Part 1. Financial Planning. Essay

1 Part 1 Financial Planning Essay

2 Training for Finance Managers

Essay 3 Financial Planning Summary This essay will examine ways that financial planning can be developed and implemented in local governments. We will provide a definition of financial planning and forecasting and relate these to financial policies. We will also describe the benefits that accrue to local government when implementing a financial planning and forecasting process, considerations for organizing the process, types of financial planning and methods of forecasts. Included in the discussion will be obstacles, limitations, and risks inherent in developing a financial planning and forecasting process. Definitions Financial planning and financial policies are terms that are used extensively throughout the handbooks in this series. It is important to understand what each term means, their relationship, and any differences between them. What do we mean by financial policies? Financial policies are defined in the Financial Policy Making handbook in this series as: Policy the principles and goals that guide the financial management of a local government. Policies influence financial decision making. They lead to the development of strategies to achieve goals. And they provide standards for evaluating and monitoring the performance of a local government financial management system. Financial policies are statements created by policy makers to clarify their financial management philosophy. Broadly defined, policies are formal positions taken by a city governing body to support the implementation of its financial goals. Policies provide a framework for financial management and guidance for the finance managers in conducting the financial affairs of a local government. The policy framework, therefore, represents a comprehensive financial strategy for achieving and maintaining sound financial stewardship. If you need additional information, you should turn to the section of the handbook on Financial Policy Making. What is financial planning? FINANCIAL PLAN- NING is a process in which coordinated comprehensive strategies are developed and implemented to achieve a local government s financial goals and policies. These strategies are developed in response to projections of a picture of the future over various timeframes. Local governments assess the probability of those future projections coming true and prepare a response (a financial plan) to mitigate adverse financial consequences. The concept of financial planning has become increasingly popular in private corporations and personal finance in the United States. At the same time, local governments have borrowed many of these financial planning tools and techniques and applied them to local government finance to improve their financial planning efforts. What are the financial planning tools and techniques used by local governments? To pose this question to local government officials would yield different answers depending upon the experi-

4 Strategic Budget ence of the person answering the question. To some, this may be the latest financial planning techniques such as downsizing or rightsizing, cutback management, impact fees, user charges or creative financing. However, local governments occasionally get caught up and overlook the basics. The basics of financial planning are: budgeting, financial forecasting, and economic development strategies. Properly applied, these basic strategies can assure financial health of the community for the future. Financial planning means different things to different people. The reason for this is that there are a number of different types of financial planning tools and techniques available. The more common planning tools and techniques include: Trend Monitoring budgeting, financial forecasting, capital programming, debt planning, trend monitoring, strategic planning and economic development planning. A brief description of these follow: Budgeting Capital Programming Financial Forecasting Debt Economic Development Budgeting is by far the Budget most commonly used tool in the financial planning toolbox. Budgeting is the public policy process of allocating scarce resources to achieve a desired end result. An annual budget allocates revenues to provide for the operation of city services and maintenance of facilities. Financial forecasting Financial forecasting is a process that produces projections of future Financial Forecasting years revenues and expenditures based on a set of specific policy and economic assumptions. Strategic Capital programming Capital Programming Capital programming is a process that produces a multi-year capital improvement plan (CIP) for short and long-range physical development of a community. The capital improvement plan (CIP) can be thought of as a link between the community s master plan for physical development and fiscal plans funded in the budget. Debt planning Debt planning is a process that determines the type and optimum amount Debt of debt needed to finance a community s short and longterm capital improvement program. Debt planning links the capital improvement program with the annual operating budget in which debt service is funded. Trend monitoring Trend monitoring uses numerous economic and financial indicators to monitor the fiscal condition of a community and local government. Local governments regularly monitor and track these indicators over time to identify key trends that are underway. Many of the indicators are used by financial institutions, underwriters and rating agencies as tools in credit analysis to evaluate a local government s financial condition. Strategic planning Trend Monitoring Strategic planning is a systematic process by which a community anticipates and plans Training for Finance Managers

