Use of Key Financial Indicators

by Local, National and

International Governments
By: Jesse Hughes, Ph.D., CGFM, CPA, CIA, and Meena Katwal, MBA

46 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT

FALL 2011

Figure 1: Types of Analyses

Many different types of analyses are used in the private sector to assess the
financial condition of a company. The different types of analyses used in the
private sector are explained in the table below:

Horizontal

Horizontal analysis is the process of comparing particular items in

a financial statement over a period of time.

Vertical

A vertical analysis can be performed of either the income statement or the balance sheet item. In a vertical analysis, different
figures in a financial statement are compared to a specific figure
in the same accounting period and are reported as a percentage.

Trend

Trend analysis is based on the theory that what has happened in

the past is a good indicator of what might happen in the future.
With analysis of the magnitude and direction of the trend, we are
able to predict what we can expect to see in the immediate future
and plan accordingly.

Ratio

Ratio analysis helps to organize the massive amount of

information given in an entitys financial statements and perform
an analysis of the information. The performance of the company
can be judged by computing the ratios for the current year
and comparing them against the industry, the economy, other
companies or the previous year ratios of the same company. An
entitys performance, liquidity, efficiency, financing etc., can be
judged by studying the ratios like quick ratio, current ratio, asset
turnover ratio, debt-equity ratio etc.

(year to year)

(financial element
to financial
element)
(over a number
of years)

(key indicators
to other key
indicators)

Information in financial statements

published by the private sector is
closely tracked, as investors make the
decision to buy or sell stocks in the
company. Earnings are one of many
factors that may impact the price of
the stock. So, financial statements act
as a guide for an investor as they can
refer to them frequently. Financial
statements in the public sector are
also important, but are frequently
not fully used in the decision-making
process. Since the public sector is
more thinly capitalized than the private sector, the ability to pay its debt
in a timely manner and to achieve fiscal sustainability is critical.
In this article, we discuss different types of analyses1 (see Figure 1)
used in the public sector and how
globalization may demand changes
in accounting practices by the public
sector for harmonization with the rest
of the world. The use of these analytics by public sector entities and a case
study on the city of Hampton, VA,
illustrates its application in the public
sector with special emphasis on measures of liquidity and solvency.

FALL 2011

The same types of analyses are also used in the public sector to assess the financial
situation associated with a public sector entity. However, most analyses performed
by these entities relate to budgetary information and fund balances. Few analyses are
performed by public sector entities to determine the degree of liquidity or solvency.
Some ratios used to assess the financial health in these areas are computed
as follows:
Quick RatioThis ratio, also called acid test or liquid ratio, considers only cash,
marketable securities (cash equivalents) and accounts receivable because they are
considered to be the most liquid forms of current assets. A Quick Ratio less than 1.0
implies dependency on inventory and other current assets to liquidate short-term debt.
This ratio is calculated using the following formula: (Cash + Marketable Securities +
Accounts Receivable) / Current Liabilities).
Current RatioThis ratio is a comparison of current assets to current liabilities,
commonly used as a measure of short-run liquidity, that is, the immediate ability of an
entity to pay its current debts as they come due. Potential creditors use this ratio (typically greater than 2.0) to measure an entitys liquidity or ability to pay off short-term
debts. This ratio is calculated using the following formula: (Current Assets / Current
Liabilities).
Total Liabilities to Net Assets RatioThis ratio shows how all of an entitys
debt relates to the equity of the entity. The higher this ratio (preferably less than 1.0), the
less protection there is for the creditors of the entity. This ratio is calculated using the
following formula: (Total Liabilities / Net Assets).

Comparative Data on U.S.

Local Governments
Many states maintain financial
databases on revenue and spending
patterns of the local governments
within their state. However, to the best
of our knowledge, none of the states
include data by which to compute the
liquidity or solvency ratios identified
earlier. In 1981, the Virginia General
Assembly passed a bill requiring the
Auditor of Public Accounts to prepare
a comparative cost report for each of

the local governments in Virginia

with a population of more than 3,500.
The initial format of this report
included comparative fund financial
data. This format was revised in 2000
to include changes required in the
Comprehensive Annual Financial
Reports (CAFR) prescribed by Governmental Accounting Standards
Board (GASB) Statement No. 34.
However, the revision to the comparative cost report (subsequently
retitled the Comparative Report of
JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT 47

information users receive under current

standards, and to consider whether
guidance should be considered for the
remaining information. The principal
focus of the project is to consider
whether any additional information
useful for assessing a governments
economic condition should be
required or encouraged for inclusion
in a governments financial report. In
light of growing national concern with
fiscal sustainability, the project will
consider how these concerns relate to
economic conditions.
Federal Accounting Standards
Advisory Board (FASAB):

