Use of Key Financial Indicators

Use of Key Financial Indicators by Local, National and International Governments By: Jesse Hughes, Ph.D., CGFM, CPA, CIA, and Meena Katwal, MBA 46 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT FALL 2011

Figure 1: Types of Analyses Many different types of analyses are used in the private sector to assess the financial condition of a company. The different types of analyses used in the private sector are explained in the table below: Horizontal (year to year) Vertical (financial element to financial element) Trend (over a number of years) Horizontal analysis is the process of comparing particular items in a financial statement over a period of time. A vertical analysis can be performed of either the income statement or the balance sheet item. In a vertical analysis, different figures in a financial statement are compared to a specific figure in the same accounting period and are reported as a percentage. Trend analysis is based on the theory that what has happened in the past is a good indicator of what might happen in the future. With analysis of the magnitude and direction of the trend, we are able to predict what we can expect to see in the immediate future and plan accordingly. Information in financial statements published by the private sector is closely tracked, as investors make the decision to buy or sell stocks in the company. Earnings are one of many factors that may impact the price of the stock. So, financial statements act as a guide for an investor as they can refer to them frequently. Financial statements in the public sector are also important, but are frequently not fully used in the decision-making process. Since the public sector is more thinly capitalized than the private sector, the ability to pay its debt in a timely manner and to achieve fiscal sustainability is critical. In this article, we discuss different types of analyses 1 (see Figure 1) used in the public sector and how globalization may demand changes in accounting practices by the public sector for harmonization with the rest of the world. The use of these analytics by public sector entities and a case study on the city of Hampton, VA, illustrates its application in the public sector with special emphasis on measures of liquidity and solvency. Ratio (key indicators to other key indicators) Ratio analysis helps to organize the massive amount of information given in an entity s financial statements and perform an analysis of the information. The performance of the company can be judged by computing the ratios for the current year and comparing them against the industry, the economy, other companies or the previous year ratios of the same company. An entity s performance, liquidity, efficiency, financing etc., can be judged by studying the ratios like quick ratio, current ratio, asset turnover ratio, debt-equity ratio etc. The same types of analyses are also used in the public sector to assess the financial situation associated with a public sector entity. However, most analyses performed by these entities relate to budgetary information and fund balances. Few analyses are performed by public sector entities to determine the degree of liquidity or solvency. Some ratios used to assess the financial health in these areas are computed as follows: Quick Ratio This ratio, also called acid test or liquid ratio, considers only cash, marketable securities (cash equivalents) and accounts receivable because they are considered to be the most liquid forms of current assets. A Quick Ratio less than 1.0 implies dependency on inventory and other current assets to liquidate short-term debt. This ratio is calculated using the following formula: (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities). Current Ratio This ratio is a comparison of current assets to current liabilities, commonly used as a measure of short-run liquidity, that is, the immediate ability of an entity to pay its current debts as they come due. Potential creditors use this ratio (typically greater than 2.0) to measure an entity s liquidity or ability to pay off short-term debts. This ratio is calculated using the following formula: (Current Assets / Current Liabilities). Total Liabilities to Net Assets Ratio This ratio shows how all of an entity s debt relates to the equity of the entity. The higher this ratio (preferably less than 1.0), the less protection there is for the creditors of the entity. This ratio is calculated using the following formula: (Total Liabilities / Net Assets). Comparative Data on U.S. Local Governments Many states maintain financial databases on revenue and spending patterns of the local governments within their state. However, to the best of our knowledge, none of the states include data by which to compute the liquidity or solvency ratios identified earlier. In 1981, the Virginia General Assembly passed a bill requiring the Auditor of Public Accounts to prepare a comparative cost report for each of the local governments in Virginia with a population of more than 3,500. The initial format of this report included comparative fund financial data. This format was revised in 2000 to include changes required in the Comprehensive Annual Financial Reports (CAFR) prescribed by Governmental Accounting Standards Board (GASB) Statement No. 34. However, the revision to the comparative cost report (subsequently retitled the Comparative Report of FALL 2011 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT 47

