Information Paper 9. Local Government Financial Indicators

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1 Information Paper 9 Local Government Financial Indicators November, 2006

2 Introduction Formal financial statements contain a wealth of information. Unfortunately their detail and format often mean it is hard for people without specific training (like accountants and auditors) to readily ascertain an entity s financial health and performance from this data. As a consequence, financial indicators and targets have been developed both in the public and private sectors to assist organisations, and others who are interested in their performance, to understand the messages the financial statements contain. For example, the South Australian Government has set target outcomes for its key financial indicators to guide overall budget revenue and expenditure decisions. They are used by Cabinet, Ministers and senior public servants in their financial assessment of specific initiatives and overall budget strategies. Corporate boards in both the public and private sectors do the same. Many of these people are not finance experts but they can readily ascertain the financial health of their organisations and the impact of decisions under consideration by reference to simple financial indicators. The Financial Sustainability Inquiry recommended greater use of financial indicators by Councils and this has prompted considered work, much led by the SA Local Government Financial Management Group Inc, to develop a set of standardised financial indicators applicable for all Councils. This paper outlines those indicators, describing why they have been selected and what they mean. They are effectively a road map to assist Council Members and senior staff in steering their Council s financial performance and sustainability (and other stakeholders in judging their success). This information paper is one of a number being developed as part of the LGA s Financial Sustainability Program. It is designed to provide an overview of the value and nature of the recommended financial indicators. This paper should be read in conjunction with the other information papers on Financial Sustainability which highlight the increasing demands on Councils and the importance of efficiently managing the delivery of services. Information papers have been, or will soon be, prepared on the following topics: Financial Sustainability An Overview of Audit Mechanisms Audit Committees Scope of External Audits - Audit Specification Efficiency & Economy Audits Infrastructure and Asset Management (Policy and Planning) Service Delivery Framework including the Role of Shared Services Long-term Financial Plans Governance in Local Government Financial Governance and Management Revenue and Funding Policies A New Approach to Standards in Local Government A New Approach to State-Local Resourcing Depreciation Local Government Financial Indicators Debt Management An Approach to Assessing Financial Sustainability for Local Government 1

3 A number of manuals, guidelines, templates, technical definitions, codes, standards and similar documents supporting this series of information papers are also being prepared by the LGA to provide practical assistance to Councils. For an update on which information papers have now been completed or information about other documents and activities, including briefing and training sessions, please visit our website at: What does legislation require? Amendments introduced to the Local Government Act in 2005, as a result of the passage of the Local Government (Financial Management and Rating) Amendment Act 2005, are expected to come into operation in early They will require a Council to develop a long-term financial plan and an infrastructure and asset management plan as part of its suite of strategic management plans and for these plans collectively to address: the sustainability of its financial performance and position; the maintenance, replacement or development needs for infrastructure within its area; and, proposals with respect to debt levels. Section 122 (1) (d) will require a Council when preparing and adopting its strategic management plans to state the measures (financial and non-financial) that are to be used to monitor and assess the performance of the council over the relevant period. Councils effectively will be required to evaluate past performance and project the future impact of strategies under consideration against appropriate financial indicators. Proposed SA Local Government Financial Indicators Most Councils have used and reported on various financial indicators over many years but until the Financial Sustainability Inquiry no consistent approach had evolved. Some commonly used indicators were developed during the cash accounting 1 era, or have been drawn from what is used in the corporate sector, and are less relevant in an accrual accounting 2 and Local Government environment. Councils have often also used a large number of indicators and the myriad of data generated has not necessarily helped to clarify focus on key issues concerning their financial performance and position. The Financial Sustainability Inquiry recommended the adoption by the Local Government sector of a standard set of financial indicators. The seven indicators outlined below have been developed specifically to focus attention on factors that the Inquiry identified as key to securing a Council s long-term financial security. These indicators are supported by the SA Local Government Financial Management Group and the LGA Financial Sustainability Advisory Committee and are intended to be recommended for adoption by the Local Government sector at the April 2007 AGM. They are all based on information derived from Councils audited financial statements. A more detailed technical description of accounting terms used in this paper to describe the basis for calculating the indicators and to assist in interpreting results from their use is provided in Attachment 1. Attachment 2 shows an Income Statement and Balance Sheet for a hypothetical South Australian Council and is presented here to illustrate, where possible, the calculation and interpretation of the recommended indicators. Since this data is entirely fictional, the calculated financial indicators for 1 Cash accounting recognises events as having occurred only when payments are made or received. 2 Accrual accounting recognises revenues when they are earned and expenses as they are incurred. 2