Financial Planning for its future. The result is a written document called a strategic plan that guides the community toward its future. To achieve it, a financing plan must be developed to support it. Economic development planning Economic development planning is a process that utilizes local government policy and incentives to Economic Development stimulate growth and economic activity in a community. Tools such as fiscal impact analysis and scenario analysis are used in this planning to assess the impact of various economic development strategies on local government s future revenues and operating expenses. As you can see, financial planning has many and varied tools and techniques to meet different needs. However, this module will focus primarily upon financial forecasting as one of the basic tools of financial planning. Budgeting, capital programming, debt planning and trend monitoring (i.e., financial condition analysis) are addressed and discussed in detail in other handbooks in this series. Economic development planning and strategic planning, while elements of financial planning, will not be addressed in this handbook. What is financial forecasting? FINANCIAL FORECASTING is a process for local government to produce projections of future years revenues and expenditures based upon a set of specific policy and economic assumptions. Forecasts are the financial management tools that can project the future financial impact of current program policies, economic trends and assumptions. When applied beyond the annual budget, forecasts link the annual budget to other, longer term city planning and development efforts. In this instance, multi-year financial forecasts of revenues and expenditures tie the annual budget together with capital programming, debt planning, labor contracts, strategic plans, and economic and community development planning. The financial forecasting process is determined by local elected and appointed officials to meet the unique needs, objectives and constraints of the local government. As a result, there are many possible approaches and no correct solutions. Nevertheless, some generalizations can be made about the process and products expected from multi-year financial forecasts: Unlike the annual budget, which is generally balanced with revenues equaling expenditures, forecasts tend to be unbalanced, with expenditures exceeding revenues. The reason for this is the methodology of forecasting which is based on current policies and programs and economic assumptions. These policies and assumptions affect revenues and expenditures differently because they grow at different rates, causing a balanced budget to be unbalanced in the future. Expenditure forecasts are primarily extensions of current service programs or planned and approved investment programs that are controlled by the local government. Revenue forecasts, on the other hand, are based partly on economic assumptions that are beyond the local government s control and partly on policy assumptions regarding the level of taxes and fees that are within the local government control. If the actual conditions differ from the assumptions in the forecast, then the actual revenue and expenditures will differ from the projections. Differences between actual and projected revenue can usually be traced to: financial control problems for locally generated revenues (such as fees and charges since they are usually within the local government control); 5

6 unforeseen economic conditions that might affect income tax collections; or first time changes in state allocated transfers to local government that don t have a historic track record. Differences between actual and projected expenditures can usually be explained by changes in local government policies and programs made to balance the budget, meet citizen requests, or deal with unanticipated national mandates or natural disasters. A financial forecast serves two basic purposes. 1) It can quantify the future impact of current decisions, programs and policies (impact analysis) and 2) It can identify and analyze the revenue and expenditure adjustment options needed to close the difference between revenues and expenditures (gap analysis.) In both situations, the forecast relies on specific policy and economic assumptions. The difference is: when it is used for impact analysis purposes, the focus is on policy assumptions; and when it is used for gap analysis, it focuses upon economic assumptions. For example, a revenue and expenditure forecast might be used to project the future cost of debt service (principal and interest) of a five-year bank loan used to finance local development and investments (impact analysis.) It might also be used to project the amount of additional revenues needed if stateshared revenue is adjusted annually based on inflation averaging 15% over the next five years (gap analysis.) Used this way, revenue and expenditure forecasts can improve planning, budgeting and local government decision making. Throughout this handbook, the terms forecasting, financial forecasting and revenue and expenditure forecasts will be used interchangeably. They will refer to the preparation of all formal forecasts of revenues and expenditures from short to long-term regardless of the number of years. Multi-year forecasts will refer more specifically to forecasts covering one to ten+ years but usually medium-term forecasts ranging from one-five years. Reflection When I think of financial policies, financial planning and forecasting in my local government, the following things come to mind: 1. 2. 3. Training for Finance Managers

Financial Planning Benefits Financial planning and specifically forecasting can be important tools for the mayor, municipal board, city council, and management. Properly applied, financial planning and forecasting produce positive benefits for local government and citizens such as: Link local government s policy with specific financial plans to achieve a municipal council s long-range goals The importance of adopting financial policies was stressed in Handbook 3, Financial Policy Making, of this series. The council s long-term policy goals and direction serve a very important purpose. They make staff decision making easier by communicating council expectations and reducing the options to be considered. Develop a picture of local government s financial future and create more time to respond to adverse events When a picture of a local government s financial future is developed, elected officials have the opportunity to decide whether it is acceptable or not and what actions need to be taken. If the council decides that there are adverse events in their future, they now have advance notice to respond to the event before it becomes reality and a crisis. Prepare the local government for shifts in responsibility The national government, in recent years, has shifted a number of responsibilities to local governments and in some cases without adequate resources. This situation requires that local government acquire the financial planning skills to analyze these potential shifts while they are being planned and to persuasively argue for the resources to support them, if needed. Improve the quality of financial decision making Local governments have a need to plan for the future next year, five years or ten years from now. Financial planning uses analytical tools to fine tune the picture, analyze data and develop plans that effectively respond to the issue with the ultimate benefit a better decision. For example, in debt planning, local government must limit its total capital improvement spending plan and spread it out over a number of years based on the city s capacity to pay. Financial planning analytical tools help determine what the city can afford to pay annually for debt service to finance the CIP. Develop alternative decision strategies. By creating a vision of the future, financial planners can identify potential adverse events. These can be used not only to develop an appropriate response, but to use different assumptions of that future to test how alternative strategies would fair under different assumptions. Financial forecasting in a more focused context provides similar benefits. The benefits range from acting as an early warning system, improving budget planning and decision making, supporting legislative and borrowing programs, to educating the citizenry through disclosure of public information. Financial forecasting can: Serve as an advance warning system When prepared and presented early in the budget planning process, forecasting future revenues and expenditures can alert elected and appointed officials of the financial limitations under which the next year s budget (and future years) is developed. This helps elected officials understand the financial situation, eliminates surprises and provides time for them to take the necessary preventive actions. 7

