There is increasing focus on the fiscal health of Canadian local governments in the wake of challenging economic conditions, both in our country and worldwide. Unsettled financial times, a significant trend towards transparency, and growing pressure to be more business-like means more attention is being paid to the ability of our communities to be fiscally resilient. Decision makers and stakeholders alike have questions: “Will services be disrupted or taxes and fees increase?” (Citizens); “Can we meet expenditure requirements with current projected revenue?” (Local Government staff & Council); “Will we have to intervene should one of our municipalities go into financial difficulty?” (Regional/Provincial Governments).
In British Columbia, almost all local governments except Vancouver borrow through our organization, the Municipal Finance Authority of BC, and as such, do not need to issue bonds in their own names to raise capital for infrastructure expenses. Elsewhere in Canada, however, Ratings Agencies (DBRS, Moody’s, Standard and Poors) will assess bond issuers in the Municipal Sector against a myriad of criteria in order to derive a credit rating that reflects the credit-worthiness of that entity. The better the rating, the higher-quality the bonds they issue and the lower the interest rate on the debt, and subsequently, the lower the taxes that are levied on citizens to fund the obligation. Although BC local governments do not face this scrutiny individually, the economic health of BC’s local governments is an important component of the MFA’s own credit rating, and forms part of the rating agencies’ review.
The MFA has developed a course “An Introduction to Financial Indicators” on this subject, delivered in cooperation with the Government Finance Officers of British Columbia (GFOABC) to assist our Local Governments explore the potential of broader assessment methods. If a credit rating agency reviewed your local government, what would they find? Would it be rated “AAA”?
It’s clear that assessing the status of one’s own community’s financial indicators is integral to accountability, transparency, and ultimately of understanding the reality of the financial position you hold. By going beyond required financial statement reporting, municipalities can explore year-over-year changes, assess intergenerational equity burden, debt load trends, and revenue source overdependency. This deeper analysis facilitates early identification of risks and opportunities, while enabling more nimble and timely responses. It may also provide insight, internally and externally, on policy impact, demonstrate excellence in fiscal stewardship, and provide the opportunity to benchmark key metrics against peers.
No two communities are alike, so it is important to both define your purpose for such analyses and select those measures that are most relevant to you. Are you completing ratio analysis to assess trends that identify areas that could be improved or to validate those where progress is being demonstrated? Are you benchmarking to other similar communities or against identified “hurdle rates”? Do you want to improve reporting to your community when financial and/or numerical data is translated into information on how residents will be impacted? Each of these objectives presents multiple options and is developed from different indicators and data sources.
PSAB SORP – 4
The Public Sector Accounting Board (PSAB) Statement of Recommended Practice – 4: Indicators of Financial Condition (SORP-4) provides guidance on placing financial statement results in greater context through analysis of financial indicators in three main areas: Sustainability/Viability, Flexibility, and Vulnerability. The main outcome is to be able to quantify a municipality’s financial condition. “Financial condition” is defined by PSAB as “A government’s financial health as assessed by its ability to meet its existing financial obligations both in respect of its service commitments to the public and financial commitments to creditors, employees and others.” The three core areas of the SORP-4 analysis are outlined as:
- Sustainability/Viability – The degree to which a government can maintain its existing financial obligations both in respect of its service commitments to the public and financial commitments to creditors, employees, and others without increasing the debt or tax burden to the economy within which it operates.
- Flexibility – The degree to which a government can change its debt or tax burden on the economy within which it operates to meet its existing financial obligations, both in respect of its service commitments to the public and financial commitments to creditors, employees, and others.
- Vulnerability – The degree to which a government is dependent on sources of funding outside its control or influence, or is exposed to risks that could impair its ability to meet its existing financial obligations, both in respect of its service commitments to the public and financial commitments to creditors, employees, and others
It is recommended that indicators from each of the core areas are selected, this will help to provide context and answer “why” you’re measuring and monitoring certain metrics. However, these three areas are not necessarily the end-all-be-all of financial measures. Further selection and segmentation of indicators may provide further insight into important areas of fiscal health. For example, selecting indicators that measure a shorter-term view of financial sustainability such as the Current Ratio can be useful. Similarly, for example, selecting measures that relate directly to a local government’s ability to service long-term debt may provide another lens to view financial health into the future.
