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Financial Management Systems

Lance Morrell , FEI Consulting, LLC

World Bank Learning Week, March 2017

Objective

The objective of this module is to review and

discuss financial management policies and

procedures (systems) and the overall control

environment, from the perspective of enhancing

creditworthiness.

Content

2

� Importance of financial management and

financial reporting

� Budgets and Controls: Operational and

Capital

� Ratios and Indicators for Financial

Management

� Audits and auditing

Key Messages

3

Effective financial management systems promote governance, transparency and accountability and are a pre-condition to being creditworthy

Budgets provide a valuable tool to both plan for and control operations

Operating and capital budgets should be part of the business plan and linked to financial reporting for plan-actual comparisons

Financial Management Systems

Creditworthiness

5

A creditworthy entity has the ability and the willingness

to repay its debts on-time and in-full

A positive net cash flow from operations is one of the

key indicators of creditworthiness

However ..

Importance of Financial Management

• A strong financial management system is a critical

pre-condition to an entity being able to generate a

positive net cash flow from operations and to

demonstrate the capacity and discipline to repay its

debts on-time and in-full

• The strong financial management system must be

well documented, understood by the management

and staff and implemented

6

Financial Management Systems

7

• Effective computerized financial management systems provide a system of internal controls needed to ensure that all transactions are properly recorded and reported

• The budgeting and financial reporting systems should be integrated so that the actual results are reported in the same formats and line-items as the operating budgets to allow for meaningful comparison and control

Discussion Point

8

Do the WSPs in your client countries have

integrated financial reporting and budgeting

systems? If not how do they meaningfully

control the budgets?

1. Yes

2. No

3. Don’t know

Importance of Financial Management for

Creditworthiness

9

• A strong financial management system gives

investors, rating agencies and creditors the

confidence that the utility’s financial statements

reflect the actual results

• Reliable financial information enables an:

- Appropriate assessment of a utility’s

creditworthiness, and

- Evaluation of the risk of financing.

Financial Management and Creditworthiness

10

Adherence to good accounting practices

Standardized financial procedures and documents

Clear, formal/written financial management policies, objectives and processes

• Good financial management practices help assure lenders that the utility can weather economic shifts and still repay its debt

Reliable operating surpluses and clean auditors’ opinions

Credit Analysts/Evaluators look for…

Impact of Good Financial Management

11

Consistent and goal-oriented financial management

leads to overall fiscal sustainability, and…

1. Ensures appropriate resource mobilization and

allocation

2. Enhances performance, value for money and

budget management

3. Improves governance, transparency and

accountability

4. Enhances fiduciary risk management controls,

compliance and oversight

Financial Management Evaluation Framework

12

Source: PEFA, Public financial management (PFM) measurement framework

Budgets and Controls

Developing the Operating Budget for the

Business Plan

• Estimating the revenue component of the budget

covers:

14

Projecting revenue from all major components (the 3 T’s) for each category of services

Forecasting revenue from each customer segment, e.g. residential, commercial, institutional, bulk, etc.

Detailed segmenting for accuracy and pattern recognition (Thefts and pilferages can be detected using pattern recognition!)

Forecasting revenues for multiple budget years as part of the revolving business plan

Use of Robust Assumptions

15

• The budget is always wrong – so ensure that the

business (budget) planning process is based on

detailed and robust assumptions – for expenditures

and revenues

• Operating budgets should be developed from the

bottom-up (how many staff at what salary, cost of a

unit of fuel, how many m3 of water sold) – rather

than inflating the previous year’s budget

• Avoid the hockey-stick forecast – too optimistic

Discussion Point

16

Budgets are generally required by agency

statute – do the WSPs in your client countries

make effective use of their budgets for planning

or control purposes?

1. Yes

2. No

3. Don’t know

Developing the Operating Budget for the

Business Plan

• Estimating the expenditure component of the budget

covers

17

Projecting expenditure for all major components (e.g. personnel, power, chemicals, etc.) for each category of services

• Maintain detailed assumptions for each expenditure item for review as part of the plan-actual analysis

Forecasting expenditures for multiple budget years. Typical items in the expenditure section of the operating budget are…

• Payroll and personnel (salary, benefits, overtime, etc.)

• Operating expenses (Consumables like electricity, chemicals, fuels, and other supplies, Contracted services, Travel & Trainings, Maintenance of systems, etc.)

• Debt service

The Water Demand Forecast

• One of the most important elements in the

revolving business plan forms the basis for any

kind of planning, budgeting or management.

• Forecasting water demand is the basis for the

entire water utility operations plan.