8 Improve the policy development and budget preparation process Financial forecasting can provide information about potential changes in services, new demands for service, anticipated revenues and any expected surplus or deficits. An early forecast gives local elected officials an opportunity to provide policy direction, set budget priorities and establish budget guidelines based on this information. This direction can be incorporated into more detailed budget instructions given to departments to aid in budget request preparation. This saves considerable time and effort in preparing budget requests. Budget priorities may be program oriented by indicating a preference for increased spending in one program or service over another. Priorities may also be resource oriented, by indicating a priority for property taxes over user fees and charges. Evaluate alternative financial plans Financial forecasting can illustrate the immediate and longer term fiscal implications of various economic and policy scenarios. It also helps in determining the extent in which governments can afford them. As a result, elected and appointed officials can better evaluate competing budgetary proposals and alternative financial plans. government or shifts in responsibilities to local government. Forecasts can be effective in convincing the Parliament of the impact of these changes and to modify the proposal. Similarly, financial forecasts can help convince the Parliament of the need for new revenues or restructuring of existing ones. Support borrowing and credit evaluation Financial institutions that underwrite loans to local governments view financial forecasting as a necessity. These institutions and other agencies that evaluate the creditworthiness of local governments view forecasting as a sound financial management practice. Promote open government and disclosure of public information Financial forecasts can help the local government show political organizations, businesses, media and citizens the long-term costs of various service programs and economic policies. In turn, this improves their understanding of local government. There are also a lot of reasons why local governments don t prepare multiyear forecast of revenues and expenditures. The chart on the opposite page contains some of those observations. Aid decision making Financial forecasting can increase the awareness of elected and appointed officials of the longrange implications of decisions. It also helps decision makers to understand the cumulative effects of decisions resulting in better decisions from the start. Support lobbying the Parliament Financial forecasts applied to projecting the financial impact of proposed legislation such as the changes in formulae for sharing revenue between state and local Training for Finance Managers

9 Why local governments don t prepare multi-year forecasts. Some random thoughts and observations 1. Prior state economic planning has given all planning a bad name. 2. Local government revenues are too unstable and unpredictable to forecast for future years. 3. Forecasting multiple years' revenues and expenditures is difficult with a 20-30% annual inflation rate. 4. Staff is too busy with the day to day activities. There isn t time to plan. 5. Local governments are limited in their ability to raise revenue and have little flexibility to manage revenue sources. It seems pointless to spend time identifying a problem that can t be solved. 6. There is no reliable historical data on which forecasts can be made. 7. Elected officials are not interested in planning for the future just the next election. 8. The computer equipment, software or skills do not exist to prepare forecasts. 9. There s no law that requires it. Reflection Now that we have reviewed the benefits of financial planning and forecasting (and some of the reasons not to plan), consider how it can be applied in your local government. Recall the two or three multi-year decisions you noted earlier in the material. How was local government s financial forecasting beneficial to those decisions or projects? How can you counter some of the reasons not to plan? Financial Planning

