Before looking at the systems for analyzing financial condition, it would be helpful to consider what the term ‘‘financial condition’’ means and how it relates to the more comprehensive concept of ‘‘economic condition.’’ The hundreds of articles, books, dissertations, and other documents related to the broad topic of assessing governmental financial health employ a multi- plicity of terms to describe financial health. These terms typically combine the wordsfinancialorfiscal with the wordsposition, condition, capacity, health, or status, and so on. And for each term there is a multitude of definitions. It is not hard to find two or more authors using the same term
to mean different concepts, nor two or more authors using different terms to refer to the same concept. The terms financial position and financial condition, in particular, have been used interchangeably. More often than not, however, the meaning is ambiguous or not spelled out at all. Berne (1992) was decidedly understated in concluding that ‘‘there is ambiguity over the definition and measurement of financial condition.’’
Remarkably, despite the variability of terminology applied to the topic of financial health, there is considerable agreement about the key areas of concern that must be considered when assessing financial health. Six areas predominate assessments of government financial health:
1. Fund balances, equity, or net assets
2. Revenues and expenditures/expenses, as well as surpluses and deficits
3. Changes in revenue bases
4. Spending pressures and expenditure needs
5. Outstanding debts, debt service, and postemployment benefits 6. Liquidity.
There was less widespread, though still notable, agreement on several other types of information, including short-term debt, credit ratings, number of employees, condition of the physical plant, output and outcome measures, and management issues such as the quality of financial reporting, planning and budget processes, and accounting practices. Although some definitions of financial condition focus on one or more of the six areas listed above, the concept of ‘‘economic condition’’ employed in this chapter encompasses all of them to present a comprehensive review of governmental financial health.
In the process of developing a conceptual statement on methods of communicating financial information, the GASB considered the variety of definitions applied to the terms financial position and financial condition. To avoid the general confusion over conflicting meanings, the GASB adopted the term economic condition to reflect a broader under- standing of a government’s financial well-being. The GASB developed a definition of economic condition as ‘‘a composite of its financial health and its ability and willingness to meet its financial obligations and com- mitments to provide services.’’ A government’s financial position was identi- fied as a component of economic condition, along with its fiscal capacity and service capacity (GASB, 2004). One reason for updating the 10-point test is to come closer to encompassing this more expansive view of financial health by incorporating the longer-run and more complete information required by GASB Statement 34.
A Manageable System of Economic Condition Analysis for Governments g 385
15.2.1 The ICMA Handbook
There are few examples in the literature that set forth a comprehensive model of financial health and attempt to develop an extensive set of indicators for examining the major components of that model. Perhaps the best known of those that do is the International City/County Manage- ment Association’s (ICMA) Evaluating Financial Condition: A Handbook for Local Government (Groves and Valente, 1994). The ICMA model suggests there are four potential meanings to financial condition — cash solvency, budgetary solvency, long-run solvency, and service level solvency (Groves, Godsey and Shulman, 1981). Cash solvency is a government’s capacity to generate enough cash or liquidity to pay its bills. Budgetary solvency is a government’s ability to generate sufficient revenues over the normal budgetary period to meet expenditure obligations and not incur deficits. Long-run solvency refers to a government’s long-run ability to pay all the costs of doing business, including expenditure obligations that normally appear in each annual budget, as well as those that show up only in the years in which they must be paid. Finally, service level solvency relates to whether a government can provide the level and quality of services required for the general health and welfare of a community.
This conception of financial condition is affected by 12 factors. There are six financial factors (revenues, expenditures, operating position, debt structure, unfunded liabilities, and condition of capital plant) that are the results of how five environmental factors (community needs and resources, external economic conditions, intergovernmental constraints, natural disas- ters and emergencies, and political culture) are responded to by organi- zational factors (management practices and legislative policies). ICMA suggests three dozen indicators for evaluating the six financial factors and community needs and resources, and calls them ‘‘quantifiable indicators of financial condition.’’ However, such an evaluation must take place in light of the other factors — the ‘‘environmental and organizational aspects of financial condition’’ or the context in which the financial activity takes place.
15.2.2 The Florida Auditor General
In Florida, auditors are required under the Local Government Financial Emergencies Act to inform local governments if their financial condition is deteriorating such that a financial emergency may occur. The Auditor General (2001) has developed procedures and a set of financial indicators for auditors to use in making this determination. The methodology employs 14 recognizable indicators and describes how to calculate them using both pre- and post-GASB Statement 34 information, primarily from the fund financial statements. The indicators include typical measures of financial
position (such as unreserved fund balance compared to expenditures and revenues) and financial condition (a quick ratio, for instance, and the differ- ence between revenues and expenditures). The methodology also uses a measure of flexibility (intergovernmental revenues divided by total reven- ues), an indicator of debt affordability (debt service divided by expendi- tures), and revenue-raising capacity (millage rates compared to legal limits).
15.2.3 Berne and Schramm
Perhaps the only textbook in recent memory entirely devoted to the topic of governmental financial analysis is Berne and Schramm’s The Financial Analysis of Governments(1986), though it is long out of print. As a textbook, it takes a more theoretical approach to developing a framework and methods for analyzing government finances. Consequently, it is less prac- tical as a ready assessment tool than the documents already discussed.
