On March 22, 2014, the side of a hill near the town of Oso, Washington, gave out after three days of relentless rainfall. A massive landslide followed, with mud and debris covering more than a square mile. Forty-three people were killed when the slide engulfed their homes.

In the days that followed, more than 600 personnel participated in search and recovery operations. They rescued eight people from the mud and evacuated more than 100 others to safety. Most of the rescue personnel came from the four rural Snohomish County fire districts surrounding Oso.

Minutes after hearing of the slide, staff at the Washington State Office of Financial Management (OFM) – the governor’s budget office – made two critical phone calls. Earlier that week, they had reviewed some data on the financial health of local special districts across the state. They observed that rural fire districts in the counties north of greater Seattle showed signs of acute fiscal stress. Those districts had seen huge growth in property tax collections during the real estate boom of the 2000s. But since the real estate crisis of 2007-2009, those revenues had fallen precipitously. Many of these districts had laid off staff, cut back on specialized training, and back-filled shifts with volunteer firefighters.

So, moments after hearing of the slide, OFM staff called the fire chiefs at two of the most financially stressed Snohomish County fire districts. Their message to those chiefs was simple: send your people. OFM agreed to reimburse the districts from state or federal emergency management funds if needed. In turn, personnel from two of those districts were among the first on the scene and were responsible for three of the eight life-saving rescues.

A few weeks later, the chiefs of both those districts acknowledged that had OFM not called, they would not have sent their personnel. Both districts were so financially stressed that they could not have afforded the overtime wages and other expenses they’d have incurred to participate in the rescue operations.

Financial condition matters. It shapes how a public organization thinks about its mission and capacity. In the case of the Oso mudslide, it was the focal point for some life-saving decisions. That is why all aspiring public servants need to know how to evaluate financial statements and measure, manage, and improve their organization’s financial position.

What is Financial Position?

Financial position is a public organization’s ability to accomplish its mission now and in the future. When stakeholders ask, “How are we doing financially?” the answer should reflect that organization’s financial position.

An organization’s financial position has three main components:

1. Liquidity. Does the organization have liquid resources to cover its near-term liabilities?
2. Profitability. Do the organization’s revenues cover its operating expenses?
3. Solvency. Can the organization generate enough resources to cover its near-term and long-term liabilities?

In the previous chapter, you learned how to extract information about an organization’s financial position from its balance sheet. For example, are most assets liquid (e.g., cash and marketable securities), or does the organization have assets that are more difficult to convert to cash (e.g., receivables, inventory, or prepaid expenses)?

The balance sheet also tells us a lot about solvency, namely if the organization has a lot of long-term liabilities (e.g., long-term debt or pension liabilities). Long-term liabilities mean the organization will have to divert some of its resources to meet those obligations, which can mean fewer resources to invest in its mission. To be clear, there are times when an organization can and should take on long-term liabilities in pursuit of its mission. Sometimes it makes sense to borrow and invest in a new facility that allows the organization to serve its clients effectively. Pensions and retiree health care benefits are an important employee recruitment and retention tool, even though offering current and future employees these benefits could result in a long-term obligation.

To learn about profitability, we typically look to the income statement. Recall that if an organization’s revenues exceed its expenses, its net assets will grow. The income statement clarifies the organization’s key sources of revenues, which revenues are growing, and whether those revenues cover program and administrative expenses. The income statement also shows depreciation, bad debt expenses, and other expenses that reduce net assets but do not impact cash. These are all solvency considerations.

While financial ratios can provide useful metrics, always start with a quick review of the financial statements. Ideally, the financial statements you are working with should report on the organization’s operating and financial position for at least two financial periods – though that is not always the case. Keep in mind that funding agencies and financial analysts need access to at least four, if not five years, of financial data. A review of the trends should inform your interpretation of the ratios.

A review of the Statement of Financial Position (or Statement of Net Position) can be guided by the following questions:

• Assets: How have the assets changed? What proportion of assets are current? How much is reported under cash and cash equivalents? How much is reported under property plant and equipment, net of depreciation? Were there any new investments in property, plant, and equipment (review note on fixed assets)? How much is reported in investments? What proportion of investments are restricted? Have investments changed significantly, and was this the result of market gains and investment income, a capital campaign, or transfers from cash? How much more or less is the organization reporting in receivables, prepaid expenses, or inventory? Have changes in current assets had a negative or positive impact on cash flows?
• Liabilities: How have the liabilities changed? What proportion of liabilities is the result of operations? What proportion of liabilities is current? What proportion of liabilities is the result of financing activities? Of that, how much is in the form of a short-term loan or a line of credit? Is the organization subject to loan covenants or restrictions, and are these disclosed in the notes to the financial statements? Are there any contingent liabilities because of recent lawsuits, and what is the probable liability?
• Net Assets: What proportion is reported as net assets without donor restrictions? What proportion is reported as net assets with donor restrictions? Of net assets with donor restrictions, what proportion is reported as permanently restricted (review notes on Endowment funds)?