10 Organizing for financial planning and forecasting Organizing the initial financial forecasting process is similar to establishing other local government programs. The initial forecast process must be allocated sufficient resources (staffing, time, and equipment), given access to necessary data and information, and supported by management and political bodies to complete the project. Key people Financial planning and multi-year forecasting is a cooperative effort among elected and appointed local government officials. There are five general categories of people who should play a key role in preparing a multi-year forecast of revenues and expenditures. Legislative The legislative category includes the council, municipal board and committees. Council representatives should concern themselves with approving the overall financial and program policies of the city on which forecasts are based. Their role in the forecasting process depends upon whether or not it was their initiative. If the impetus for financial forecasting came from the council, then the elected officials deserve an active role in the design of the forecasting system. This may be carried out through the committee of the council. If the impetus for the forecasting process came from the mayor or municipal board, then the council s role may be more properly limited to providing policy guidance to the mayor or municipal board, and the forecasting team. The councilors should review any resulting forecasts. Executive The executive category includes the mayor. The mayor s role should be to develop and recommend financial policies to the council for consideration and execute the policy decisions of the council. The mayor translates policy guidance from the council into specific direction that can be applied to the forecast. In the forecasting process, the mayor should review the forecast, ensure that the forecast adheres to the policy guidance, make changes, as needed, and present the recommended forecast to the council. Finance and Management Staff This category includes the finance director and staff, the forecast team and department directors. The finance director is usually the person assigned the responsibility to prepare the forecast. The finance director has the knowledge of finance, budgeting, and accounting, as well as access to the information needed to support the planning process. The finance director also has an established relationship with the mayor and the Finance/ Economic Committee through the budgeting process that complements the forecasting process. The finance department staff generally has the knowledge of the administrative and financial management practices, accounting, and budget processes to support forecasting. They may also have the computer and statistical skills needed to analyze the data and perform the analysis required in forecasting. A forecasting team is organized by the finance director to carry out the forecasting assignment. The finance director forms either an ad hoc team or creates a permanent unit in the finance organization. The forecasting team can be made up of finance and budget personnel, or persons with more diverse skills from throughout the organization and even include consultants or citizens with specialized skills. The source of the personnel comprising the team is less important than the skills on the team. Training for Finance Managers

11 Financial Planning Department directors may or may not be involved in the forecasting process. This depends upon the approach taken to prepare the forecast. For example, in a centralized approach where much of the forecast is done by a single agency, such as the finance department, the department directors are generally not involved. In a decentralized approach, department directors may be used to provide forecasts for the department programs based on current service levels or future commitments, and may even serve on the forecasting team. Additionally, if revenue collection is decentralized, then the finance department would require the collecting agency to forecast the revenue collections based on its experience. Contributory organizations and utility districts A CONTRIBUTORY ORGANIZATION is a semi-autonomous legal governmental entity created by the municipality. A foundation agreement adopted by the municipality defines, in general terms, the core activities to be performed by the organization. The number of contributory organizations and scope of their duties varies among municipalities. Additionally, because these organizations may receive contributions from the municipality and/or contribute to the municipality, contributory organization staff should be included in the forecasting process. Their business activities and future financial condition may have an impact on the municipality and should be included in the forecast. Additionally, they may consider developing similar forecasting processes to complement the governmental forecasting process with agreed-upon assumptions. A UTILITY DISTRICT is a state operated enterprise that serves a geographic area with a public service, such as water and sewer or electricity. A utility district is created by state government and responsible to the state for its actions. Utility districts are generally not included in the forecasting process because they do not receive contributions from the municipality or contribute a portion of the profits to the municipality. However, the municipality should establish contact with each organization to be alert to any future changes. This includes changes in the level of service, rate schedules or addition of new facilities that might impact municipal operations and service costs. Citizens Normally, when a single staff agency or a multi-department forecasting team prepares the forecast, citizens role is to comment on the resultant forecast in public sessions. However, if a higher level of citizen participation is desired, it is advisable to use citizens and businesses in situations where their input can be successfully utilized and to avoid token participation. One way to accomplish this is to include citizens on the forecasting team. These citizens should provide skill sets that are not available from city staff such as a statistician or computer specialist. Another way is to invite finance, economics and business specialists from local universities, businesses and government to participate in round-table discussions concerning the local, regional and national economic trends. This information can be helpful in acquainting elected officials with economic issues and their relationships with local government financial trends. Of these key persons, two are essential to the success of the forecasting project the strong and continuing support of the mayor and the municipal board and the managerial and organizational support of the finance director. Without such a unified commitment during the development period, the forecasting project may be viewed as meaningless by department directors and middle management. This, in turn, undermines the use of the forecasts. Without the finance director s support, the project will lack the commitment of staff and resources to make the project successful.