In September 2009, FASAB issued

SFFAS 36, Comprehensive Long-Term
Projections for the U.S. Government.3
Although this standard applies only
to the U.S. government and does not
address the liquidity or solvency
ratios, it provides some background
beneficial to the debate as to how best
to measure fiscal sustainability.
International Public Sector
Accounting Standards Board
(IPSASB):

"The global financial crisis has significantly

increased these pressures in many cases, which has
led to heightened interest in the long-term financial
consequences of government interventions."
Local Governments) did not include
the asset and liability information
prescribed by GASB for inclusion
in the Statement of Net Assets for
the CAFRs.
Consequently, the liquidity (quick
assets or current assets to current
liabilities) and solvency (total liabilities to net assets) ratios cannot
be obtained from the comparative
report. These two ratios are very
important to ensure that sufficient
funds (liquidity) are available to pay
the liabilities in a timely manner and
to sustain fiscal health (solvency).
Long-term fiscal sustainability is
the ability of a government to meet its
service delivery and financial commitments both now and in the future.
A number of demographic and technological factors have created fiscal
pressures for many governments.
48 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT

The global financial crisis has significantly increased these pressures in

many cases, which has led to heightened interest in the long-term financial consequences of government
interventions. However, information
on long-term fiscal sustainability is
essential even without the additional
pressures that arose as a result of the
financial crisis. The standards-setting
bodies have recognized this shortcoming and have established projects
to address the issue as follows:
Governmental Accounting
Standards Board (GASB):

A project on Economic Condition

Reporting: Fiscal Sustainability is
under way.2 The long-term objectives
of this research project are to identify
the information users require to assess
a governments economic condition,
to compare these needs with the

In November 2009, the IPSASB issued

a consultative paper titled, Reporting on the Long-Term Sustainability
of Public Finance,4 and the project is
ongoing. Although IPSAS has not yet
been adopted in the U.S., the potential
application in other countries might
have a bearing on the standards
being established in the U.S.
The IPSASB has concluded that
the presentation of information on
long-term fiscal sustainability is
necessary to meet the accountability and decision-making objectives
of financial reporting. Although the
paper focused mainly on reporting by national governments, the
IPSASB believes that simpler forms
of long-term fiscal sustainability
reporting are also appropriate for
the consolidated reports presented at
sub-national levels.
Key Indicators in the
City of Hampton, VA
The following financial indicators
are published by the city of Hampton in its CAFRs. The significance
of each indicator is explained in the
CAFRs Management Discussion and
Analysis Section. Noteworthy by its
absence is the lack of any reference to
the liquidity or solvency ratios identified earlier for government activities, business-type enterprises or
FALL 2011

component units as presented in the

Statement of Net Assets. The number
of fiscal years, shown in parenthesis,
reflects the trend over the number of
years indicated.
Financial TrendsNet Assets by
Component (8), Changes in Net
Assets (8), Fund Balances of Governmental Funds (10) and Changes
in Fund Balances of Governmental
Funds (8).
Revenue CapacityGeneral Governmental Tax Revenues by Source
(10), Assessed and Estimated
Actual Value of Taxable Property
(10), Principal Property Tax Payers
(10), and Real Estate Tax Levies and
Collections (7).
Debt CapacityRatio of Outstanding Debt by Type (10), Legal Debt
Margin Information (10) and
Pledge/Revenue Coverage (10).
Fiscal Discipline for the General
FundBudget to Actual Schedule
of Revenues and Other Credits,
Schedule of Appropriations and
Expenditures.

Hampton City Financial Policy:

In April 2007, the city council

amended its existing financial policies. The financial policies relate to
general operating elements of the
city. These policies are used as financial planning parameters during the
annual budget process. The citys
FY11 managers recommended budget is in compliance with all five policies to ensure that the city has met its
statutory requirements.
Debt Limit Policy No 1. This policy
is comprised of three guidelines:
General obligation debt shall not
exceed 3 percent of the assessed
value of all real estate within
the city subject to taxation. The
legal debt limit authorized by
the Virginia State Statute limits
bond issuing authority up to 10
percent of the assessed value.
General obligation bonded debt
together with indirect debt,
which includes certain revenuebacked debt and subject to
appropriation or moral obligation commitments, and debt of

certain special-purpose entities

(that is, Community Development Authority) shall not exceed
4.5 percent of the estimated
assessed value of all real and
personal property subject to
taxation within the city.
Debt of certain special-purpose
entities, such as Community
Development Authorities, shall
not exceed 1 percent of the
assessed value of all real and
personal property subject to
taxation within the city.
Debt Service Limit Policy No. 2.
General obligation bonded debt
and indirect debt shall not exceed
10 percent of the citys total general
fund, school operating fund and
convention center expenditures, of
which all are included in the citys
total debt service.
Debt Retirement Policy No. 3. The
city shall retire 60 percent of the
principal balance of general bonded
obligation debt within 10 years of
the date the debt is issued.

