Five things you can do to improve your utility’s financial health

There are five basic things that must be accomplished to ensure that your utility is financially healthy. Successfully addressing all of these is essential to your system’s financial sustainability.

The board and management of utilities have very important responsibilities and duties to perform in the financial area. Chief among these responsibilities are:

1. developing and maintaining the rules governing the utility’s financial system
2. planning for the utility’s financial future
3. preparing, adopting and adjusting annual budgets
4. monitoring and oversight of financial performance
5. ensuring accountability and integrity of the financial system

1. Establishing a framework: Policies and procedures for managing finances

Get the full guide on financial management for small utilities

[1] The Basics of Financial Management for Small-Community Utilities [1] is an easy-to-understand how-to guide for water utilities in small, rural communities. Produced by the Rural Community Assistance Partnership (RCAP), this primer and its tools are an ideal orientation for new board members or background for experienced board members on this topic. The Basics guide covers the key financial statements—balance sheets, income statements and cash-flow statements—and a lot more. It discusses the importance of solid, effective financial management of a utility—developing a system that is financially sustainable. The guide is available in print from RCAP staff in the field or as PDF, which you can view and print yourself on your own computer. There are also multimedia supplements to the guide that can be accessed through the link above.

Financial-management policies are rules that are developed and enacted by the governing body and management of the utility. These rules spell out the basic framework for how the financial functions of the utility will be carried out. Examples of what should be in financial policies are:

• statement of applicability—that policies will conform to all applicable laws
• whether the accounting system will be run on an accrual or cash basis
• that the utility will be operated on an enterprise basis
• revenues shall be used solely for the system’s operations
• revenues shall cover the full cost of operations
• definition of the fiscal year of the entity
• that financial affairs will be based on generally accepted accounting principles
• how/when the utility will be audited
• definition of financial conflicts of interest
• definition of financial risk mitigation such as insurance coverage and bonding
• user rates: when and how rates will be reviewed/adjusted
• what financial reserves will be required and purposes of each reserve fund

Your financial-management policies – and all policies, for that matter – should be in writing. Any “policy” that is not written down is not really a policy. Many small organizations and businesses operate on an assumption that “this is the way we’ve always done it” or “everybody knows the rules.” Policies that are written are thus official and can then be enforced, and they let everybody know what is expected of them. Putting policies in writing also contributes to an institutional memory for times that board or staff members are replaced.

Financial procedures

If policies are the rules defining how the financial system will function, then financial procedures are the routine, often day-to-day tasks that must be carried out for system to function. As with policies, putting procedures in writing in a financial procedures manual is recommended for every utility (or even a folder with a series of documents on your computer may suffice). The procedures manual details how specific financial functions and transactions of the utility will be carried out, by whom, and when. The manual should outline the specific process for how general categories of financial tasks will be carried out and which personnel are responsible for their completion. For example:

Accounts receivable: How are monthly billings accomplished, by whom, and by when?

Accounts payable: Who receives and tracks invoices from vendors?

Reconciliation procedures: How are billings, receipts and payments reconciled with ledgers and accounts of the system?

Financial reporting: How will financial reporting (income statements, balance sheets, etc.) be accomplished, by whom and by when?

2. Planning for the utility’s financial future

In the same way that individuals plan for their retirement years and parents plan for their children’s college education, utilities should plan for the future. Most small utilities do not plan ahead. Planning for future needs includes:

• Forecasting the utility’s future financial needs (operating and capital needs)
• Determining how those future financial needs will be met

A capital-improvements plan (sometimes called a long-range plan) is a written document that specifies:

• what improvements to the facility will be needed in the future
• when certain projects will be needed and when they will be undertaken
• how much those improvements will cost

In preparing capital-improvements plans, a number of considerations are taken into account, such as:

• Will current facilities reach their design capacity in the near future?
• What current components of the system will require major repair, rehabilitation or replacement?
• Will failure to upgrade existing facilities result in regulatory violations or enforcement actions?
• What are the most critical improvement needs and what is the urgency of meeting those needs?
• Which capital projects can be financed through the system’s own resources, and which projects will require outside financing?
• How do financing options for improvements relate to the annual budgeting process?

A capital-improvements plan should cover at least a ten-year period into the future. The plan is of great importance in helping the utility’s board and management make informed decisions about rate setting, future debt-service requirements and future revenue requirements.

3. Preparing, adopting and adjusting annual budgets

An annual operating budget is a short-term, twelve-month financial plan that coincides with the fiscal year of the utility. An operating budget is simply a one-year forecast of expected revenues and expenses. The budget helps the decision-makers of the utility keep adequate control of its finances and provides adequate funding to the highest-priority areas of system’s operations.

The operating budget may be a separate document, but it should be compatible with the utility’s long-range financial plans for planned repair/replacement and major capital improvements.

The annual budget should be realistic, and it should be balanced. If annual revenues appear to be insufficient to meet projected expenses, a full rate review and adjustment should be considered.

Ideally, the final annual operating budget should be adopted by the governing body no later than 30 days prior to the start of the fiscal year. Financial records of the utility are critical for creating a budget. Utility management should take into consideration:

• previous expenses from the past 2 to 3 fiscal years
• current debt-service requirements
• any unplanned, emergency expenses that occurred within the past several years
• revenues from customer billings and other sources of income for the past several years
• required reserve levels necessary for the coming year

In addition to previous years’ records of revenues received and expenses incurred, consideration must be given to anticipated changes to those revenues/expenses during the coming year, including:

• changes in operating expenses, such as wage/salary increases, new hires, changes in costs of materials, transportation, utilities, as well as adjustments for inflation
• changes in debt-service expenses, including anticipated new debt
• changes in revenues due to expected rate and fee adjustments, growth or decline in the customer base, etc.
• transfers to/from financial reserves

The annual operating budget should contain budget categories that match the same categories of revenue or expense contained in the utility’s chart of accounts. Once the final budget plan has been completed, a projected cash-flow statement should be prepared in order to make sure that monies will be available when needed, that is, the budget should “cash flow.”