12 An approach to financial forecasting The approach to organizing the financial forecasting process depends on the organization and needs of the municipality making the forecast, the resources available, the time allotted to complete the forecast, and the degree of management and political support. The person who has been given the responsibility should ask basic questions about the expected output, and based upon the answers, develop an approach that achieves that expected outcome in the most efficient and effective manner. To simplify, all future references to this person, team or department in this handbook will refer to them generically as the forecaster. Define the purpose The first step in determining an approach to forecasting is to define its purpose, its scope, audience and other project parameters. The person who provided the impetus for the forecasting project is the most likely person with whom to discuss these issues. Usually, the mayor or municipal board provides this direction. At a minimum, the forecaster should obtain the answers to the following questions: 1. What is the purpose of the report? 2. What benefits will accrue to the municipality? 3. Where in the budget calendar does the multi-year forecast fit? Beginning, middle, or end? 4. When is the forecast needed? 5. Will the forecast be used internally or externally? 6. Who is the audience that will review and receive the forecast? 7. How many years will be forecast? 8. What resources are committed to the project? Are they adequate? Staff, computers, other? 9. Who is responsible for the project finance director, budget officer, mayor, other elected officials? 10. Who should be included on the forecasting staff finance staff only, other departments, elected officials, citizens? Address other technical issues Will the forecasts be prepared centrally or by departments for their respective areas or a combination of both? Centralizing the preparation offers advantages: 1) consistent assumptions; 2) fewer highly skilled people involved; and 3) a uniform methodology applied to similar subjects. The disadvantage is that the central office may not have the data, knowledge and experience to make accurate forecasts. A combination of both may be the way of addressing a pure centralized or decentralized approach. Will the forecast project revenues in the aggregate or individually? Although it is possible to forecast in the aggregate, separate forecasts of each revenue source provide better control of the variables and allow more opportunities for analysis. Will the forecast project expenditures based on accounting classification, department organization, programs or a combination of these? To simplify matters, the forecast of project expenditures should be organized consistently with the capabilities of the accounting and financial reporting system. What major assumptions are included in the forecast that must be applied uniformly? For example, inflation, salary adjustments, commodity price changes, etc. How will that be done? Training for Finance Managers

13 Financial Planning What data and information sources will support the project? Are they current, accurate and available? When the answers to these questions are obtained, the forecaster needs to decide the approach to forecasting. Approaches to forecasting For the initial effort at forecasting, a simple and practical approach is advisable. Centralized, single department approach The following steps should be followed to organize the initial multi-year forecast: 1. Document the need for, and benefits of a multi-year forecast; 2. Ascertain the interests and needs of the mayor, municipal board or city council regarding the decision making process; 3. Obtain the necessary management and political support; 4. Assign responsibility for the forecasting project to a single department such as finance or budget; 5. Designate a senior finance or budget officer as project leader. (relieve them of other responsibilities until the project is completed this will be a full time effort); 6. Assign other staff (if possible) with the proper skills to support the project; 7. Ensure the necessary information, equipment, space and time is provided to complete the forecast; 8. Ensure that an action plan is prepared to guide the project with specific outputs, deadlines, assigned tasks and individual responsibilities included therein; 9. Monitor the work at planned intervals that represent completed stages of the project; 10. Complete the forecast project; 11. Coordinate the finished product with the appropriate supervising officials, and 12. Prepare the materials to present the forecast with recommended actions to address the issues raised in the forecast. Since it is important to succeed on the first effort, keep it simple. As you gain experience with forecasting and a permanent staff is retained, other approaches may be tried. Data and information requirements Historical data is required for the forecasting process since most forecasting methodologies use an historical experience base to arrive at a new forecast. Actual revenue and expenditure data for the last five years is usually a minimum requirement. For some forecasting methodologies, a series of ten to fifteen years of observations is best (i.e., regression analysis.) However, many Slovak local governments lack historical data covering this many years. At best, cities might have six to seven years of reliable, consistent data. If that is not available, the only practical solution is to use what you have. Recognize and factor in that this may place limitations on the forecasting methodology. Then, begin to build the database by adding subsequent years data and over time you will reach the necessary levels. Local governments should gather and analyze the following type of data concerning own source revenues, (i.e., local taxes and fees, sale of municipal assets, and shared taxes from the state) and state subsidies. The source of this data is typically found in local governments prior and current years budgets, prior years audits and accounting records, local and state laws or department program activity records.