information users receive under current standards, and to consider whether guidance should be considered for the remaining information. The principal focus of the project is to consider whether any additional information useful for assessing a government s economic condition should be required or encouraged for inclusion in a government s financial report. In light of growing national concern with fiscal sustainability, the project will consider how these concerns relate to economic conditions. Federal Accounting Standards Advisory Board (FASAB): In September 2009, FASAB issued SFFAS 36, Comprehensive Long-Term Projections for the U.S. Government. 3 Although this standard applies only to the U.S. government and does not address the liquidity or solvency ratios, it provides some background beneficial to the debate as to how best to measure fiscal sustainability. "The global financial crisis has significantly increased these pressures in many cases, which has led to heightened interest in the long-term financial consequences of government interventions." Local Governments) did not include the asset and liability information prescribed by GASB for inclusion in the Statement of Net Assets for the CAFRs. Consequently, the liquidity (quick assets or current assets to current liabilities) and solvency (total liabilities to net assets) ratios cannot be obtained from the comparative report. These two ratios are very important to ensure that sufficient funds (liquidity) are available to pay the liabilities in a timely manner and to sustain fiscal health (solvency). Long-term fiscal sustainability is the ability of a government to meet its service delivery and financial commitments both now and in the future. A number of demographic and technological factors have created fiscal pressures for many governments. The global financial crisis has significantly increased these pressures in many cases, which has led to heightened interest in the long-term financial consequences of government interventions. However, information on long-term fiscal sustainability is essential even without the additional pressures that arose as a result of the financial crisis. The standards-setting bodies have recognized this shortcoming and have established projects to address the issue as follows: Governmental Accounting Standards Board (GASB): A project on Economic Condition Reporting: Fiscal Sustainability is under way. 2 The long-term objectives of this research project are to identify the information users require to assess a government s economic condition, to compare these needs with the International Public Sector Accounting Standards Board (IPSASB): In November 2009, the IPSASB issued a consultative paper titled, Reporting on the Long-Term Sustainability of Public Finance, 4 and the project is ongoing. Although IPSAS has not yet been adopted in the U.S., the potential application in other countries might have a bearing on the standards being established in the U.S. The IPSASB has concluded that the presentation of information on long-term fiscal sustainability is necessary to meet the accountability and decision-making objectives of financial reporting. Although the paper focused mainly on reporting by national governments, the IPSASB believes that simpler forms of long-term fiscal sustainability reporting are also appropriate for the consolidated reports presented at sub-national levels. Key Indicators in the City of Hampton, VA The following financial indicators are published by the city of Hampton in its CAFRs. The significance of each indicator is explained in the CAFR s Management Discussion and Analysis Section. Noteworthy by its absence is the lack of any reference to the liquidity or solvency ratios identified earlier for government activities, business-type enterprises or 48 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT FALL 2011

component units as presented in the Statement of Net Assets. The number of fiscal years, shown in parenthesis, reflects the trend over the number of years indicated. Financial Trends Net Assets by Component (8), Changes in Net Assets (8), Fund Balances of Governmental Funds (10) and Changes in Fund Balances of Governmental Funds (8). Revenue Capacity General Governmental Tax Revenues by Source (10), Assessed and Estimated Actual Value of Taxable Property (10), Principal Property Tax Payers (10), and Real Estate Tax Levies and Collections (7). Debt Capacity Ratio of Outstanding Debt by Type (10), Legal Debt Margin Information (10) and Pledge/Revenue Coverage (10). Fiscal Discipline for the General Fund Budget to Actual Schedule of Revenues and Other Credits, Schedule of Appropriations and Expenditures. Hampton City Financial Policy: In April 2007, the city council amended its existing financial policies. The financial policies relate to general operating elements of the city. These policies are used as financial planning parameters during the annual budget process. The city s FY11 manager s recommended budget is in compliance with all five policies to ensure that the city has met its statutory requirements. Debt Limit Policy No 1. This policy is comprised of three guidelines: General obligation debt shall not exceed 3 percent of the assessed value of all real estate within the city subject to taxation. The legal debt limit authorized by the Virginia State Statute limits bond issuing authority up to 10 percent of the assessed value. General obligation bonded debt together with indirect debt, which includes certain revenuebacked debt and subject to appropriation or moral obligation commitments, and debt of certain special-purpose entities (that is, Community Development Authority) shall not exceed 4.5 percent of the estimated assessed value of all real and personal property subject to taxation within the city. Debt of certain special-purpose entities, such as Community Development Authorities, shall not exceed 1 percent of the assessed value of all real and personal property subject to taxation within the city. Debt Service Limit Policy No. 2. General obligation bonded debt and indirect debt shall not exceed 10 percent of the city s total general fund, school operating fund and convention center expenditures, of which all are included in the city s total debt service. Debt Retirement Policy No. 3. The city shall retire 60 percent of the principal balance of general bonded obligation debt within 10 years of the date the debt is issued. New AGA CPAG Auburn research University at report Montgomery explores GRC implementation challenges Sample Findings 94% 81% Provide the continuing education you need to maintain your other Can governance, risk, and compliance help agencies meet current and future professional accounting certifications. challenges? AGA members, federal stakeholders, and subject matter experts were asked about the status of GRC in the public sector. The findings and recommendations are shared in the latest AGA CPAG research report The Maturity The right option no matter where you are. of GRC in the Public Sector: Where Are We Today? Where Are We Going? Download the full report at www.morganfranklin.com/grcresearch Government Financial Management Get the competitive edge with courses specifically designed to: BELIEVE GRC IS RELEVANT OR Prepare you for financial management and audit responsibilities in VERY RELEVANT TO THEIR JOBS government federal, state and local. HAVE NOT ImPLEmENTEd A unified, INTEGRATEd Provide GRC you model with college level education in preparation for Certified Government Financial Manager (CGFM) examinations. Undergraduate and graduate courses online. Learn anytime, anywhere. Program Visit www.aum.edu/gfm or call 334-244-3495 for additional program information and course registration. MANAGEMENT CONSULTING FINANCIAL ADVISORY IT SOLUTIONS FALL 2011 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT 49 MF_AGA2010WinterJournallAd_FINAL.indd 1 10/20/2010 4:30:41 PM