Similar questions can guide your review of the Statement of Activities:

• Revenues: What are the major sources of revenues? Were there significant changes in operating revenues? Of total revenues, what percent is “with donor restrictions”? What proportion is contributed versus earned (e.g., fee for services, government contracts)? How much does the organization report as foundation grants? Corporate gifts? Is the organization susceptible to changes in governmental agency or foundation funding priorities?
• Expenses: How much did the organization spend on programs? How much did the organization spend on administration? Fundraising? Were there significant changes in the level of spending? What proportion of our expenses are personnel costs? Have personnel costs changed? How much did the organization report in depreciation and amortization? Are there other fixed costs that limit budget flexibility?

Financial Statement Ratios

The purpose of accounting is to help organizations make better financial decisions. Financial statement analysis is the process of analyzing an organization’s financial statements to produce new information to inform those decisions. Public organizations make dozens of crucial decisions every day: Should we expand a program? Should we lease or buy a new building? Should we move cash into longer-term investments? Should we accept terms in a contract with a government agency? Should we accept a grant with restrictions from a foundation? Should we, as a funding agency, fund a particular organization?

These decisions can be informed by financial statement analysis. An organization should only expand if its existing programs are profitable. It should invest in new property or equipment once it understands how existing fixed asset costs contribute to or detract from its net position. It should move cash into less liquid investments once it knows the organization has sufficient liquid resources to cover its operating expenses.

To answer these questions, we need metrics that demonstrate an organization’s liquidity, profitability, and solvency. We turn to financial ratios (sometimes called financial statement ratios) for those metrics. Financial ratios are calculations derived from information included in the financial statements. Each ratio illustrates one dimension of an organization’s overall financial health. Analysts who evaluate public organizations’ financial statements employ dozens of different financial ratios. However, the way they use ratios will be unique to their needs. For example, the criteria used by financial institutions (or credit rating agencies) will differ from those used by funding agencies. In other words, context and goals matter.

Therefore, a word of caution is necessary when it comes to financial ratios. For many, financial statement ratios objectively assess the organization’s financial position and overall performance. However, when applied incorrectly, they can lead to improper allocation of resources within an organization. For example, focusing on profit maximization, particularly on programs that do not align with the organization’s core values or mission, could lead to mission creep.

Relatedly, criteria used to assess the organization’s financial health should not be the sole criteria used to determine a non-profit’s eligibility for a grant or contract. As you’ll see below, financial ratios are objective measures of financial position and performance that do not incorporate an organization’s proven track record in service delivery. Financial ratios emphasize the organization’s financial strengths and do not address the organization’s effectiveness. Financial ratios do not relay the organization’s unique challenges, or the efforts management and staff have undertaken to address those challenges. In fact, the widespread use of ratios has resulted in widespread inequity in philanthropic giving. Research shows that Black-led organizations receive less funding and are more likely to receive funding with restrictions when compared to peer white-led organizations. As a result, these organizations report low cash reserves, frequently report operating deficits, and often report fewer net assets without donor restrictions. Continued use of financial ratios as criteria for funding organizations perpetuates the cycle – well-funded organizations continue to receive funding without restrictions. In contrast, smaller organizations in poor financial health receive less or restricted funding.

We apply a similar word of caution when using ratios to assess the financial health of governments. A careful review of budget documents or related socio-economic or legal environments would give users a better understanding of why the government reported a deficit or high debt burden. And as we discuss later in this chapter, governments need not be profitable to continue operations.

So, while we endorse the use of financial ratios, we recognize there are limits to their usability and encourage users to contextualize their analysis to the organization, industry, and region of operations.

The first table lists a set of liquidity ratios. Recall that liquidity is the ease with which an asset can be converted to cash with minimal loss in value. Liquidity ratios assess liquid assets that can cover the organization’s obligations or day-to-day expenses. The numerator in these ratios measures liquid resources – either current assets or a specific type of current asset (e.g., cash and cash equivalents, receivables, etc.). The denominator is a measure of existing obligations – either current liabilities or average daily cash expenses. To estimate average daily expenses, we take total expenses and deduct expenses like depreciation, amortization, and bad debt expense that do not require an outflow of liquid resources. Our estimate of cash expenses is then divided by 365 days to produce a rough measure of average daily cash spending.