14 Revenues Five years of historical revenue data should be obtained: 1. Actual revenues collected by source (house tax, agricultural tax, earnings tax, etc.) 2. Definition and description of the revenue source 3. Legal basis for the revenue source 4. Specific revenue data: number of customers/accounts, rates and bases of revenue source, collection rates, exemption policies, formulae, and any other related factors Expenditures Revenues Five years of historical expenditure data should also be obtained: 1. Actual expenditures by account, department or program 2. Descriptions of account classification, program or department organization 3. Legal or contractual basis for account, program and department expenditures 4. Expenditure specific data: (needs to be detailed enough to relate significant year-to-year increases/decreases to policy, program or onetime changes) Expenditures Gathering data on the current year presents a different problem for the forecaster the actual data for the entire fiscal year is not available, and it is constantly changing as revenues are collected and expenditures are made throughout the year. In this situation, the forecaster should compare the budget for current year to the latest current year estimate, and explain significant variations for revenues and expenditures. This allows the forecaster to determine accuracy of the current budget to yearend estimates and include the most accurate information in the forecast base. The historical and current data should be analyzed by the forecaster to determine an appropriate methodology to make the forecast. A discussion of forecast methodologies will be covered in a later section. The forecaster should also consider gathering other related financial information from the state and local sources that may be helpful in understanding the forecasting environment and existing plans that will influence the forecast in the future. Occasionally, banks, financial institutions and universities may be sources of this information, as they gather economic data for their own purposes. The forecaster should be cautious about incorporating plans in a wholesale way into the forecast. In many cases, these plans have not been adopted by the governing body. The forecaster should incorporate only plans in which the council is either obligated or mandated to do something or has made a binding commitment to implement in the future. Some of these mandates or commitments, as well as other useful information about the economy, may be found in the following documents: State approved budget subsidies and transfers Bank loan agreements principal and interest payment schedules and maturity dates Contracts for public services financial commitments and adjustment provisions State and local strategic plans program priorities State and local development plans future project priorities and plans to complete projects under construction Training for Finance Managers

Financial Planning State and local economic forecasts inflation estimates, population projections, business indicators, construction and building activity After analyzing the historic and current data and applying an appropriate methodology, the forecaster should document the basis on which the forecast was made. It is important to be able to explain how the forecast was made and determine the reason for differences between projections and actuals. The following revenue and expenditure information should be documented in the forecaster s records: Revenues Assumed revenue bases and fees Assumed economic changes that will impact revenues Committed state and local policy changes that will occur in the forecast period Projected revenues by source for forecast periods Explanations of key assumptions by source An explanation of the forecast methodology Expenditures Assumed expenditure base and committed programs Assumed policy changes that will have an impact on expenditures Committed state and local policy changes that will occur in the forecast period Projected expenditures by account, program or department for the forecast period Explanations for program increases and decreases An explanation of the forecast methodology Resources Three resources are Sk required to produce forecasts: staff with required skills, development time, and computer equipment. The requirement for each depends upon the intended uses of the forecast, quality of the data and the qualifications of the forecasting team. The ideal team to support the forecasting effort should include a top policy maker, the finance director, analysts who are knowledgeable in economics, statistics and data processing, and a senior financial person to lead the project. A policy maker is included on the team to ensure that users needs are incorporated into the resulting forecast process. The finance director s role is to bring knowledge of the local financial management practices, accounting and budget to the process. The finance officer should also coordinate the involvement of other senior officials to determine their needs and to locate the data needed to support the forecasting processes. The project team leader is usually a senior finance officer or budget officer and is given the following responsibilities: Building a coalition of key people concerned with the forecast, and handling the liaison with other departments. Insuring administrative and technical aspects are executed in a timely fashion. Recommending key decisions (the economic and policy assumptions to be built into the forecast) as necessary, to top management. Guiding overall development and operation of the forecasting system. Presenting the resulting forecasts to the mayor, municipal board, council and its committees as appropriate. 15

16 Skills of the forecast team are very important. An understanding of economics is necessary to ensure that the revenue and expenditure forecasting assumptions reflect the influences of the national, regional and local economies. If the local government employs an economist, then that person should be included on the team. An alternative is to contract with a local university to provide a person or persons to serve on the team or at least review the economic assumptions. Other organizations such as the national government, banks, financial institutions and business organizations are often involved in economic forecasting. They may have resources on which the local government might draw. Statistical skills are important. The preferred forecasting methodologies for income tax and other economic sensitive revenues involve the use of statistical techniques such as multiple regression analysis. Statistical techniques can also be used for forecasting fees and user charges. Data processing skills are needed because most statistical techniques require the use of computers. Automation of the forecasting increases the efficiency of the team who prepare the forecast. Data processing skill does not mean programmers since electronic spreadsheet software packages are available. Using these tools, the forecaster can do what if scenarios and quickly break out the expenditures by different cost or program categories by changing a few assumptions or selecting a different variable. Personnel with these skills can be found at local universities, if not available on the local government s staff. Development time is the amount of time it takes to prepare the forecast. Preparing an initial forecast requires more time than do subsequent updates. The level of detail increases the time required to produce a forecast. A considerable amount of that time is devoted to gathering historical revenue and expenditure data and testing forecast methodologies. Also, unless an experienced staff is hired, the staff will be learning as it is preparing the forecast. This will extend the development time. Once the initial year s data and information is gathered, subsequent years require only updating. As a result, the time for preparing the forecast is reduced. Automated budget and financial accounting systems also will reduce the data gathering time. Another technique to reduce the development time is to build upon the experience of other municipalities rather than develop your own. Multi-year revenue and expenditure forecasts can be prepared without computers it just takes longer. Computers are required if statistical techniques are employed in the forecast. Computers are also a necessity if the local government desires to perform detailed revenue and expenditure forecasts or test different what if scenarios; such as, using varying inflation rates or other economic assumptions to test different program policy options. Management and political support The most essential ingredient to a successful forecasting process is a strong and continuing commitment from the chief executive officer (mayor.) Without evidence in the development process that the forecasts will actually be used, it will be difficult to get the continued allocation of staff and time to complete the process. The same is true if department directors and their staff are involved in the forecasting process. If they perceive that their work will not be used, the process will be viewed as useless. When this happens, the inputs from department management and resulting forecasting process will become meaningless. In the financial planning and forecasting processes, gaining management and political support are important first steps. Here are some suggestions: To gain management support: Determine whether and where financial planning and specifically financial forecasting can help. Training for Finance Managers