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JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT 49

10/20/2010 4:30:41 PM

 Equity Funding Policy No. 4. This

policy is comprised of two guidelines as outlined below:
A minimum of 2 percent to 6
percent of general fund revenues
will be applied to Capital
Improvement Plan (CIP)
projects each year.
A minimum of 10 percent to
15 percent of CIP projects over
a rolling five-year period are
to be funded from general
fund revenues.
The city will maintain an
undesignated general fund
balance equal to 10 percent of
total general fund and school
operating fund revenues less
school transfers. To the extent
undesignated fund balance falls
below the policy, the shortfall
shall be replenished over a
three-year period.
International Comparisons
In the private sector, much work
is ongoing between the International
Accounting Standards Board (IASB)
and Financial Accounting Standards
Board (FASB) in their attempts to converge the International Accounting
Standards/International
Financial
Reporting Standards (IAS/IFRS) to
make the financial statements more
comparable throughout the world.
This may eventually impact the public sector in the United States since
the IPSAS are based on the IAS/
IFRS. For ratios to be fully comparable, some differences between the
standards prescribed by GASB and
IPSASB need to be considered:
The IPSASB requires a separation
between the current/non-current
classification of assets and liabilities
while GASB does not.
The IPSASB requires the Unfunded
Actuarial Accrued Liability (UAAL)
to be reflected as liabilities on the
face of the financial statements
while GASB does not. However,
GASB has issued an Exposure
Draft that will require UAAL to
be reflected as a liability on the
face of the financial statements as
required by the IPSASB. If included
as a liability, the total liabilities/net
sssets ratio would increase considerably for most governments.
50 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT

The IPSASB requires the preparation of a Statement of Cash Flows

for all controlled entities while
GASB does not. Such a statement
enhances the reporting comparability of operating performance by
different entities because it eliminates the effects of using different
accounting treatments for the same
transactions and other events.
The IPSASB has five characteristics
that must be met to be recognized as a Government Business
Enterprise (GBE), whereas some
of the CAFRs examined did not
consistently adhere to any such
characteristics for their businesstype enterprises. The following
two IPSAS characteristics for GBEs
did not appear to be consistently
applied under GASB guidelines for
business-type enterprises:
Sells goods and services, in the
normal course of its business, to
other entities at a profit or full
cost recovery; and
Is not reliant on continuing government funding to be a going
concern (other than purchases of
outputs at arms length).
The IPSASB requires a wholeof-government report to identify
the overall financial situation for
all controlled entities within the
government. In those instances
in which a whole-of-government
report is not prepared, governments are encouraged to prepare
consolidated reports for each controlled entity to fully identify the
costs of services provided. In line
with GASB requirements, state and
local governments separately report
government activities, businesstype enterprises and component
units but do not prepare a wholeof-government report.
Conclusions
Financial statements provide great
insight into any entitys financial
condition. In the public sector, some
information in the financial statements is used less than in the private
sector. Since so much work is done
each year in compiling the CAFRs, it
would be beneficial to use the information to the fullest extent so as to be
better equipped for the changes that
might be on their way in the future.
This is especially true for the liquidity and solvency ratios used to deter-

mine the overall financial condition of

each governmental entity. Further, all
states that prepare comparative cost
reports about their local governments
should include pertinent information
from each entitys Statement of Net
Assets presented in each CAFR to
compute the degree of liquidity and
solvency of each public entity.
Most governmental entities in the
United States do a good job of monitoring their budgetary resources
to assure that fiscal discipline is
maintained. However, the CAFRs
are not as fully used in monitoring
the liquidity and solvency ratios.
Movement toward converging the
standards promulgated by GASB
with the standards issued by IPSASB
should be considered to become
more comparable to the governmental standards being implemented
throughout the world and to permit
the liquidity and solvency ratios to
be more uniformly computed.
End Notes
1. Further explanation of these ratios are
available in most accounting and finance
texts as well as the following websites:
www.accountingformanagement.com/horizontal_analysis_or_trend_analysis.htm and www.
investopedia.com/university/ratios.
2. See www.gasb.org.
3. See www.fasab.gov.
4. See www.ifac.org/PublicSector.

Jesse W. Hughes,
Ph.D., CGFM,
CPA, CIA, a
member of AGAs
Virginia Peninsula
Chapter and the
Journal Editorial
Board, is professor emeritus of
accounting from
Old Dominion University, Norfolk, VA,
and is a past member of the Board for the
International Consortium on Governmental Financial Management. He is an
international consultant on accounting
and auditing issues.
Meena Katwal,
MBA, computer
engineer, is an
international student from Nepal.
She is completing
her masters degree in accounting
at Old Dominion
University, Norfolk, VA.
FALL 2011

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