For governments, the focus is on the General Fund. Recall that the General Fund accounts for unrestricted resources or resources that are not required to be accounted for in other funds. The unassigned fund balance is the most closely watched number in governmental accounting. It reports on the government’s unrestricted resources.

Profitability is an intuitive measure derived from changes in net assets (or change in net position). Recall that net assets increase when revenues exceed expenses – and vice versa.

The operating margin speaks to profitability in the organization’s core operations (i.e., change in net assets without donor restrictions). Gross margin (sometimes called margin) is the difference between net sales and cost of goods sold. Industries like retail clothing have extraordinarily tight margins, meaning the price often exceeds unit costs by a percent or two. Low-margin businesses must be “high volume,” meaning they must sell a lot of products to be profitable. Professional services like accounting, tax consulting, and equipment leasing are “high margin,” meaning the price charged far exceeds the unit cost, sometimes by orders of magnitude. High-margin industries tend to have barriers to entry. They require highly trained professionals, expensive equipment, or other significant up-front investments.

The total margin is a broader measure of profitability across the entire organization. For non-profits, the total margin accounts for all activities reported in the year, regardless of the restriction. For governments, the total margin incorporates the change in the net position of business-type activities. For for-profit or hybrid organizations, total margin accounts for all expenses before interest, taxes, depreciation, and amortization, frequently referred to as “EBITDA” (e-bit-dah).

There are caveats to the total margin ratio – particularly for governments and non-profit organizations. Organizations that receive funding with donor restrictions are more likely to report a total margin ratio greater than their operating margin. As noted in Chapter 2, change in net assets has two components – net assets without donor restrictions and net assets with donor restrictions. The total margin includes the latter, even though the organization will need to expend those resources at a future date or are restricted in perpetuity. Using the organization’s total margin ratio would incorrectly signal the non-profit’s profitability.

For governments, the total margin ratio would include the change in the net position of their business-type activities. While business-type activities are self-sustaining, the profits cannot be used to subsidize the government’s core operations without legislative approval or a voter referendum. Consider the case of the City of Detroit when it filed for bankruptcy protection in 2013. City officials sought to transfer funds from its business-type activities (mainly funds in water and sewer) to the General Fund. Bondholders, secured with revenues from water and sewer services (i.e., business-type activities) sued and successfully prevented the transfer of funds to the General Fund, arguing resources are not fungible. Changes in law, contract, and administrative procedures would be required before resources are transferred from one fund to another.

Profitability measures are less salient for governments because governments need not be profitable to continue operating. Governments have the legal authority and monopolistic advantages that non-profits and for-profits do not. Governments can bolster their financial position by raising taxes or imposing fees. That’s why profitability measures for government are focused on not just the change in net position but the share of revenues derived from general revenues versus grants or contributions.

Solvency measures speak to where the organization gets its resources. Revenues – earned or contributed – pay for regular programming and operating expenses. Capital – loans and mortgages – are how an organization acquires its assets. If a non-profit depends too much on unpredictable or volatile donor revenues, that’s a potential solvency concern. The same is true of revenues from governments. Intergovernmental grants and contracts can disappear quickly if the government changes its fiscal policies and priorities.

Non-profits will report a wide variety of obligations, including accounts payable, accrued salaries and benefits, deferred revenue, long-term debt, and pension obligations. Since these are the result of doing business, they are expected and acceptable.

Although necessary, long-term debt is a drain on future resources. Research has shown that non-profits with long-term debt are less liquid and less profitable. An organization with long-term debt will make principal and interest payments every month (e.g., loans or mortgages) or semi-annually (e.g., bonds) – and, therefore, strain liquid resources and operating costs. Fixed assets frequently add to maintenance costs and depreciation expenses, resulting in lower profitability margins. These factors could inhibit an organization’s ability to continue to serve its mission.