Chart a course to accomplish multiyear financial forecasting. Identify the benefits and pitfalls of forecasting. Tie forecasting to existing budget planning processes. (For example, as the first step of the budget calendar.) Acquire planning and forecasting tools and expertise through staff development training. Present the plan to management for consideration and approval. If approved, seek guidance on obtaining political support. To gain political support: Seek the advice and counsel of the chief executive/administrative officer (mayor.) Identify the potential political benefits and pitfalls. Focus the proposal on a policyoriented effort to direct or redirect a government s financial future. Coordinate the proposal with other interest groups and political parties, as appropriate. Present it to the mayor, municipal board, council and appropriate committees. Adjust the proposal based on the elected officials response. 17 Reflection Now that we have discussed organizing the forecasting process, it is time for you to look at your local government. Identify the key persons in your local government that would need to be involved in a forecasting project. What role would each person play? Who would be the best person to organize such an effort? How would you gain the management and political support? List the critical steps that would need to be taken in your local government to establish a multi-year financial forecast on an annual basis. Financial Planning

18 Types of financial forecasts Financial forecasting has been previously defined as the process that produces a projection of future years revenues and expenditures based on a set of policy and economic assumptions. When we talk about types of financial forecasts used in local government, the most frequently used classification is based on length...short-term (up to one year), medium-term (1-5 years) and long-term (+10 years.) For annual budgeting, short and mediumterm forecasting is more useful and relevant than long-term, and will be the focus of this module. Long-term planning is used most often in economic development planning and strategic planning. Short-term (0-1 Year) Short-term estimates are continually updated, refined and ultimately included in the budget. Cash management A second example of the use of shortterm forecast is in cash management. Local governments should forecast monthly cash inflows and outflows as a part of preparing the annual budget for two reasons: 1) to project interest earnings on invested bank account balances, and 2) to identify any cash shortfalls and the possible need for interim financing during the year. Monitor budget implementation Another example of the use of shortterm forecasting is to monitor budget implementation. It is prudent to monitor the budget after adoption to forecast the actual performance of revenues and expenditures compared to budget. If significant variations from budget are forecast based upon actual operating results, swift management actions may be needed to bring the budget back into balance. Short-term forecasts cover a period up to one year. The principal uses of short-term forecasts are related to the development of the operating budget and cash management. Operating budget In developing the operating budget, annual forecasts of revenues and expenditures are needed for next year s budget. These forecasts may occur at different times. For example, some local governments prepare preliminary estimates of next year s revenues and expenditures as one of the first steps in the budget calendar, six to nine months before the start of the fiscal year. These early estimates are used by mayor, municipal board, council and management in setting priorities and budget guidelines. The Short-term forecasting helps management prepare a budget for next year based on reasonable assumptions. It also eliminates surprises by identifying variances from expected performance early in the fiscal year which, if properly used, provides time for management action rather than waiting for a crisis to happen. Finally, it provides a tool to monitor the budget and assure compliance with the legal appropriations. When problems are identified, corrective actions can be initiated, eliminating the problems. Medium-term (1-5 Years) Medium-term Training for Finance Managers