Equity Funding Policy No. 4. This policy is comprised of two guidelines as outlined below: A minimum of 2 percent to 6 percent of general fund revenues will be applied to Capital Improvement Plan (CIP) projects each year. A minimum of 10 percent to 15 percent of CIP projects over a rolling five-year period are to be funded from general fund revenues. The city will maintain an undesignated general fund balance equal to 10 percent of total general fund and school operating fund revenues less school transfers. To the extent undesignated fund balance falls below the policy, the shortfall shall be replenished over a three-year period. International Comparisons In the private sector, much work is ongoing between the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) in their attempts to converge the International Accounting Standards/International Financial Reporting Standards (IAS/IFRS) to make the financial statements more comparable throughout the world. This may eventually impact the public sector in the United States since the IPSAS are based on the IAS/ IFRS. For ratios to be fully comparable, some differences between the standards prescribed by GASB and IPSASB need to be considered: The IPSASB requires a separation between the current/non-current classification of assets and liabilities while GASB does not. The IPSASB requires the Unfunded Actuarial Accrued Liability (UAAL) to be reflected as liabilities on the face of the financial statements while GASB does not. However, GASB has issued an Exposure Draft that will require UAAL to be reflected as a liability on the face of the financial statements as required by the IPSASB. If included as a liability, the total liabilities/net sssets ratio would increase considerably for most governments. The IPSASB requires the preparation of a Statement of Cash Flows for all controlled entities while GASB does not. Such a statement enhances the reporting comparability of operating performance by different entities because it eliminates the effects of using different accounting treatments for the same transactions and other events. The IPSASB has five characteristics that must be met to be recognized as a Government Business Enterprise (GBE), whereas some of the CAFRs examined did not consistently adhere to any such characteristics for their businesstype enterprises. The following two IPSAS characteristics for GBEs did not appear to be consistently applied under GASB guidelines for business-type enterprises: Sells goods and services, in the normal course of its business, to other entities at a profit or full cost recovery; and Is not reliant on continuing government funding to be a going concern (other than purchases of outputs at arm s length). The IPSASB requires a wholeof-government report to identify the overall financial situation for all controlled entities within the government. In those instances in which a whole-of-government report is not prepared, governments are encouraged to prepare consolidated reports for each controlled entity to fully identify the costs of services provided. In line with GASB requirements, state and local governments separately report government activities, businesstype enterprises and component units but do not prepare a wholeof-government report. Conclusions Financial statements provide great insight into any entity s financial condition. In the public sector, some information in the financial statements is used less than in the private sector. Since so much work is done each year in compiling the CAFRs, it would be beneficial to use the information to the fullest extent so as to be better equipped for the changes that might be on their way in the future. This is especially true for the liquidity and solvency ratios used to determine the overall financial condition of each governmental entity. Further, all states that prepare comparative cost reports about their local governments should include pertinent information from each entity s Statement of Net Assets presented in each CAFR to compute the degree of liquidity and solvency of each public entity. Most governmental entities in the United States do a good job of monitoring their budgetary resources to assure that fiscal discipline is maintained. However, the CAFRs are not as fully used in monitoring the liquidity and solvency ratios. Movement toward converging the standards promulgated by GASB with the standards issued by IPSASB should be considered to become more comparable to the governmental standards being implemented throughout the world and to permit the liquidity and solvency ratios to be more uniformly computed. End Notes 1. Further explanation of these ratios are available in most accounting and finance texts as well as the following websites: www.accountingformanagement.com/horizontal_analysis_or_trend_analysis.htm and www. investopedia.com/university/ratios. 2. See www.gasb.org. 3. See www.fasab.gov. 4. See www.ifac.org/publicsector. Jesse W. Hughes, Ph.D., CGFM, CPA, CIA, a member of AGA s Virginia Peninsula Chapter and the Journal Editorial Board, is professor emeritus of accounting from Old Dominion University, Norfolk, VA, and is a past member of the Board for the International Consortium on Governmental Financial Management. He is an international consultant on accounting and auditing issues. Meena Katwal, MBA, computer engineer, is an international student from Nepal. She is completing her master s degree in accounting at Old Dominion University, Norfolk, VA. 50 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT FALL 2011