
insignificant profitability determinants for Ethiopian MFIs. The study tried to see the effect of
economies or diseconomies of scale for Ethiopian MFIs, the macro economic variables included
in this study such as GDP was found to be statistically insignificant profitability determinants for

46
Ethiopian MFIs and finally the industry specific variable included in the study Market
concentrations was found statistically insignificant profitability determinants for Ethiopian MFIs.

5.2 Recommendations

Based on the findings of the research, the researcher has recommended certain points what he
thought to be very critical if considered and implemented by the microfinance institutions
accordingly and properly. Therefore, the following recommendations have been given.

 Operational Efficiency, Capital Adequacy, Gearing, Age and Inflation are significant
determinants of profitability of MFIs in Ethiopia. Therefore, the management may need to
develop a good credit management policy, inefficiency is the bottleneck of MFIs in
Ethiopia, the management should give great attention to a good expense management
policy or reduce operating costs and credit risk management by employing different
technologies which can minimize cost example mobile banking and Gearing, Since
Microfinance institutions that employ higher debt in their capital structure are less
profitable, and highly leveraged microfinance institutions are less profitable so the
management should not give a great attention and finally the matured MFIs have found
their way to profitability so the new MFIs entering the industry must have different set of
goals and operational set of skills leading to profitability.
 The MFIs have to learn from profit-making banking practices by implementing a sound
financial management and good managerial governance to assure their financial
sustainability in the long run profitability without affecting their main objective.
 The MFIs managers and policy makers should give high concern in the motives of MFIs
that is MFIs should be perform their activity with comprising the two motives together.
Meaning the government and policy makers should give due attention for both poverty
reduction and financial self-sufficiency of MFIs.
 Since MFIs in Ethiopia is at its infant stage, hence the government should avail different
facilities and infrastructures like expanding the cash flow security and e- banking and
electronic property management systems property managements in the country level to
reduce inefficiencies.
5.3 Further Research

47
This study examined only limited internal and external variables by using 13 years’ data. There
are other variables which are not included in this study like, Capital to Asset ratio ,type of
institutions, ownership structure from internal factors and unemployment rate, , from external
factors. Having further investigation with the inclusion of the above variables might have a better
role in identifying other factors which contribute for the profitability of Ethiopian micro finance
institutions.

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APPENDIXES

Breusch-Godfrey Serial Correlation LM Test

Table 4.14 Heteroscedasticity Test Heteroskedasticity Test: Breusch-Pagan-Godfrey

54
0.175

0.17

0.165

0.16

0.155

0.15 Series1

0.145

0.14

0.135

0.13
1 2 3 4 5 6 7 8 9 10 11

40
35
30
25
20
Series1
15
10
5
0
1 2 3 4 5 6 7 8 9 10 11

55
56