The liability-to-asset ratio is an alternative measure of solvency. This ratio allows analysts to assess the scope of non-current liabilities that are not in the form of loans, mortgages, or bonded debt. For example, a significant proportion of liabilities reported by the Bill and Melinda Gates Foundation and the Susan G. Komen Breast Cancer Foundation were non-current grants payable. This reflects the organization’s use of multi-year grants to support the operating activities of other non-profits. The Boy Scouts of America, USA Gymnastics, and various Catholic dioceses have sizeable contingent liabilities following several recent sexual abuse lawsuits. These obligations are contingent on a court ruling or legal settlement. Accounting rules require organizations to report a contingent liability in the basic financial statements or notes to these financial statements. These disclosures depend upon the degree of certainty and materiality of the court ruling or legal settlement. These organizations will likely need to liquidate their existing assets to meet these obligations (as a side note, these organizations have filed for bankruptcy protection to allow for a negotiated settlement of outstanding obligations). The March of Dimes, Girls Scouts of America, American Civil Liberties Union, and the Metropolitan Opera Association all report an accrued pension liability. If the obligation is unfunded, it represents a drain on the organization’s resources.

We, therefore, encourage users to estimate a liability-to-asset ratio, keeping in mind that all debt is a liability, but not all liabilities are debt.

The Internal Revenue Service (IRS) monitors the contributions ratio as part of its public support test for charitable organizations. According to this test, a non-profit must receive at least 10 percent of its support from contributions from the public or gross receipts from activities related to its tax-exempt purposes. Less than that suggests the public is not invested in that organization’s mission. By contrast, non-profit analysts also emphasize the tipping point where a non-profit depends too much on individual donors. Different analysts define the tipping point threshold differently, but most agree that 80 percent of total revenues from individual contributions is dangerously high. At that point, a non-profit’s ability to serve its mission is far too dependent on unpredictable individual donors and not dependent enough on either earned income (e.g., government contracts or fees-for-services) or gifts from corporations or foundations.

For governments, the solvency ratios are focused entirely on debt and other long-term obligations. Governments can borrow money that won’t be paid back for decades. If careless, a government can take on too much leverage. That is why solvency ratios for governments focus on how much money a government has borrowed or owes in its governmental and enterprise funds and its ability to meet those obligations as they come due. The latter is known as coverage. Bond investors, particularly for public utilities, often stipulate how much coverage a government must always maintain. Coverage ratios are usually expressed as operating revenues as a percentage of interest expenses.

In addition to financial health, financial statements can illuminate how efficiently a non-profit raises money and how much of its resources it devotes to its core mission. These effectiveness measures are related to but separate from the financial position. Fundraising efficiency shows the financial return a non-profit realizes for its investments in its fundraising capacity.

The program expense ratio is one of the most closely watched and controversial ratios in non-profit financial management. It tells us how much of a non-profit’s total expenses are invested in its programs and services rather than administration, fundraising, and other overhead spending. Many analysts and non-profit monitors recommend a program service ratio of at least 80 percent – though we caution against the use of the program-expense ratio as allocation of expenses into program, administrative, and fundraising is far from clear cut.

RATIOS AND RULES OF THUMB

These rules of thumb are derived from the rich academic literature and industry analysis. To be clear, there is no legal or GAAP-based definition of “financially healthy” or “strong financial position.” Every financial institution, foundation, donor, or grantor defines these metrics differently. Measures of financial health will vary by sector and the size of the organization. The rules listed in the ratio tables above represent figures cited by analysts in the public and private sectors. Before going further, let’s consider a few key points about financial statement ratios:

• Ratios are only part of the story. Ratios are useful because they help us quickly and efficiently focus our attention on the most critical parts of an organization’s financial position. In that sense, they are a bit like watching ESPN’s 30-second highlight recap of a football game (or whatever sporting event, if any, you find interesting). If we want to know which team won and who made some big plays, we’ll watch the highlight reel. If we want to know the full story – the coaches’ overall game plan, which players played well throughout the game, when a key mistake changed the course of the game, etc. – we need to watch a lot more than just the highlights. Ratios are the same way. They are fast, interesting, and important. If we want a quick overview and not much more, they are useful. If we don’t have the time to dig deeper into an organization’s operations, or if it’s not appropriate for us to dig deeper, then they’re the best tool we have. But they are never the whole story. Always keep this limitation in mind.
• Always interpret ratios in context. Ratios are useful because they help identify trends in an organization’s financial behavior. Is its profitability improving? How has its overall liquidity changed over time? Are its revenues growing? And so on. But on their own, ratios don’t tell us anything about trends. To reveal a trend, we must put a ratio in context. We need to compare it to that same ratio for that same organization over time. For that reason, we often need multiple years of financial data. It is also essential to put ratios in an industry context. Sometimes, a broader financial trend will affect many organizations in similar ways. A decline in corporate giving will mean lower donor revenues for many non-profits. Increases in overall healthcare costs will impact all organizations’ income statements. Reductions in certain federal and state grants will affect particular types of non-profits in similar ways. To understand these trends, we need to compare an organization’s financial ratios to the ratios of organizations in similar industries. It is useful, for instance, to compare human services-focused non-profits with less than $2 million in assets to other small, human service-focused non-profits in the same region with less than $2 million in assets. We should compare fee-for-service, revenue-based non-profits to other fee-for-service, revenue-based non-profits. Large non-profits with national or international missions should be compared to each other.
• Financial statement analysis raises questions. A good financial statement analysis will almost always reveal some contradictory trends. Why does this organization’s profitability look strong, but the current ratio is well below the rule of thumb? Why is this organization less liquid than its peers? Why does this organization not have debt and is far more liquid than similar organizations? A good financial statement analysis raises questions about the organization’s financial assumptions, program operations, and overall effectiveness. Sometimes these follow-up questions can be answered from other publicly available information, such as the notes to the financial statements or the annual report. Sometimes they can’t. If your analysis concludes with many unanswered questions, that does not mean your analysis is bad. It simply means there are limits to what we can learn from financial statements alone.
• Ratios are retrospective. Most organizations release their financial statements three to six months after the close of their fiscal year. As a result, analysis based on those statements relies on information that is at least 12 to 18 months old. A lot can happen in 18 months! Always keep this in mind when doing financial statement analysis.

