Sound financial management can be one of the most difficult aspects of running a utility or system. This blog will break that process down into four basic parts, addressing wastewater system financial statements, budgets, rate setting, and affordability.
The Financial Statement shows how the utility is operating. It provides information on how the utility generates revenue, the cost of operations, how the utility handles its cash, and provides a list of assets and liabilities. The Financial Statement contains three main reports: the balance sheet, the income statement, and the cash flow statement.
The Balance Sheet provides an overview of assets, liabilities, and the net worth at a specific point in time. The assets are what the utility owns including infrastructure, cash, investments, accounts receivable, infrastructure property, plant, and equipment. Liabilities are what the utility owes, debt and accounts payable. The Balance Sheet (Statement of Net Worth) will show the value of the utility. The assets (everything owned by the utility) minus the liabilities (everything owed by the utility) results in the net worth of the utility. In municipal accounting the Balance Sheet is listed as a Statement of Net Position in the Utility Proprietary Fund.
The balance sheet lists the depreciation of the assets and this is an important factor to monitor. Depreciation is based on a schedule that includes the cost of all capital assets and the expected life of the asset. Capital assets are generally those assets with a value of $5,000 or more, but that will depend on the size and asset inventory of each individual utility. Small or very small systems may choose to set a lower price to define what qualifies as a capital asset. Each year in the aging process the asset losses value. It is important to be rehabilitating and possibly replacing assets each year to keep up with depreciation. There is an asset depreciation ratio that is important to monitor. It is the depreciated capital assets divided by the accumulated depreciated assets. The goal for the ratio should be 35%. Any percent greater than 35% indicates the assets are not being replaced as they depreciate. Tracking the replacement or repair of assets in this manner is good, however the best way is by an Asset Management Plan.
The Income Statement shows how revenues are comparing to expenses during a particular period of time. The purpose of the income statement is to show whether the utility made sufficient revenue to cover all expenses. Revenue minus expenses equals net income which can be positive or negative.
The Statement of Cash Flows shows how the cash is flowing into and out of the utility and shows the changes in cash position from one period to another. The statement has three activities: operating, investing, and financing. The operating activity shows the net income from user rates, receivables collected, and accounts paid. The investing activity shows purchases or sales of bonds, real estate, and investments into infrastructure. The financing activity shows if bonds were issued, any other debt, or reduction in debt.
An analysis of the financial statement will show negative or positive cash flow, increase or decrease in equity over time, and net income changes. The operating and debt service ratios are two ratios to monitor. The operating ratio is total revenue divided by total expenses which may or may not include depreciation. The ratio of 1.0 indicates revenues are meeting expenses. A ratio less than 1.0 indicates expenses are exceeding revenue. A ratio greater than 1.0 indicates revenues are exceeding expenses. The goal should be at least 1.2 if depreciation is not included in expenses, this would provide cash for reserve funds. The debt service ratio is net revenue divided by annual principal and interest payments. A ratio of 1.0 indicates the utility is generating just enough cash to pay all operations and annual principal and interest payments. A ratio less than 1.0 means the utility may not be able to make loan payments. A ratio greater than 1.0 indicates the utility can make loan payments and have a buffer as well. Lenders generally require a debt service ratio of at least 1.2 for the utility.
The wastewater utility annual budget is the primary fiscal control mechanism. It is a critical planning tool for the next year and is used in rate setting. A budget is how the governing body sets priorities and controls the utilities spending. A budget should provide staff with a clear direction for spending on projects and purchases that are expected to be completed within the budget’s time frame. The budget will include utility system expenses that include operation and maintenance expenses, repair and replacement, capital improvements, debt service, and reserve funds. The reserve fund line items in the budget could include Asset Management Plan repair and replacement, debt service, capital improvements, operations, and emergencies.
Full cost budgeting would provide sufficient funds in the budget to replace 100% of the asset items that have reached the end of their useful life. The alternative to full cost budgeting is a financing strategy where assets are replaced by securing loans and grants and the debt service related to the loans are budgeted.
The budget will determine the revenue needs and the budget is the foundation for the wastewater utility system user rates. The purpose of the rates structure is to generate revenue to cover all the costs to collect, treat and discharge the wastewater into the environment and at the same time protect the public health and the environment. Revenue must meet or exceed expenses. The budget should justify the utility system rates. The rate payers are the residential, commercial, institutional, and industrial users of the wastewater system. In most communities the residential customers will be the majority of the customers, generate the majority of the wastewater, and be the source of the major portion of the revenue.
The wastewater utility rates should be fair and equitable, cover all wastewater system costs only, customers should know and understand the rates, be annually reviewed, based on actual financial information, and be easy to administer. Examination of the rates will determine if the revenues have exceeded expenses for the last three years, were all debt payments made on time, were all reserves fully funded, were repair and replacement costs covered, is the system in compliance with state standards and regulations, has there been an increase in rates in the past three years?
The different types of rates are base and variable. The base rates cover fixed costs such as debt service, administration costs, reserve funds and salaries. The variable costs include utilities, chemicals, labor, and repairs and replacements. The different rate structures include uniform flat rate, single block rate, increasing block rate, decreasing block rate, and seasonal rates. For a helpful guidebook on rate-setting, click here.
The EPA defines affordability of wastewater rates as 2% of the community median household income. USDA Rural Development defines wastewater rate affordability as 1.5% of the community median household income. The affordability of wastewater rates in a community can be determined by a multi-step process:
- determine the proportion of wastewater flow attributable to residential customers,
- multiply the proportion of wastewater flow by the total costs of the wastewater utility,
- determine the cost per residential household,
- determine the median household income of the service area using US Census data,
- divide the cost per residential household by the service area median household income.
The affordability will be low if the result is less than 1%, 1 – 2% is mid-range for affordability, and greater than 2% is a high cost. Other affordability factors are poverty levels, fixed incomes, unemployment levels, and inflation. Customer assistance programs are used by some communities to make wastewater charges affordable. Customer assistance programs can be for low income, hardship, disabled, seniors, military, or other relevant demographics. Funding customer assistance programs can be from general fund contributions, a proportion of rate revenues, voluntary contributions by rate payers, the general public, or non-profit organizations. To learn more about affordability, see EFCN blog, “Wastewater Rates and Affordability.”