• Possible time horizons for forecasting: detailed-

patterns for next 5 years; long term vision for 20-25

years

• Use of growth scenarios (high growth, medium

growth, and low growth) better informs capacity

development and utilization

18

Impact of the Water Demand Forecast

• Water demand will affect operating revenue and

expense forecasts (variable costs affected by the

volume of water production include electricity, fuel,

chemicals, etc.) and hence the operating budget

projections

• Water demand will also affect the capital

investment plan by suggesting the investments

required to build and maintain the capacity to meet

anticipated demand.

19

Interrelation Between Operating and Capital

Budgets

20

• Building additional facilities in turn affects OPEX as additional treatment capacity would call for greater expenditure on chemicals, electricity, fuel, and personnel for running the new facility.

• The amount of debt that can be repaid depends on the operating margin (operating revenues minus operating expenditures) which guides how much debt can be raised for the capital budget.

• Infrastructure maintenance (renovation, CapManEx) funded through capital expenditure can reduce operating expenditures

Challenges & Action Planning

21

13. BUDGETING problems

A. Operating & Capital Budgets mixed

B. Annual Budgeting only

C. Participation low

D. Reserves low

Action 13.1 Create separate budgets and accounts for operating

expenses and capital expenses. [A]

Action 13.5 Establish publicly transparent procedures for

proposing, reviewing and adopting water utility operating and

capital budgets. [C]

Action 13.4 Establish a 5 year rolling budget for capital

expenditures. [B]

Action 13.2 Project operating expenditures at least two years

ahead (and more if possible) beyond the annually approved

budget. [B]

Action 13.6 Establish and maintain a formal Operating

Reserve Fund. [D]

Action 13.7 If the water utility has debt obligations,

create and maintain a Debt Service Reserve. [D]

Potential Actions

Action 13.3 Formally link service expansion planning to the

budgeting projection process to project the impact on revenues

and expenditures of services to new residential and commercial

development. [B]

Action 13.8 Have the engineering staff actively

participate in the budgeting process [C]

Poor Management of Resources

Rules for Good Budgeting

1. Prepare separate operating and capital budgets

using robust assumptions

2. Use 3 to 5 year multi-year budgeting for capital

expenditures

3. Annual operating expenditures using IRC at least

one year ahead, beyond the annually approved

budget

4. Keep capital expenditures at or below the level of

capital resources available to pay for the

investment

22

Budget vs Actual as a Control Measure

Budgetary control:

• A control technique whereby actual results are compared with budgets.

• Differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets.

• Budget control is necessary to make sure that funds are being received and spent as planned, or that appropriate adjustments are made in time to avoid financial problems.

Responsibility centers:

• These enable managers to monitor organizational functions. A responsibility center can be defined as any functional unit headed by a manager who is responsible for the activities of that unit.

• Responsibility centers should also exercise budgetary control over their activities.

23

Ratios and Indicators

For assessing a utility’s financial

management

24

Liquidity Ratios

25

Ratio Calculation Use

Quick Ratio (current assets –

inventories) or (cash and

equivalents + marketable

securities + accounts

receivable) / current

liabilities

The quick ratio is an indicator of a company’s

short-term liquidity. The quick ratio measures a

company’s ability to meet its short-term

obligations with its most liquid assets.

Current Ratio Current assets/Current

liabilities

Short term liquidity, the availability of cash and

other liquid assets to meet short-term financial

obligations such as operating and maintenance

expenditures and debt service payments.

Operating

Cash Flow

Ratio

Cash flow from operations /

Current liabilities

The operating cash flow ratio is a measure of

how well current liabilities are covered by the

cash flow generated from a company's

operations.

Cash on hand

(in days)

(Unrestricted Cash &

Equivalents) / (Daily

Operating

Expenses excluding

Depreciation)

How long, in days, the organization could meet

operating expenses without receiving new

income. It is helpful to compare your current

figure to past values as well as to other similar

organizations

Financial Leverage

26

Ratio Calculation Use

Liabilities-to-

Assets Ratio

Total liabilities divided by Total

Assets

Measures the relationship of asset

values to claims against those

assets

Capitalization

Ratio

Long-Term Debt divided by

Long-Term Debt and Owners‘

Equity

Measures long-term debt relative to

other sources of capital

Debt to Equity Ratio of debt to equity In utilities projects D/E is high as the

return on capital is low and capital

investment is for longer term.