19 Financial Planning Medium-term forecasts cover the period one to five years into the future. The principal uses are for budgeting, policy analysis, legislation and capital programming. Budgeting For example, in budgeting, mediumterm forecasting is used to project gaps between anticipated revenues and expenditures during the next one to five years. This prompts policy discussion, and hopefully, decisions to close these gaps. If decisions are implemented, the actual revenues and expenditures will not be the same and the forecast gap will not be the same. The altered level will be the result of actions taken in response to the forecast. Policy analysis Forecasting is also used to aid policy analysis. For example, wage negotiations often have implications beyond the current year. Identifying alternative scenarios and the future years impact on these negotiations is critical information for policy decision making today. Decisions regarding funding investments from own source revenues reduces the availability of funds for operating expenditures in the current year. They also potentially increase operating costs when the facilities are completed in future years. Similarly, incurring debt to finance new facilities has multi-year implications both in paying debt service and in operating the facilities when they are complete. Both investment decisions should be made understanding what the future cost is and how it will be funded. These situations need to be considered with the future impact identified at the time the policy decisions are made. Once the decision is made, the forecast can reflect it as a future year s committed cost. Fiscal impact of legislation Medium-term forecasts are useful in determining the fiscal impact of legislation, especially tax or revenue legislation. For example, changing an allocation formula for state-shared revenues with local governments will have multi-year impact. Forecasting the impacts of this change in the law upon local governments, and presenting this information to the legislative body is one way to forestall or reduce the adverse impacts upon the jurisdiction. Identify financial trends Medium-term financial forecasts help management and policy makers identify financial trends that will require management/council action to avoid potentially disastrous financial results. Being prepared eliminates surprises and reduces management by crisis. Forecasts also promote more efficient operations of local government. Capital Programming Medium-term financial forecasts are also useful in capital programming. Capital projects or investments normally have a life greater than a year. As a result, expenditures related to a project extend beyond the annual budget and may continue for many years for major investments. There are two types of expenditures: construction expenditures and debt service charges (i.e., bank loan repayments.) Most capital projects are constructed using local government s own source revenue or dedicated state grants or transfers. Because current revenues are limited, a current revenue financing approach tends to stretch out the completion of a project over a number of years. Another multi-year expenditure related to capital programming is debt service. Local governments incur these expenditures when they borrow money from banks or other lending institutions to construct a capital project. The principal amount is repaid with interest over the term of the loan. Annual debt service charges represent fixed costs of the local government once the transaction is completed, and must be funded in the annual budget. Medium-term financial forecasts identify these projected construction and debt service costs by year, so that each year s increment can be anticipated and funded in the annual budget when needed.

20 The last use of medium-term forecasts in capital programming relates to the operating and maintenance costs associated with opening a capital facility. Operating and maintenance costs include staff to operate the facility and supplies, services and equipment to maintain it. These costs are normally funded in the operating budget when the facility opens. Including this item in a medium-term forecast alerts the local government of the need for an increase in the annual operating budget. Long-term (10+ years) Long-term Long-term forecasts cover a period ten or more years into the future. Longterm forecasting is most widely used in strategic planning, physical and economic development planning, capital programming and debt planning. Longterm financial planning is a study unto itself, and should be studied by serious advocates of financial planning. Separate handbooks will discuss Capital Programming and debt planning (Debt Management.) Strategic planning Strategic planning is both a process and a product. As a process it uses organization and environmental analysis in an attempt to identify internal and external strengths, weaknesses, opportunities, and threats that will shape an organization s future direction. This information is then used to formulate strategic alternatives over the next ten to twenty years. A strategic planning exercise typically creates layers of goals, objectives and strategies that provide a target path for the operations of an organization. In local government, strategic planning typically involves the governing body in a systemic process that seeks to establish a new direction for the organization and thus overcome the traditional incremental decision-making. The product is a plan that establishes the organization s future strategic direction. That direction must ultimately be reflected in the budget. While the budget has always been a choice between different revenue sources and program expenditures, in the future the budget must reflect strategic choices. Budgets can be used to implement strategic plans, in effect, as strategic financing plans to stimulate economic development. On the other hand, the lack of strategic financing plan may, by default, constrain development, local planning and investments. Physical and economic development planning Long-term forecasting can also be used for physical and economic development planning for a community. To forecast a community s economic development potential ten to twenty years into the future, forecasters initially must determine the past and current state of the local economy. This would include documenting the population (size, age mix, ethnicity, education level), income structure, and employment mix. Together, these reveal the capacity of local residents to pay taxes and requirements for public expenditures. Historic trends document past financial problems and provide forecasters an indication of whether there may be financial problems ahead. Fiscal impact analysis One tool, used to project long-range changes in population, income and land use on the local economy, is called a fiscal impact model. The model assumes that, as the size and composition of the population shift, as income levels and distribution change, or as land use patterns are altered, there will be impacts on both revenues and expenditures of the local government. Fiscal impact analysis attempts to determine the magnitude of the impacts by modeling various scenarios using current policies and potential policy changes to determine what Training for Finance Managers