By Brian Reilly
Are we headed for an economic downturn? What if we don’t hit our projections for tax and other revenues? Can we afford to take on more debt right now? Questions like these float through city halls across Minnesota every day.
And while it may seem impossible to answer them accurately, you can gauge fiscal sustainability and make reasonably well-informed decisions by focusing on metrics related to two basic financial components: cash reserves and debt.
How much cash do you have relative to planned spending? At home, we know a good rule of thumb is to keep three months’ salary in reserve to ensure you stay afloat should you encounter the unexpected, such as a job loss or major medical expense.
The same thinking holds true for municipalities, but you may wonder how much is enough. The answer, while ultimately unique to each city’s financial landscape, can be found by measuring and managing reserves.
Reserves are typically calculated as the amount of available cash as a percentage of annual operating expenses. But don’t mistake available cash with the fund balance since fund balance can include restricted or noncash assets. The rule of thumb is to hold minimum reserves greater than 25 percent of budgeted annual expenditures or—you guessed it—three months’ worth!
Depending on your community’s revenue collection cycle and the source and diversity of that income (e.g., sales tax, property tax, fees), it may be more prudent to choose a 50 percent reserves benchmark. It’s also important to remember the amount of reserves you hold can affect your city’s debt rating. Standard & Poor’s (S&P), a nationally recognized provider of municipal credit ratings, gives positive marks for rated debt issuers who consistently maintain reserves greater than 75 percent of expenditures.
Bottom line? Keep a solid cash cushion to guard against the unexpected. Because, as S&P puts it, “while financial crisis may arise from many factors, we have observed that the quickest route is through a liquidity deficiency.”
Issuing debt allows cities the flexibility to fund capital projects, cover unexpected shortfalls, and ultimately achieve their vision for the future. However, too much debt can erode that financial flexibility quickly due to potential credit rating downgrades, increased debt service costs, and the cash flow crunch that often ensues.
Managing your community’s debt burden is a critical tool for maintaining overall financial health. And knowing how much can be too much is a good way to help you do it. Debt burden is measured by calculating debt ratios, and there are typically three ways to do it. Moody’s Investor Service (another national rating agency) measures debt as a percentage of a city’s market-value tax base and provides guidance as to what ratios are deemed adequate. It’s called a debt-to-value ratio and it looks something like this:
Another benchmark—debt-to-expenditure ratio—calculates annual tax-supported debt service cost as a percentage of total expenditures. Both Moody’s and S&P indicate that this ratio should not exceed 25 percent, as shown in the following table.
The third option is the debt-to-revenue ratio. Opinions as to what constitutes acceptable debt levels vary. Moody’s states cities can carry up to 300 percent of annual operating revenues in net direct debt and still maintain adequate coverage. S&P takes a more conservative view, recommending a ratio no higher than 180 percent, as you can see in the following table.
Using these metrics to regularly assess liquidity and leverage will go a long way in guiding day-to-day decisions and provide a level of comfort and transparency for your constituents.
Note: For more long-term financial planning information, see Financial Planning for Elected Officials.
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