Burden

Coverage Ratio

Earnings before Interest and

Taxes divided by Interest and

Principal, which is divided by 1

minus the tax rate

Measures the relative ability of the

firm to meet required interest and

principal payments (Strong positive

relationship with creditworthiness)

Debt Service

Coverage Ratio

It measures the amount of

“free cash” available from

operations to cover debt

service payments.

Debt Service Coverage Ratio

(DSCR) is one of the most important

financial ratios that lenders use to

assess creditworthiness.

Efficiency

27

Ratio Calculation Use

Billing ratio% Water billed /water

produced in m3

Utilities’ ability to bill water and monitor

NRW. A ratio closer to 1 is desired for

optimal resource utilisation.

Collection

ratio

Bills collected/ Total

Bills generated

Utilities’ ability to collect billed accounts.

Represents actual revenue realisation and

hence is fundamental for creditworthiness.

Net Debtor

Days

Net billed amount

outstanding/ total

annual operating

revenues excluding

grants and transfers

*365

Average number of days it takes the utility

to collect monies billed. Represents the

time taken to realise the revenue

generated. A low score is better for

creditworthiness. Operating reserve is

maintained for higher score to not effect

creditworthiness.

Solvency/Profitability Ratios

28

Ratio Calculation Use

OPEX transfer

(subsidy)

dependency

% of OPEX covered by

transfers (subsidies) from

national, state/provincial

and/or local governments

Determines financial viability if operating

profit is negative. High % generally

indicative of low creditworthiness and/or

high social value

Working Ratio Operating Revenue/ Cash

Operating Expenditure

The cash flow generated from providing

agreed upon services – should at least

2.0.

Operating Ratio Operating Revenue/

Operating Expenditure (+

Depreciation, depending on

situation)

Should be more than 1.

Operating Cost

Coverage Ratio

Total annual operating

revenue divided by total

annual operating cost

OCCR of more than 1 is necessary for

financial sustainability.

Return on Asset Net Income after tax / Total

assets (or Average Total

assets)

Return on assets (ROA) is a financial

ratio that shows the percentage of profit

that a company earns in relation to its

overall resources (total assets).

Discussion point

29

Do the Managing Directors in the WSPs that you

support receive morning reports with key financial

ratios each morning on his/her near real-time

dashboard or only operating data?

1. Yes

2. No

3. Don’t know

Limitations of Ratio Analysis for

Creditworthiness Assessment

The specific limitations of ratio analysis applied to water

utilities include…

30

The need for accurate historical data,

• Ratio analysis requires the collection of historic financial data that is comparable across companies and across time for benchmarking and assessing impact of the ratios on the creditworthiness of the utility.

The need to accommodate oddities in data,

• The results of ratio analysis sometimes require interpretation and often cannot be taken at face value.

The difficulty involved in scaling ratios,

The relative sensitivity of data

Audits and Auditing

31

Importance of Auditing

• The audit is an unbiased, objective assessment of

whether resources are managed responsibly and

effectively to achieve intended results,

– Ensures accountability and integrity, improve

operations, and instill confidence among all

stakeholders.

• Credit raters use documents including financial

audits, performance audits, investigations, and

advisory service reports to inform their credit risk

analyses.

32

Distinction Between Internal and External Audit

33

Item External audit Internal audit

Recipients of

reports

Shareholders, board members, and

(for utilities) the public

Board members

Objective(s) Add credibility and reliability to

performance reports

Provide the assurance that members of

the board and senior management fulfil

their duties

Coverage Financial reports and related

disclosures, financial reporting risks

and their management

All categories of risks, their management

including the flow of information around

the company, and governance

Timing and

frequency

Tied to financial reporting cycle,

focused, at least annually

Ongoing and pervasive

Focus Mainly historical Ideally forward-looking

Status and authority Statutory and regulatory framework International standards and Code of

Corporate Governance

Independence Professional ethical standards

overseen by board’s audit

committee and regulatory

framework

Professional ethical standards overseen

by board’s audit committee

Benefits of Auditing

• External audits are fundamental to credit rating

agencies and to creditworthiness, as they assure that

“annual accounts give a 'true and fair view' and are

prepared in accordance with legal requirements.”

• For credit risk analysis, audited records are essential, (A

minimum of last 3 years of records, and ideally 5 years’

financial data is needed for analysis)

• Internal audits are an important tool enabling senior

management to monitor and improve overall

performance.

34

Discussion point

35

With a strong management team and good

external auditors, is it important to spend the

money on a team of internal auditors?

1. Yes

2. No

3. Don’t Know

Conclusions

36

Good financial management and budgeting are essential to be rated as being creditworthy

Budgets enable management to control the operations and improve efficiency

Benchmarking using selected ratios provides management with critical information

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