4 individual Councils will vary from this hypothetical example and the interpretation offered will not necessarily be applicable for a particular Council. Attachment 3 shows an Income Statement and Balance Sheet that has been prepared to reflect the actual financial performance and position of the South Australian Local Government sector based on aggregation of all Councils audited financial statements. The statements are similar in format to those that Councils are required (by regulations under the Local Government Act 1999) to produce to set out their annual budget and report their end of year financial performance and position but have been modified for simplicity. Attachment 3 also includes, for information, the calculation of the indicators discussed in this information paper on the basis of this sector-wide data. Although the indicators provide a robust ready assessment of financial performance and sustainability, they need to be interpreted in the context of a Council s operating environment. They do not replace the need for sound judgement. It is particularly important to consider trend data, both historic and that projected from a Council s long-term financial plan in decision-making and in reviewing financial performance. Looking at one year s data or in movements between 2 or even 3 years in isolation could lead to misleading conclusions. Indicator 1: Operating Surplus (the difference between day to day income and expenses for the period) An operating surplus (deficit) arises when operating revenue exceeds (is less than) operating expenses for a period (usually a year). Just like any household or other organisation, a Council s long-term financial sustainability is dependant upon ensuring that, on average over time, its expenses are less than associated revenues. In essence this requires current day citizens to fully meet the cost of services provided for them by their Council. If a Council is not generating an operating surplus in most periods then it is unlikely to be operating sustainably. It means that the cost of services provided to the community exceeds revenue generated. The change of an operating deficit into a surplus can only occur by ensuring in future that revenues are increased and/or that costs are reduced (at least relative to revenue increases, either by reducing service levels or improving productivity). If a Council is operating with a significant deficit over several years and its strategic management and long-term financial plans do not provide clear proposals for this to be turned around then it is inevitable that it will face major financial shocks in future. The Council effectively is in the same position as individuals living beyond their means. Sooner or later they will be caught by the consequences. For a Council the problem is likely to come to a head when existing major assets fail. The Council would then need to choose between large rate rises or not replacing assets thereby effectively providing its community with a lower standard of service. Attachment 2 shows that the hypothetical Council had an operating deficit of $0.4 million in followed by a surplus of $1.3 million in (the difference between Total Operating Revenue and Total Operating Expenses, is Operating Surplus (Deficit) ). Interpretation: The hypothetical Council has eliminated its operating deficit in If the Council continues to maintain a modest operating surplus it will be operating in a financially sustainable manner and therefore avoid future potential cuts to services and/or significant increases in rates. 3

5 Indicator 2: Operating Surplus Ratio (by what percentage does the major controllable income source vary from day to day expenses) The operating surplus ratio is the operating surplus (deficit) expressed as a percentage of general and other rates net of rate rebates and revenues from the NRM levy. A positive ratio indicates the percentage of total rates available to help fund proposed capital expenditure. If the relevant amount is not required for this purpose in a particular year, it can be held for future capital expenditure needs by either increasing financial assets or preferably, where possible, reducing debt in the meantime. A negative ratio indicates the percentage increase in total rates that would have been required to achieve a break-even operating result. This indicator and the operating surplus indicator above are by far the most important financial indicators for Councils. If a Council consistently achieves operating surpluses and estimates that it can do so in future, having regard to asset management and its community s service level needs, then it is financially sustainable. Favourable trend results measured against the other financial indicators described below will assist, but not in themselves ensure, that a Council operates sustainably. In Attachment 2 the ratio of the hypothetical Council was -1% in and 3% in ( Operating Surplus (Deficit) as a percentage of Total Rate Revenue excluding Water Catchment/NRM Levy income ). Interpretation: The Operating Surplus Ratio is improving as the hypothetical Council s rate revenue has increased proportionately by more than its operating expenses between the 2 years. Indicator 3: Net Financial Liabilities (what is owed to others less (net of) money you already have or is owed to you) Net financial liabilities equals total liabilities less financial assets. Often too much focus is placed on the level of a Council s borrowings. This number has little meaning without also considering the Council s available financial assets and other liabilities. It would make no sense for individuals, in assessing their financial positions, to look at one pile of bills and ignore others and disregard how much money they have in the bank. Councils are no different. (Note, for more detailed discussion of this issue and other debt related matters highlighted elsewhere in this paper, refer to the LGA Financial Sustainability Information Paper 10 on Debt Management.) Net financial liabilities is a broader and more appropriate measure of indebtedness than the level of borrowings as it includes all of a Council s financial assets and obligations including employee entitlements and creditors. There is no right or wrong target level of net financial liabilities. It depends on a variety of factors and a target range should be set by each Council having regard to needs identified in its strategic, long term financial and infrastructure and asset management plans. In the absence of these plans many Councils have implicitly and understandably applied very conservative ceilings to net financial liabilities, or more likely net (or even gross) debt. 4

