Developing and maintaining water and wastewater systems’ infrastructure is essential and also expensive. For effective management, communities of all sizes generally must complete an annual audit or financial statement. The economic health and sustainability of these community systems depend on annual assessment and strategizing. These documents include a balance sheet, a statement of cash flows, and an income statement. These statements show how the business, or the utility, operates.
A review of the financial statement will provide insights into how the utility operates, its cost of operation, how efficiently it manages its cash, and its assets and liabilities. In this blog, we walk through the essential components of an annual audit or financial statement.
Balance Sheet
The balance sheet will list the value of all assets, the accumulated depreciation, all liabilities, and the fund balance.
The purpose of the balance sheet is to determine the utility’s net worth. The main features of the balance sheet are the assets, which are what the utility owns, including infrastructure (property, plant, and equipment), cash, investments, and accounts receivable. The list of liabilities includes what the utility owes, debt, and accounts payable. The difference between assets and liabilities is the utility’s net worth.
Statement of Cash Flows
The statement of cash flows will show where the cash is being spent and what types of revenue sources the utility has.
The purpose of the statement of cash flows is to identify how cash flows into or out of the utility and show the change in the cash position from one period to another. The cash flow is divided into three categories:
- Operating activities list the net income from user rates, receivables collected, and accounts paid.
- Investing activities are the purchase or sale of bonds, real estate, and investments into infrastructure.
- Financing activities include the issuing of bonds and receiving or repaying debt.
Income Statement
The income statement, which is also known as the profit/loss statement, will show if the utility is earning sufficient revenue to cover expenses.
The purpose of the income statement is to show whether the utility made sufficient revenue to cover all expenses. There is a listing of all revenue and gains that increase the value of assets or property. The utility expenses are listed and the difference between revenues and expenses is the net income. The statement shows financial performance during a period, such as a quarter or a year.
Analyzing & Understanding Financial Statements
An analysis of the financial statements shows if cash flows are negative or positive, the changes in equity over time (increase or decrease), and net income changes.
Pay attention to two important financial ratios: the operating ratio and the debt-service ratio. The operating ratio is the revenue divided by the expense including depreciation. If the ratio is less than 1.0 then the utility is losing money, a ratio of 1.0 indicates the revenue and expenses are equal. A ratio greater than 1.0 indicates the utility may be able to fund reserves and respond to unplanned emergencies. The debt-service ratio is the net revenue divided by the annual principal and interest payments. A ratio of 1.0 indicates the utility has the money to pay the annual debt service from operating revenues once all operating expenses are paid. A ratio greater than 1.0 indicates the utility will have enough money to pay O&M costs and debt service and still have a buffer. A ratio less than 1.0 indicates the utility may not be able to make loan payments. Lenders generally require the ratio to be at least 1.2.
Another useful ratio that can be calculated from financial statement data is the asset depreciation ratio. It is the accumulated depreciation divided by the total capital assets. The goal for the ratio should be 35%. Any percent less indicates a need for more investment in capital assets.
Utility Spending Plan & Budgeting
The utility should have an annual budget listing all revenues and expenses. The budget is the primary fiscal control mechanism. The budget is how the governing body sets priorities and controls the utilities’ spending while providing staff with clear direction and limits on projects and purchases that are expected to be completed in the budget’s time frame. It is a critical planning tool for the coming year. It is the key component for setting the rates for the utility, because it tells you what, ideally, you need to receive in payments from your customers. For more information on rate-setting, see these other EFCN Blog and Podcast resources.