Nonetheless, it is instructive in the factors it emphasizes as important to understanding the financial health of a government and in its thorough consideration of how to examine each.
Berne and Schramm define financial condition simply as ‘‘the probability that a government will meet its financial obligations.’’ Financial condition is the product of available resources, on the one hand, and expenditure pressures, on the other. In addition to current expenditure pressures from constituent demands for certain quantities and qualities of service and intergovernmental mandates, governments are subject to expenditure pres- sures from past decisions and commitments. The resources available to a government are a combination of internal resources that can be converted into cash with varying degrees of difficulty and external resources that can be tapped.
The availability of external resources is ascertained through revenue analysis, which entails an examination of the community’s economic base, the government’s revenue base, actual revenues, and revenue capacity and reserves. Current expenditure pressures are considered via expenditure analysis, which includes a review of actual expenditures by purpose over time, assessment of the effects of input prices, exploration of the relationship between inputs and service outputs, and comparisons of the foregoing information with community needs in light of production and service conditions. Analyses of outstanding debt and unfunded pensions liabilities provide information about the expenditure pressures of past commitments, and generally involve looking at debt structures, burdens, and affordability, as well as the funding status of pension. Lastly, internal resource analysis involves examinations of liquidity and cash flows, and fund balances and other balance sheet accounts.
A Manageable System of Economic Condition Analysis for Governments g 387
Practical applications of Berne and Schramm’s paradigm may be found in the financial condition analyses performed for Ambac, a bond insurance company, by Berne and Drennan (1985, 1987a, and 1987b). Their analyses of the fiscal and economic condition of the states of New York, California, and Texas are substantially based on the approach outlined in the text- book. Together, these documents foreshadow Berne’s conclusions in a research report written for GASB (1992) and a subsequent book chapter (Berne, 1996).
15.2.4 Systems Incorporating GASB Statement 34
According to another, more recent comprehensive approach authored by Ives and Schanzenbach (2001), financial condition is not merely a state of being that can be assessed at a given point in time. More importantly, it is something to be monitored and managed during the course of the year by a variety of key players, from departmental personnel to the director of finance to the chief executive and governing board, as well as intergovern- mental oversight, internal auditors, and rating agencies and insurers.
Ives and Schanzenbach are keenly interested in the influence of eco- nomics, demographics, and ‘‘managerial adaptation’’ on financial condition.
Their model offers 19 indicators for evaluating four major aspects of finan- cial condition — cash solvency, structural budgetary solvency, long-term solvency, and economics/demographics and other factors. They also put forth 10 indicators of management’s ability to adapt, such as accuracy of original budget estimates, management practices such as long-term planning and budgeting and managing for results, political environment and structures, and ability and willingness to influence economic and land use development.
In addition to common-size ratios — percentage distribution and percentage change — for assets, liabilities, revenues, and expenses or expenditures, the GASB’s series of user guides (especially Mead 2001a) and subsequent articles by their author (Mead, 2001b, and Chaney, Mead, and Schermann, 2002) identify eight factors to consider ineconomic condition analysis. Financial position considers the status of a government’s asset, liability, and equity accounts at a given point in time.Liquidityexamines a government’s ability to meet its short-run obligations.Leverageandcoverage are two ways to approach long-run solvency.Fiscal capacity or ability-to- pay compares debt and revenue information with economic indicators to assess a government’s ability to raise revenues or issue debt when neces- sary. Postemployment benefits information addresses the often expensive long-term obligations governments make to their employees in the form
of pensions, health care, and other benefits.Exposure to riskratios measure a government’s ability to respond to financial difficulties, such as revenue shortfalls and overspending. A final set of ratios measure the efficiency with which a government utilizes its resources. Altogether, 29 ratios are suggested, as well as multiple variations on many of them.
15.2.5 Shortcomings of These Systems
The principal problem with the aforementioned paradigms for assessing economic condition is their complexity. Economic condition, when defined as a comprehensive conception of financial health, is complex, so it should not be surprising that an attempt to thoroughly assess economic condition would also be complex. However, one must ask if a complex assessment tool is practical in all situations. For an external analyst with considerable time to focus on a single government, or for a government budget office with the resources to devote to extensive financial self-monitoring, these systems are truly valuable. ICMA’s handbook, in particular, is widely used.
But for the analyst considering multiple governments that vie for her attention, or the government with scarce resource to spare in its finance office, these systems may be overwhelming.
This may be especially true when one considers the importance of benchmarking to economic condition analysis. It is not sufficient to com- pute a set of ratios for a single government for a single year. Those ratios alone tell you very little. In order to make them most meaningful, they need the context provided by a comparison with prior years and with other, similar governments. If the task of computing the dozens of ratios in these larger, more expansive systems is immense for just a single government in a given year, then doing so for multiple years and for a comparison group of governments is insurmountable. For many governments and many analysts, a simpler system that trades off some comprehensiveness for ease of use is prescribed. Brown’s 10-point test was just such a system.