6 Before considering an increase in its net debt a Council needs to recognise that interest associated with the debt will impact negatively on its operating result. However Councils with significant asset rehabilitation and replacement backlogs may find that their financial sustainability is improved if they raise debt to fund the works needed to address these backlogs i.e. if the operational savings achieved from addressing these backlogs exceed the additional interest costs resulting from the debt raised, financial sustainability would be improved. A Council s indebtedness should be managed to ensure its liabilities and associated costs can be met comfortably from operating revenues without the prospect of disruptive service cuts and/or excessive rate increases (i.e. without impinging on financial sustainability). Attachment 2 shows that the hypothetical Council s net financial liabilities fell marginally from $12.1 million in to $11.6 million in ( Net Financial Liabilities equals Total Liabilities less the sum of Cash & Cash Equivalents, Trade & Other Receivables and Other Financial Assets ). Interpretation: The hypothetical Council has a modest level of net financial liabilities. Provided that future operating deficits are avoided, there appears to be considerable scope for the Council to increase its level of borrowings (or to liquidate financial assets which is equivalent to borrowing) to help finance capital expenditure if required, including for any infrastructure backlog. Indicator 4: Net Financial Liabilities Ratio (how significant is the net amount owed compared with income) This ratio indicates the extent to which net financial liabilities of a Council could be met by its operating revenue. Where the ratio is falling over time it indicates that the Council s capacity to meet its financial obligations from operating revenue is strengthening. An increase in the net financial liabilities ratio will sometimes mean that a Council is incurring higher net operating costs (eg as a result of additional maintenance and depreciation costs associated with acquiring new assets). This will detract from the Council s overall operating result. Nevertheless a Council with a healthy operating surplus could quite appropriately decide to allow its net financial liabilities ratio to increase in order to provide additional services to its community through acquisition of additional assets without detracting from its financial sustainability. There is no optimal single number or even narrow range for this indicator. What is important is that a Council understands and is comfortable with its ratio and that it has been determined based on future community needs and long-term financial sustainability. In Attachment 2 the ratio fell from 27% in to 24% in ( Net Financial Liabilities as per Indicator 3 as a percentage of Total Operating Revenue excluding Water Catchment/NRM Levy income ). Interpretation: The hypothetical Council s net financial liabilities ratio is very modest. In it was equivalent to a household with an income of $50,000 per annum and no other debt or money in the bank having a mortgage of $12,000. The ratio also fell between the 2 years indicating the capacity to meet financial obligations from operating revenues is strengthening. 5

7 Indicator 5: Interest Cover Ratio (how much income is used in paying interest on loans) This ratio indicates the extent to which a Council s operating revenues are committed to interest expenses. As with all financial indicators associated with measuring indebtedness and its associated costs there is no right or wrong ratio. A Council simply needs to manage this ratio within a range acceptable to it, having regard to long-term financial sustainability and its suite of strategic management plans and financial management policies. Attachment 2 shows that for the hypothetical Council the ratio fell from 0.7% in to 0.6% in (( Finance Costs less Investment Income ) as a percentage of Total Operating Revenue excluding Water Catchment/NRM Levy and Investment income ). Interpretation: Only a very small proportion of the Council s operating revenue is committed to meeting net interest costs. Indicator 6: Asset Sustainability Ratio (are assets being replaced at the rate they are wearing out) This ratio indicates whether a Council is renewing or replacing existing non-financial assets at the same rate that its overall stock of assets is wearing out. It is calculated by measuring capital expenditure on renewal or replacement of assets relative to the recorded rate of depreciation of assets for the same period. If capital expenditure on renewing or replacing existing assets is at least equal to depreciation on average over time then a Council is ensuring the value of its existing stock of physical assets is maintained. If capital expenditure on existing assets is less than depreciation then, unless a Council s overall asset stock is relatively new, it is likely that it is underspending on renewal and replacement. This will progressively undermine its financial sustainability as it is likely that additional maintenance costs associated with assets that have exceeded their economic life will be in excess of costs associated with renewal or replacement. Eventually the Council will be confronted with failed assets, and significant renewal and replacement expenditure needs that cannot be accommodated without sudden large rate increases. All Councils are required to have adopted infrastructure and asset management plans (I&AMPs) by a date yet to be proclaimed. These Plans must include 10 year estimates of capital expenditure and maintenance required to responsibly manage their asset stocks and should be based on appropriate expert technical considerations. Work associated with preparing, and in future updating, such plans may reveal that a Council needs, on average over the period, to spend more (e.g. there is a significant backlog) or less (e.g. assets overall are relatively new) on asset renewal and replacement compared with aggregate depreciation of its total asset stock for the period. Where a Council already has a soundly based I&AMP a more meaningful asset sustainability ratio would be calculated by measuring the actual level of capital expenditure on renewal and replacement (or proposed in the budget or long-term financial plan) with the optimal level identified in the I&AMP. This financial indicator is not currently able to be calculated by SA Councils from their historical data. Councils have not previously been required to disclose the split of their capital expenditure between that for construction/acquisition of additional assets and that incurred in renewing/replacing existing ones. This split should be available from onwards. 6

