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After years in a continuous loop of population decline and higher taxes on a decreasing tax base, the largest municipal bankruptcy in U.S. history was filed by the City of Detroit in July 2013. After any disruptive event, our collective hindsight is 20/20, but could anyone who followed Detroit’s financial statements have seen this coming? We often discuss calculating key financial indicators to assess the financial health of a fund; would have doing so early on helped predict the bankruptcy? Recently, a study by Stone et. al., [1] sought to answer this question by analyzing Detroit’s financial condition through the lens of two dozen financial indicators. Their results illuminate some important points about using key financial indicators.

The authors computed 24 financial indicators from the City’s Comprehensive Annual Financial Reports (CAFRs) from 2002 to 2012. They calculated indicators from the financial data reported in two places: government-wide statements, and the balance sheets and operating statements for Detroit’s Governmental Funds. While they did not look at Proprietary Funds specifically, which would include the Enterprise Funds in which water and wastewater utilities usually reside, there are some lessons we can apply to Enterprise Funds using this study.

How did the City of Detroit do ahead of the bankruptcy?

For this post, I only focus on four of the indicators from the study that also can be calculated independently for water and wastewater utilities from Proprietary Funds statements, although all of the indicators below reflect government-wide metrics[2]. There are, of course, several other indicators a utility can choose from and calculate, described elsewhere in our blog.

First, there is the Quick Ratio which measures whether a governmental entity can meet short-term obligations by dividing current assets (measured by the authors as cash + cash equivalents + investments + receivables) by short-term liabilities. Despite a brief, large infusion of cash from the issuance of Certificates of Participation (COPs) in 2005 and 2006, Detroit’s government-wide Quick Ratio operated below the 1.0 benchmark for five of the 11 years analyzed. Dropping below 1.0 indicates that at that snapshot in time, the City did not have sufficient cash funds available to pay off all short-term liabilities at once. Similarly, Detroit’s Governmental Fund Quick Ratio showed a fairly consistent decline from over 1.0 to around 0.4 in 2012.[3]

The second indicator is the Operating Ratio. This ratio measures whether the entity collects enough revenue in a year to cover its expenses, and is calculated by dividing total operating revenues by total operating expenses. In Detroit, this ratio steadily declined from 1.05 in 2002 to around 0.88 in 2012, signifying that its revenues in 2012 only covered 88 percent of its expenses. This downward trend was experienced by many water and wastewater utilities across the country.

The third indicator is the Net Assets Ratio. This ratio is the entity’s unrestricted net assets divided by its total liabilities and measures the entity’s ability to meet long-term obligations. This ratio consistently declined from 1.40 to around 0.75, meaning that by 2012 Detroit could only cover 75 percent of its long-term obligations with its assets.

The last indicator is the Debt to Assets Ratio, which measures an entity’s leverage. This ratio is calculated by dividing long-term debt by total assets and measures how much of the entity’s total assets are financed by long-term debt. From 2002 to 2012, Detroit’s ratio was largely stable between 0.58 and 0.62.

Lessons for utility managers and finance directors

What are the lessons that we can apply to water and wastewater utilities from such an extreme case and from (mostly) government-wide financial indicators?

Lesson 1. Financial condition is in the eye of the beholder

One lesson this study, and many studies on financial indicators emphasize, is that various stakeholders will define financial condition differently. Bond rating agencies, citizens, governing board members, and local government administrators may all have different interpretations as to what “good financial condition” really means for a city or utility. For instance, low water rates may yield an Operating Ratio below 1.0, which might appear more problematic to bond rating agencies and local government administrators than to the citizens who enjoy their low rates.

Lesson 2. It is only after using a wide variety of indicators that we start to see the whole picture

Since stakeholders have varying definitions of “good financial condition” it is important to present various indicators that attempt to measure at least part of each of their definitions. Furthermore, using more indicators provides a more holistic picture than simply using one or two indicators (see Table 1 below).