Download Non-Profit Financial Self-Assessment Worksheet: https://bit.ly/3rbVKUR

NON-PROFIT FINANCIAL RATIOS – AN ILLUSTRATION

To see these ratios in action, let us return to Treehouse. We use FY 2022 data to illustrate how each ratio is estimated and include FY 2021 ratios for comparative purposes. We highlight the key findings below. Note that our discussion below does not focus on how one should interpret each ratio. Instead, we tell a story about the organization’s financial position and operating performance. That story – not the ratios – helps formulate questions and additional lines of inquiry. Notwithstanding, we’ve included comments in the tables to help you understand how to interpret each ratio.

FINANCIAL RATIOS – TREEHOUSE

What do the financial statements and estimated ratios tell us about Treehouse’s financial position and performance? Treehouse reported a strong financial position. At the end of FY 2022, the non-profit reported $27 million in assets, including $7.6 million in cash and investments, $5 million in receivables ($4.7 million are due in the next 12 months), $8.3 million in fixed assets (net of depreciation), and $5.2 million in endowment investments. That said, the non-profit reported a $2.1 million drop in cash and investments. While the drop in cash and investments has a negative impact on the non-profit’s liquidity position, the liquidity ratios remain at or above recommended benchmarks.

Return on EquityWhat is the return on shareholders’ investments? Rule of Thumb: PositiveChange in Net Assets Without Donor Restrictions / Net Assets Without Donor Restrictions_t-17,108,483 / 12,634,688 = 56%There was an increase in equity because of the in-kind donation of an interest in the building resulting in a 56 percent increase in net assets without restrictions (or $7.1 million).34%

Treehouse reported $516,298 in income at the end of FY 2022 – approximately 2 percent of operating revenues. Operating revenues in FY 2022 ($24 million) were up 75 percent. Much of the growth in revenues was driven by contracts, most of which were with the State of Washington. Contributions, grants, and in-kind donations increased 14 percent. The nonprofit’s expenses ($23.5 million) were also higher, particularly in program services. Changes notwithstanding, the non-profit had a program-expense ratio of 83 percent. Total Change in Net Assets for FY 2022 was $5.7 million, including $1.4 million in losses from investments – which mirrors outcomes in the broader financial markets and in-kind donation of an interest in the building ($7.1 million).

Unlike most health and human services organizations, Treehouse has no long-term debt, and its liabilities are modest ($1.2 million).

Download Treehouse Financial Statement Analysis: https://bit.ly/44SwTTL

Treehouse’s investments in fundraising are productive. For every $1 in fundraising expenses, the non-profit raised at least $5.00 in contributions and grants over the last five years. What’s more, our analysis shows it collected those receivables in 60 days or less. This ratio is critical to non-profits that rely on government contracts. If payments are late, the non-profit will need to draw down on its cash reserves and investments to meet operating expenses until the next payment is received. Non-profits that rely on monthly contributions, particularly from small donors, report a collection period that is less than 30 days. The financial statements show a significant increase in contracts in FY 2022 (up from $3.9 million in FY 2021 to $12.7 million in FY 2022) that led to a 204 percent increase in contract receivables ($3.5 million). This increase in receivables could negatively impact cash flows.