8 It is assumed that the hypothetical Council is incurring capital expenditure of $7.9 million per annum on the renewal and replacement of existing assets. This represents an asset sustainability ratio in both and of approximately 90% (Capital expenditure on renewal and replacement of assets as a percentage of Depreciation ). Interpretation: In aggregate the hypothetical Council is renewing and replacing most of its physical assets at about the same rate as they are deteriorating. Indicator 7: Asset Consumption Ratio (the average proportion of as new condition left in assets) This ratio shows the written down current value of a Council s depreciable assets relative to their as new value in up to date prices. This ratio seeks to highlight the aged condition of a Council s stock of physical assets. If a Council is responsibly maintaining and renewing and replacing its assets in accordance with a well prepared I&AMP, then the fact that its Asset Consumption Ratio may be relatively low and/or declining should not be a cause for concern - providing it is operating sustainability. It makes no sense financially to replace perfectly serviceable assets just because they are old. In such circumstances the decline in the value of a Council s physical assets will be offset by a reduction in its net financial liabilities (either by an increase in its financial assets or preferably wherever possible, a reduction in debt) as a result of operating revenue generated to cover its depreciation expense. Its Balance Sheet overall will be unaffected and it will be in a strong financial position and able to fund the future renewal/replacement of these assets when optimal to do so. Information necessary to calculate the asset consumption ratio is not currently available to SA Councils from their historical data. To date not all Councils have been disclosing this information in their financial statements but are expected to do so in future. It is assumed that the as new value of the hypothetical Council s depreciable assets is $220 million. This results in an asset consumption ratio of approximately 75% (the written down value of Councils depreciable assets [ Buildings plus Infrastructure plus Plant, Equipment, Furniture & Fittings ] as a percentage of their new value). Interpretation: The hypothetical Council s asset consumption ratio signals that the overall asset stock is relatively new. In turn, this indicates that there is less likelihood of significant asset replacement needs in the medium term than for a Council with a much lower ratio. What are the issues for Councils? Councils should review their past practices in relation to the use of financial indicators. All Councils are encouraged to use the financial indicators recommended in this paper to guide future decision-making and publish their performance against these measures for accountability purposes. As a first step, recent past financial performance should be assessed relative to the results calculated using these indicators. This will reveal any areas of a Council s current financial strategies that require particular focus in order to secure ongoing financial sustainability. Every Council should then consider setting targets (or target ranges) for aspired performance against these indicators in future and consider whether any of its policies warrant subsequent revision (eg rating, service levels and debt management). A supplementary LGA paper is proposed to be issued in the near future to help Councils determine financial targets suitable to their circumstances and objectives. 7

9 A Council s long-term financial plan should highlight projected performance using these indicators. Where targeted performance is not currently being achieved the plan should be restructured to achieve targets over an appropriate period. The annual budget also should disclose projected performance using these financial indicators and targets. Acknowledgements The contribution of Mr John Comrie of JAC Comrie Pty Ltd in the preparation of this paper, the SA Local Government Financial Management Group Inc in the development of the financial indicators discussed and the SA Local Government Grants Commission for the illustrative data utilised in this paper is acknowledged. The development of this information paper has been assisted by funding from the Local Government Research and Development Scheme. 8