Some examples of indicators that may be used with each core area are as follows:
- Net debt-to-total annual revenue
- Expense by function-to-total expenses
- Total expenses-to-taxable assessment
- Own-source revenues-to-taxable assessment
- Net book value of capital assets-to-cost of capital assets
- Government transfers-to-total revenues
- Large commercial (major) industry assessment-to-total assessment
Once sets of indicators have been matched with core areas of focus, they may be calculated and will form a basis of comparison. It is recommended that the current year, and previous 4 years are reviewed. However, it may be useful to consider years where something abnormal occurred. For example, was your municipality affected by a particular industry downturn in the past? What was the effect on your municipality’s financials during that year? That type of information may be useful for future planning. Lastly, acknowledging and noting ‘one-time’ revenues and/or expenses that had an impact on a municipality’s ratios is important. You may consider discounting (removing) those items from your calculations so that the measures reflect a ‘normal’ trend. In the end, careful consideration of the areas of focus and associated indicators, the time-horizon considered, and ‘normalizing’ the data will produce a meaningful assessment to be used by stakeholders at all levels within a local government.
Benchmarking is useful when assessing against comparable peers or to relevant hurdle rates, expanding review beyond year-over-year internal factors, and beyond the purely financial to operational and statistical data. Comparison in this way can be a catalyst to change and provide targets which inform policy, practice, and strategy-setting. Use caution when comparing your community data to that of others you believe to be similar.
Be wary of these pitfalls that may not be immediately evident:
- Scope or quality/frequency of service differences
- Differences in the number of people served, primarily where economies of scale can distort numbers, especially for smaller communities
- Differences in how data is defined i.e. overhead versus expenses or where local government entities may overlap geographically
- Varying environmental factors such as climate (snowfall, flooding, extreme cold or heat)
- Data that is incomplete, unverified, out of date, or from an unreliable source
The Benchmarking Process:
Step 1: Set benchmarking priorities
Step 2: Identify key metrics to be assessed
Step 3: Collect data – financial, operational, statistical
Step 4: Compare to internal and external standards
Step 5: Identify gaps and reasons for poor performance
Step 6: Plan an improvement roadmap and timelines
Step 7: Use the plan to close gaps and improve/refine processes, and periodically re-measure to assess progress
Analysis completed with the intention of reporting out to your community may focus more on demographic and environmental data and may or may not have a financial element and is wider in scope and audience. Some potential sources of data to consider:
- Financial statement figures
- Demographics/Census information
- Library/Museum/Park/Health Activity
- Education statistics
- Environmental data
- Real Estate/Business Activity numbers
When completing any of these reporting categories, ensure you integrate qualitative factors such as understandability, relevance, reliability, and comparability. Where possible, reference the financial statements and indicate if the condition is improving or deteriorating. Explain the reasons for changes over time, noting significant events that may have had an impact and any wider economic or environmental factors that contributed to the results.
Creating a focused approach to monitoring, measuring, and reporting of key statistics and indicators provides decision makers and other stakeholders the tools to adjust and provide timely feedback. In turn, making the commitment to review major aspects of a municipality’s operations allows for improvements that can be felt throughout a community. Incorporating ratio analysis into the financial review process, provides the basis for comparison and may be used to diagnose current or future vulnerabilities and areas for improvement. Benchmarking can be tricky process, as each municipality has its own set of challenges and advantages. Being cognizant of the differences between your community and others allows for the development of set of communities to measures your financial standing and other areas of interest against. Finally, reporting your findings to key stakeholders is an important process. Reporting allows a community to highlight areas where improvements is needed or success has been found. That process creates transparency and a dialogue within a community that is integral for continuous improvement.
Kyle Derrick is the Credit & Economic Analyst at MFABC. He is a recent MBA graduate from Royal Roads University. Further, he has an undergraduate degree in Business Administration (finance) and holds a Certificate in Economics.
Renata Hale is the Manager of IT & Strategy at the MFA. She is a CPA, CGA with a Bachelor of Accounting Science from the University of Calgary who joined the MFA as the Manager of Accounting in 2002. She is the Treasurer of the Paws For Hope Animal Foundation in BC and a member of Women For Humane Canada, in support of her passion to improve animal welfare in Canada.