ASSESSING THE FINANCIAL HEALTH OF GOVERNMENTS USING THE TEN-POINT TEST

Throughout the past few decades, analysts have developed a popular framework to evaluate a local government’s financial condition. It is known as the “Ten Point Test.” It’s comprised of 10 key ratios that, when taken together, summarize a government’s liquidity, profitability, and solvency. In the Ten Point Test framework, a government earns “points” based on how its ratios compare to its peer governments. If its ratios are consistently better than its peers, it earns a higher score. If its ratios are consistently worse than its peers, its scores are lower and, in some instances, negative.

To see the Ten Point Test at work, let’s return to the City of Bothell. The table below shows the city’s ratios and their computations based on information in its 2021 Annual Comprehensive Financial Reports (ACFRs). Bothell’s 10-point ratios are a mixed bag. The government’s General Fund liquidity position is relatively strong. The city’s General Fund unassigned balance at the end of FY 2021 was $18 million (a historical high), approximately equal to 30 percent of the revenues reported in the General Fund. The government also reported $18.8 million in cash and investments (approximately 584 percent of its General Fund liabilities).

FINANCIAL RATIOS – CITY OF BOTHELL

That said, the ACFRs show that the City’s net position declined $2.1 million or 0.4 percent of the net position. The $2.1 million deficit was a fraction of what the city reported prior to the COVID-19 pandemic. A quick review of the financial statements shows that depreciation expense has increased over the years – reflecting the city’s investment in infrastructure. This is also evident in the ratio measuring capital asset improvement, which continues to be negative (-7 percent).

The city relies on general revenues – specifically property and excise taxes – to cover operating expenses. The city reported $4.1 million in operating grants and contributions, approximately 3.12 percent of primary government revenues. Intergovernmental transfers were higher in FY 2020 and FY 2021, reflecting the infusion of federal stimulus funds in the city’s operations. The city’s operating margin for governmental activities was 61 percent. This ratio is larger because the city reported a deficit. The ratio would be lower if expenses were lower or if the government had reported more in either program revenues or general revenues. Notwithstanding, strong revenue growth and effective management of the city’s expenses have allowed the city to improve its net position.

The city of Bothell reports a high debt burden ($2,637 per capita). The rapid growth in population and the city’s planned expansion in capital improvements have resulted in the growth in the debt per capita. The government’s capital improvements make the city more attractive, which would lead to a growth in residents, resulting in a growth in revenues. Notwithstanding, its near-term solvency ratio (120 percent) is below the benchmark – reflecting growth in economic activity and, as a result, revenues. More importantly, the city’s pension and OPEB obligations are a modest share of the city’s non-current liabilities ($8.1 million, or 6 percent of non-current liabilities).

Moody’s upgraded the city from Aa2 to Aa1 on October 11, 2019. The rating agency noted that the city “benefited from its inclusion in the Puget Sound area.” Factors that could lead to a rating downgrade include “deterioration in the city’s financial position” because of “material contractions of the city’s taxable base.” The COVID-19 pandemic did not have a material negative effect on the government’s revenues. The city’s revenue portfolio is inelastic. Property values have not changed significantly since the start of the COVID-19 recession, and the housing market remains competitive.

Download Bothell Ten-Point Test: https://bit.ly/4684Kcj

Fortunately, the Ten-Point Test framework allows us to go a step further. Instead of asking how Bothell compares to generic benchmarks (or rules of thumb), we have the tools to compare Bothell to peer local governments. This allows us to make much more precise statements about the City’s financial position and operating performance.

Analysts typically make these peer comparisons by computing the Ten Point Test ratios for various local governments and assigning point values based on relative rankings. For example, to calculate Bothell’s Ten Point test score for FY 2017 – 2021, refer to the Ten-Point Test Scores table. This table shows national trends for these same ratios. These trends are based on data from the financial statements of 3,721 city governments and 1,282 county governments from FY 2005 to FY 2015.

The ratios are presented in quartiles. Recall that a quartile is a group of percentiles, and a percentile identifies a point in the distribution of that ratio. The table is organized by population groups. So, for instance, for cities with populations between 25,000 and 50,000 (Bothell’s peer group), the 25th percentile for the short-run financial position was eight percent. That means one-quarter of Bothell’s peer cities had short-run financial positions of less than nine percent, and three-quarters had short-run financial positions equal to or greater than nine percent. For all the ratios shown here, the first quartile starts at the lowest ratio and ends at the 25th percentile, the second quartile covers the 25th percentile through the 50th percentile, and the third quartile covers the 50th percentile through the 75th percentile. The fourth quartile includes all observations above the 75th percentile.