Table 1: Which Indicators did the Authors Find Effective in Predicting Detroit’s Fiscal Crisis? (Source: Stone, et. al. A Comparison of Financial Indicators: the Case of Detroit)

No sign of imminent crisis Consistently Declining Decline Immediately before Bankruptcy
Cash Ratio Governmental Fund Quick Ratio Leverage
Quick Ratio Operating Ratio Taxes per Capita
Current Ratio Fund Balance as % of Expenditures Revenues per Capita
Surplus per Capita Unrestricted Net Assets/Total Liabilities Expenditures per Capita
Unrestricted Net Assets/Expenses Long-term Liability Ratio
Debt to Assets Ratio Net Assets Ratio
Intergovernmental Ratio Long-term Liabilities per Capita
Measure of “Business-Type Activities” Self-Sustainability Government-Wide Debt Service Ratio
Governmental Fund Debt Service Ratio
General Revenues/Operating Revenues
User Charges/Program Revenues
Total Primary Government Expenditures financed from Business-Type Activity Revenues

In the case of Detroit, the study concluded that simply looking at the Quick Ratio or the Debt to Assets Ratio would not have indicated a deteriorating situation. This is partly due to the large cash infusion the City got from the COPs. Simultaneously, however, the City’s Operating Ratio and Net Assets Ratio would have been a warning sign of deteriorating financial condition. In summary, having sufficient current assets to cover short-term liabilities in most years masked over longer-term financial condition issues.

Imagine a scenario where a water utility uses debt financing to replace its water pumps, which have severely depreciated. This investment may increase the utility’s Debt to Assets Ratio. Some stakeholders, only looking at the Debt to Assets Ratio, could be dismayed after seeing it increase. However, the Capital Assets Condition Ratio[4] would show a financially-responsible investment in the utility’s capital assets. No single indicator can illuminate the whole picture.

Lesson 3)   It is important for utility directors and local government administrators to continually inform their governing boards of the utility’s financial condition

It is important for utility directors and local government administrators to continually communicate with their governing boards. Such discussions would not only include informing them of activities at the utility and rate adjustments that may be needed to sustain self-sufficiency. It would also include presenting the utility’s financial condition as measured by financial indicators, which summarize the utility’s financial position as expressed on balance sheets and operating statements.

Resources to help local government utilities calculate key financial indicators

Monitoring financial indicators over time is one approach to systematically measuring the financial health of a utility. It requires simple addition, subtraction, and division of numbers the utility already reports on annual operating statements and balance sheets.

There are numerous tools available for utility staff to use to calculate key financial indicators for their utility funds. The EFC’s Financial Health Checkup for Water Utilities spreadsheet tool is a free, do-it-yourself tool that walks you through extracting numbers from your financial statements to calculate six key financial indicators and benchmarks. The EFC’s Utility Financial Sustainability and Rates Dashboards automatically calculate financial indicators for hundreds of utilities in a few states where data are available. In North Carolina, the Local Government Commission has a tool that allows local governments to benchmark eight financial indicators against those of other local governments. Small water systems (serving fewer than 10,000 people or about 4,000 accounts) can also request that the EFC provide a free assessment of the financial health of their water fund by completing this request form.

Tracking financial indicators over time and regularly providing their interpretation to governing board members can help prevent a utility from encountering a financial crisis. By identifying any downward trends in certain aspects of the financial management of a fund, the decision-makers have more time to make adjustments to rates, costs, financial policies and plans in order to remedy the situation and maintain a healthy financial condition.

Jordan Paschal is a graduate student studying in the MPA program at the UNC School of Government.

The contents of all posts authored by students are solely the responsibility of the authors. Statements made and opinions expressed are strictly those of the authors and not the Environmental Finance Center or The University of North Carolina at Chapel Hill.

[1] Stone, S. B., Singla, A., Comeaux, J. and Kirschner, C. (2015), A Comparison of Financial Indicators: The Case of Detroit. Public Budgeting & Finance, 35: 90–111. doi: 10.1111/pbaf.12079

[2] Unless otherwise noted, indicators are calculated on a full accrual basis, the same accounting basis Enterprise Funds use.

[3] This is based on modified accrual. The Quick Ratio for an Enterprise Fund would use full accrual accounting.

[4] This indicator was not calculated for this study. It is calculated as: 1.0 – (accumulated depreciation divided by capital assets being depreciated)