4. Monitoring and oversight of financial performance

Once budgets have been prepared, the job of oversight and monitoring the financial performance of the utility begins. The purpose of monitoring financial performance is to make sure that everything is proceeding according to plan, and that, financially speaking, the system is on the right track.

Providing effective financial oversight means not only monitoring and adjusting the current operating budget, but also understanding common financial statements (like the balance sheet, the annual income statement and audit reports) and making informed decisions about the future based upon this important information.

The governing board should receive and review financial reports on a monthly basis. A standard, monthly and year-to-date budget report measures actual revenues and expenditures vs. budgeted revenues and expenses on a line-item basis. Budget adjustments should be made during the fiscal year if necessary. 

Financial ratios

Some good methods for monitoring a utility’s financial performance over time are financial ratios. They can be computed from two important financial statements: the balance sheet and the income statement.

Balance-sheet ratios

The liquidity ratio (or current ratio) measures the system’s ability to pay off current liabilities. Systems with less than a 1.5 liquidity ratio are considered to be in financial distress. To calculate the liquidity ratio, simply divide the balance sheet’s current assets by the current liabilities:

Current assets ÷ Current liabilities = Liquidity Ratio

The leverage ratio measures how much the system relies on debt. A leverage ratio below 0.30 indicates the system may be in financial distress. The leverage ratio is determined by dividing the equity by total assets:

Equity ÷ Total assets = Leverage ratio

Income-statement ratios

The operating ratio is a simple calculation used to measure the profitability of the system. Normally, a utility that has an operating ratio of less than 1.0 is considered financially distressed. The operating ratio is determined by dividing the operating revenues by operating expenses:

Operating revenues ÷ Operating expenses = Operating ratio

The debt-service coverage ratio will vary from system to system, depending upon the requirements of each lender, or in some cases, state statute. The Rural Utilities Service (of the U.S. Department of Agriculture Rural Development) Water and Waste Disposal loan program is a major federal lender for small and rural utilities. RUS prefers a minimum debt-service coverage ratio of 1.1 or higher, as calculated by the following formula:

(Net Operating Income + Depreciation) ÷ Total Debt Service = Debt service coverage ratio

Financial ratios can be computed from year to year in order to establish financial trends and to determine whether the financial direction of the utility is positive or negative.

5. Insuring accountability and integrity of the financial system

The best method of insuring the accountability and integrity of a utility’s financial system is to have an annual audit prepared by an independent accounting firm. In an audit, the auditor’s opinion letter is usually the first page of the audit report. An unqualified opinion or clean opinion is the best an organization can receive. It means the auditor did not find any material misstatements in the system’s financial records.

The report will also include the primary financial statements:  the balance sheet, the income statement and the cash-flow statement.  The next major item is the notes to the financial statements. The notes provide valuable information regarding the nature of operations and in-depth information about various balances in the financial statements, such as notes payable and property, plant and equipment. The notes will contain a lot of other pertinent information and should be read carefully.

The audit report may also contain useful recommendations from the audit firm for making improvements within the financial system that will provide better safeguards for financial assets, improve efficiency or both.  The governing board and management of the utility should strongly consider taking the actions necessary to implement the recommendations of their auditor.

Thanks to Community Resource Group, the Southern RCAP, for this article.

Sustaining essential utility services in the face of federal budget cuts

With all of the uncertainty about the federal budget and the threat of budget cuts because of the deficit, it seems that local governments will be affected. What should small communities do to sustain their essential utility services? The federal deficit affects all of us, and the president and Congress are giving their attention to this problem. Financial instability at the federal and state level need not prevent your community from setting a course toward financially sustainable water and wastewater services. While these budget and deficit issues will affect governments for the foreseeable future, your community can take steps to plan for your future and move toward sustainability. The key is taking a long-term view of financing utility services. This involves looking beyond this year’s budget to understand the long-term costs of providing safe drinking water and effective wastewater service. Start with your water and wastewater budgets. Look at your history of revenues and expenditures for these operations. Are your user fees sufficient to meet expenses—not just this year, but into the near future? Take the long-term view to decide now if gradual increases in revenues will be needed in future years to meet your expenses. Raising rates is a strategic decision based primarily on your need for revenues. Next, look at the replacement costs of long-term assets, and plan to reserve monies for replacing key assets in the future. If the federal deficit requires federal grant and loan programs to be cut back, the cheapest alternative for funding replacement is to save money, earn interest, and replace assets on your schedule. Think about what you’re buying. Ask yourself, “What are the future replacement costs?” and “Can we really afford this?” After that, consider the external events that may or may not affect the community. For example, learn about upcoming changes in regulations, the forecast for the local economy and jobs, and other local factors. These will affect the costs of your system’s operations or the ability of customers to pay their user fees. External factors can have a big effect on the water and wastewater budgets. Pay attention to these signs over the long-term, or meet with people who can provide this information and advice to you. Finally, stick to it. Planning for sustainability is a continuous process, not something you do to meet another government’s legal requirement. Remember, each year of history becomes the basis for more accurate forecasting of revenues and expenditures. Nobody really knows your community or the services you provide better than you do. Put that historic information to good use to keep your system up-to-date and ahead of the curve. Spend a little time before the budget cycle begins to review the history of your utility (both internal and external factors). The good habits you develop for long-term management of services will be passed on to generations of leaders in your community for years to come. - Midwest Assistance Program, the Midwest RCAP