These quartiles are the basis for assigning scores for all ratios. If a local government is in the second quartile for a ratio, its score for that ratio is zero. It is not qualitatively better or worse than its peers, so that ratio does not help or hurt its relative score. If a ratio is in the third quartile, it earns one point. The logic here is that a ratio above the median (i.e., the 50th percentile) is a financial positive for that government. If a ratio is in the fourth quartile, it earns two points. To land in the fourth quartile, a government is better than most of its peers on that ratio, and that indicates a source of financial strength. By contrast, a ratio in the first quartile means that the government is comparatively weak in that dimension of financial health. To reflect that weakness, we subtract one point.

A local government’s overall Ten Point Test score is easy to interpret. Analysts generally use the following categories:

• A score of 10 or greater suggests a government’s financial position is “among the best.” It can easily meet its immediate spending needs; it has more-than-adequate reserves to mitigate the effects of recessions, natural disasters, or other unexpected events; and it can generate adequate resources to cover its long-term spending needs. Most of its ratios must be as good as or better than its peers to earn that score.
• A score between 5 and 9 means the government is “better than most.” Most of its ratios are better than its peer governments.
• A score between 1 to 4 means the government is “average.” Most of its ratios are equal to, or weaker than, its peer governments.
• A score between 0 and -4 means the government is “worse than most.” Most of its ratios are weaker
  than its peer governments.
• Scores less than -5 mean the government is “among the worst.” It has major financial problems and may be insolvent. Scores this low are quite rare.

Let’s return to Bothell’s Ten Point Test Score. Recall that the city’s population in FY 2021 was 48,920, so we will use the “Population 25,000 to 50,000” quartiles to assign points to the city.

Bothell’s liquidity is strong and improved significantly over the last five years. The city scores in the second (0 points) or third quartile (1 point) for its short-run financial position and third (1 point) or fourth (2 points) quartile on its liquidity position. The city’s profitability ratios are below average. The city was in the lowest quartile for net asset growth (-1 point) and operating margin (-1 point). Its dependency on operating grants was limited before the COVID-19 pandemic. The infusion of federal funds resulted in a higher ratio (and correspondingly a lower score); this should revert to historical trends now that federal funds have been disbursed.

As we noted earlier, Bothell’s solvency profile is mixed. It has virtually no current liabilities in the General Fund but reports $157 million in liabilities, including $129 million in long-term debt and $8.1 million in pension and OPEB obligations. However, given the City’s revenue profile, its near-term solvency ratio puts it in the third quartile (1 point). Its high debt burden and substantial debt service, particularly on core operations (i.e., Coverage Ratio), put it in the lowest quartile for both metrics. Finally, the rate of depreciation of capital assets far exceeds the rate of investment in capital improvements, far below its peers (-1 point each). 

TEN-POINT TEST SCORES

CITY & COUNTY GOVERNMENTS

Download the Ten-Point Test: https://bit.ly/3r4ydFo

Bothell’s ratios add up to an overall Ten-Point Test score of 2. Its main financial strengths are its liquidity and its near-term solvency. At the same time, its higher-than-average debt load and operating deficits lower the city’s score. Recall that a score of 2 suggests Bothell is “average” relative to similarly sized local governments. With this framework, you can compute and interpret a Ten Point Test score for virtually city or county government.

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CREDIT RATINGS

A credit rating is an independent assessment by a nationally recognized statistical rating organization (NRSRO) of the issuer’s ability to make payments on time and in full. Currently, there are four NRSROs in the municipal bond market. They include Moody’s Investor Service (or Moody’s), Standard and Poor’s (or S&P), Fitch Ratings (or Fitch), and Kroll Bond Rating Agency (or Kroll).

Ratings range from Aaa (highest possible rating) to D (lowest rating, typically in default). The municipal sector is highly rated. The median rating in the U.S. municipal securities market was Aa3 – with more than 98 percent of municipalities rated Baa3 or above. This is in sharp contrast to global corporates – the median rating is Baa3, and more than 49 percent of global corporate credits have a rating below investment grade. Defaults in the municipal securities market are exceedingly rare. The 10-year average of default rates is 0.18 percent. The 10-year average default rate for global corporates is 1.78 percent.