10 Attachment 1: Glossary of Accounting Terms Used in this Paper in the Context of the Recommended Financial Indicators Financial Assets include cash, investments, loans to community groups, receivables and prepayments. Equity held in a Council business is normally regarded as a financial asset but is excluded for the purpose of calculating indicators based on financial assets in this paper. Also, inventories and land held for resale are not regarded as financial assets. Financial Sustainability is achieved where planned long-term service and infrastructure levels and standards are met without unplanned increases in rates or disruptive cuts to services. Net Financial Liabilities equals total liabilities less financial assets, where financial assets for this purpose includes cash, investments, loans to community groups, receivables and prepayments, but excludes equity held in a Council business, inventories and land held for resale. Non-financial or Physical Assets means infrastructure, land, buildings, plant, equipment, furniture and fittings, library books and inventories. Operating Deficit occurs where the value of operating revenues less operating expenses is negative and operating income is therefore not sufficient to cover all operating expenses. Operating Expenses are operating expenses including depreciation but excluding losses on disposal of non-financial assets. Operating Revenues are operating revenues shown in the Income Statement but exclude profit on disposal of non financial assets and grants and contributions specifically for new/upgraded infrastructure and other assets, e.g. from a developer. For ratios calculated where the denominator specified is total operating revenue, Natural Resource Management (NRM) levy revenue is excluded. For the purpose of calculating the Interest Cover Ratio investment income also is excluded from the denominator. Operating Surplus occurs where the value of operating revenues less operating expenses is positive and operating revenue is therefore sufficient to cover all operating expenses. Rates Revenue is general and other rates net of the impact of rate rebates and revenue from the NRM levy. 9

11 Attachment 2: Financial Statements for an Hypothetical SA Council Hypothetical Council Income Statement Operating Revenue Rates - General Rates - Other Total Rate Revenue* Statutory Charges User Charges Grants & Subsidies Investment Income Reimbursements Commercial Activity Revenue Other Operating Revenue Total Operating Revenue Operating Expenses Employee Costs Contractual Services Materials Finance Costs Depreciation Levy Paid to Water Catchment/NRM Board Other Expenses Total Operating Expenses Operating Surplus / (Deficit) (0.4) 1.3 * includes Water Catchment levy income collected on behalf of SA Government of $0.5 million in and $0.6 million in

12 Attachment 2 cont Hypothetical Council Balance Sheet Assets Cash & Cash Equivalents Trade & Other Receivables Inventories Land Buildings Infrastructure Plant, Equipment, Furniture & Fittings Equity in Council Businesses Other Financial Assets Other Assets (incl Library Books & Works in Progress) Total Assets Liabilities Trade & Other Payables Employee Entitlements Borrowings, Overdraft Finance Leases, Deposits held Other Liabilities Total Liabilities Equity Asset Revaluation Reserve Accumulated Surplus / (Deficit) & Other Reserves Total Equity All data shown in Appendix 2 is fictitious and has been compiled to aid an understanding of the calculation of the indicators discussed in this paper. 11

13 Attachment 3: SA Local Government Financial Statements SA Local Government Income Statement Operating Revenue Rates - General Rates - Other Total Rate Revenue* Statutory Charges User Charges Grants & Subsidies Investment Income Reimbursements Commercial Activity Revenue Other Operating Revenue Total Operating Revenue 1,099 1,181 Operating Expenses Employee Costs Contractual Services Materials Finance Costs Depreciation Levy Paid to Water Catchment/NRM Board Other Expenses Total Operating Expenses 1,148 1,220 Operating Surplus / (Deficit) (49) (39) * includes Water Catchment levy income collected on behalf of SA Government of $11.4 million in and $12.4 million in

14 Attachment 3 cont SA Local Government Balance Sheet Assets Cash & Cash Equivalents Trade & Other Receivables Inventories Land 2,527 3,214 Buildings 1,154 1,248 Infrastructure 5,416 5,407 Plant, Equipment, Furniture & Fittings Equity in Council Businesses Other Financial Assets 7 9 Other Assets (incl Library Books & Works in Progress) Total Assets 9,799 10,615 Liabilities Trade & Other Payables Employee Entitlements Borrowings, Overdraft Finance Leases, Deposits held Other Liabilities Total Liabilities Equity Asset Revaluation Reserve 3,918 4,689 Accumulated Surplus / (Deficit) 5,253 5,268 & Other Reserves Total Equity 9,171 9,957 All data shown in Appendix 3 has been compiled from SA Local Government Grants Commission records based on Council financial statements. 13

15 Attachment 3 cont SA Local Government Financial Sustainability Indicators Operating Surplus / (Deficit) ($49 million) ($39 million) Operating Surplus Ratio - 7% - 5% Net Financial Liabilities $362 million $358 million Net Financial Liabilities Ratio 33% 31% Interest Cover Ratio 1.4% 1.1% Asset Sustainability Ratio * * Asset Consumption Ratio * * * Not able to be calculated from available data. 14

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