 

For a fee paid by the issuer, NRSROs gather and process information about the issuer – or in the case of revenue bonds, individually issue and provide investors with an assessment of the risk of default associated with an issuer or a specific bond issue. In assigning ratings for general obligation bonds, NRSROs focus on the following key criteria:

• The economic base, including per capita income or median household income (relative to the U.S. average), the total taxable value of property and full value per capita, and diversity of economic activity (e.g., regional economic centers with a diversified taxpayer base and the presence of large institutional actors like universities or military bases).

•  The government’s operating budget, including revenue or taxing authority, whether the operating budget is structurally balanced, expenditure reduction flexibility, and five-year trends in changes in cash or fund balances. Fund balances are a proxy measure of budget outcomes – any growth (reduction) in fund balances means revenues in prior budget periods were greater (lower) than expenses. Cash balances are equally important. They are a proxy measure of the government’s ability to pay obligations as they come due.

• Management and governance structures, including legal and constitutional restrictions (e.g., tax limits and legislative supermajority requirements) or the adoption of prudent financial management practices into law (e.g., balanced budget requirements, mandatory contributions to pension programs, mandatory contributions to rainy-day or similar reserve funds, executive authority to make mid-year budget adjustments)

• Outstanding debt and pension obligations, including total outstanding debt (as a percentage of full value or revenue) and the three-year average net pension liability (as a percentage of full value or revenue)

In assigning a rating for a revenue bond, NRSROs focus on the net operating revenues of the issuer (e.g., utility revenues, tuition fees, or patient revenues – net of operating expenses) or pledged revenues (e.g., gasoline taxes, toll revenues). The issuer’s economic base, management and governance structures, and outstanding long-term obligations remain equally relevant.

For a detailed history of defaults in the U.S., see Moody’s (2018) “US Municipal Bond Defaults and Recoveries 1970 – 2018.”

FINANCIAL STRATEGY

Financial statement analysis can tell us a lot about an organization’s financial position. The question, then, is what to do about it. As mentioned, sometimes financial statement analysis offers clear follow-up questions about an organization’s financial operations and overall performance. Ideally, it also suggests some steps management can take to improve that financial position and performance.

The table below identifies some of those potential steps. It is organized around liquidity, profitability, and solvency. “+” signs identify that part of the organization’s financial position that is strong. “-” signs suggest a potential weakness. There is no “textbook” definition of financial strength or weakness. However, most public sector analysts define ratios above the benchmark rule of thumb or the median within a peer group as strong and ratios below the rule of thumb or the median within a peer group as weak. This is not a comprehensive list. That said, it illustrates some strategies management can initiate to address the organization’s financial challenges.

For example, non-profits reporting positive trends in liquidity, solvency, and profitability should prioritize reviewing and amending finance policies, invest in process improvements and innovation, and engage in a strategic planning process (including financial self-assessment). This is especially important to recognize the organization’s resiliency to future threats in operations. Those threats could be the result of an economic crisis or changes in policy or technology that fundamentally alter the organization’s business model.

Non-profits that are liquid and profitable but not solvent need only consider strategies that alter the makeup of their long-term obligations. That said, changes in long-term obligations will impact liquidity and profitability. Refinancing existing long-term debt obligations has the benefit of lowering interest expenses, thereby increasing profitability and improving liquidity. However, refinancing long-term debt should not extend the loan’s maturity beyond the asset’s useful life. Refinancing strategies should prioritize savings due to lower interest rates over savings due to a longer maturity period, especially if the organization does not have a capital improvement planning process.

Non-profits that are profitable and solvent but not liquid would likely prioritize moving investments from their diversified equity mutual fund accounts to a money-market mutual fund. While this has the benefit of providing access to cash, the returns from the money-market mutual fund are significantly lower. So, while improving the organization’s liquidity position is necessary, that strategy would likely result in a lower profit margin due to changes in investment income. The organization will therefore need to weigh the cost associated with using a line of credit with foregone revenues from long-term investments.

We must also recognize that there are strategies that the non-profit has little or no control over. The sale of surplus property and equipment could take a long time – a reason why we do not suggest this strategy to address liquidity and do not prioritize this strategy if the organization is not liquid or solvent. Funders may not be willing to renegotiate indirect cost recovery rates on existing contracts. We also know governments are more likely to delay payments in an economic downturn, as they delay payments to suppliers and vendors as a strategy to manage their cash flows.

Of course, organizations with concerns about all three aspects of financial position might consider more drastic measures like a merger with another non-profit.

In short, these strategies are some of the most typical for organizations with different financial position profiles.

RELATED CASE STUDIES

Case 3.1: Reporting on the Financial Condition of a General-Purpose Government
Case 3.2: Pineville Hearing