# Asset management

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## 5.11 Financial Sustainability Indicators

These indicators are performance measures or signals used to convey directions taken by an agency and to assess whether or not desired outcomes are achieved by the LTFP.

The definition of sustainability in Section 2.2 includes three sustainability objectives: environmental protection, social advancement and economic prosperity. Another measure of sustainability was added in Section 2 with financial sustainability being a measure of an agency’s long-term financial capacity with its financial requirements.

Many agencies report on environmental protection, social advancement and economic prosperity in their Annual Reports. Part 8 of the GAM is concerned with FSI.

Effective FSI should (LGPMC 2007):

• measure those factors which define financial sustainability
• be relatively few in number
• be based on information that is readily available and reliable.

Indicators can only tell part of the story as they only measures outputs or outcomes individually and without explanations. They give an indication of trends and where to look for reasons behind any trends.

Table 5.6 presents typical FSI for member agencies based on the hypothetical set of financial statements shown in Table 5.4 and Table 5.5.

Agencies should determine targets and monitor trends for financial indicators based on achieving/maintaining financial sustainability and their own specific circumstances.

Table 5.4: Statement of comprehensive income for hypothetical agency

Item

Current year

($M) Previous year ($M)

Income
Rates revenue 39.8 37.5
Statutory charges 1.27 1.1711
User charges 1.5 1.4
Grants, subsidies & other contributions (excl. capital) 4.8 4.8
Investment Income 0.2 0.2
Reimbursements 0.5 0.4
Income from commercial activity 0.2 0.2
Other operating income
Net gain (loss) – joint venture and associated (0.2) 0.1
Total operating income48.346.2
Expenses
Employee expenses 18.9 18.2
Contractual services 10.6 10.9
Materials 3.7 3.7
Finance costs 0.5 0.5
Depreciation 8.8 8.7
Other expenses 4.7 4.5
Total operating expenses47.246.5
Operating surplus (deficit)1.1(0.3)
Physical resources received free of charge 0.5 0.7
Net gain (loss) on revaluation of assets* 0 0.5
Net gain (loss) on disposal of assets 0.5 0.3
Other comprehensive income
Net operating surplus (deficit)3.11.9

* A gain on revaluation will only be included where it reverses a previous decrement in the asset or same class of asset.

Notes:
AASB 101(10) (AASB 2015a) defines this as a statement of profit or loss and other comprehensive income and allows entities to use the shorter description Statement of Comprehensive Income. Most jurisdictions prescribe a format for comprehensive income statements for local governments in their jurisdiction.

Grants, subsidies and other contributions. All grants, subsidies and other contributions that do not meet the criteria for disclosure as amounts specifically for new or upgraded assets or physical resources received free of charge are to be included in Grants and other contributions. Details for determining amounts received specifically for new or upgraded assets and physical resources received free of change are shown.

Source: IPWEA (2015b).

Table 5.5: Statement of financial position for hypothetical agency

Item

Current Year

($M) Previous Year ($M)

Assets
Cash and cash equivalents2.22.7
Inventories4.84.8
Land134.5133.7
Buildings34.234.7
Infrastructure254.4250.3
Plant & equipment, furniture & fittings7.36.7
Other financial assets0.91.0
Other assets (incl. work in progress)2.01.9
Total Assets442.1437.6
Liabilities
Employee entitlements3.23.1
Borrowings, overdraft, finance leases, deposits held7.77.8
Other liabilities00.1
Total liabilities15.716.8
Equity
Asset revaluation reserve124.5123.4
Accumulated surplus (deficit) & other reserves301.9297.4
Total equity14 82414 328

Source: IPWEA (2015b).

Table 5.6: Financial sustainability indicators

IndicatorDescriptionCommentCalculation Indicative target

1. Operating Surplus

The difference between day‑to-day income and expenses for the period. An operating surplus (deficit) arises when operating income (excluding capital income) exceeds (is less than) operating expenses for a period (usually a year).

Operating income (excluding amounts received specifically for new or upgraded assets and physical resources received free of charge) less operating expenses for the reporting period.

Operating income = $48.3M Operating expenses =$47.2M

Operating surplus = ($1.1M) [$48.3M – $47.2M] Breakeven operating position, or better over any five year period. What does it mean? If an agency is not generating an operating break-even result or better on average over the medium term it is unlikely to be operating sustainably. It means that the cost of goods produced and sold, or services provided to the community, exceed income generated. If an agency is operating with a significant deficit over several years and its strategic management and s LTFPs do not provide clear proposals for this to be turned around, then it is inevitable that it will face major financial shocks in the future. The agency is living beyond its means. Sooner or later, the agency will be caught by the consequences. For an agency in this position, the problem will come to a head when major assets fail and the agency would need to choose between large user charge rises or not replacing assets thereby providing its community with a lower level of service. 2. Operating Surplus Ratio The percentage by which the major controllable income source varies from day to day expenses. The operating surplus ratio is the operating surplus (deficit) expressed (excl. capital income) as a percentage of total operating income. Operating surplus (deficit) divided by operating income. Operating surplus (deficit) =$1.1M

Operating income = $48.3M Operating surplus ratio = (2%) [$1.1M/$48.3M] Operating surplus ratio between 0% and 10% over any five year period. What does it mean? A positive value indicates the percentage of operating income available to fund cost of services (operating expenditure). It is the nationally consistent measure of a council’s financial performance. If the relevant amount is not required for this purpose in a particular year, it can be held for future (capital) expenditure needs by increasing financial assets or preferably, by reducing debt in the meantime. A negative value indicates the percentage increase in total income required to achieve a break even operating result. Care should be taken when assessing the operating result on the basis of one year only, as the operating surplus (deficit) does not necessarily provide a reasonable indication of the long-term financial sustainability of the entity. 3. Net Financial Liabilities What is owed to others, less money held, invested or owed to the agency. Net financial liabilities equal total liabilities less financial assets. Total financial liabilities less financial assets. Total liabilities =$15.7M

Cash & cash equivalents = $2.2M Trade & other receivables =$1.0M

Other financial assets = $0.9M Net financial liabilities =$11.6M

[$15.7M –$2.2M V $1.0M –$0.9M]

Net financial liabilities are between zero and 100% of annual operating income, but possibly higher in some situations.

Target range should be set having regard for the target for the agency’s operating surplus ratio and needs identified in its strategic, long-term financial and AMPs.

What does it mean?

As well as borrowings, considers the agency’s other liabilities and financial assets.

Agencies with significant asset funding needs may find their financial sustainability is improved by raising debt to fund these needs, especially where the operational savings achieved from addressing asset funding needs exceed the additional interest costs resulting from the debt raised.

4. Net Financial Liabilities Ratio

Net financial liabilities as a percentage of total operating income. Indicates the extent to which net financial liabilities could be met by operating income.

Net financial liabilities divided by operating income.

Net financial liabilities = $11.6M Operating income =$48.3M

Net financial liabilities ratio = 24%

[$11.6M/$48.3M = 24%]

Net financial liabilities between 0% and 100% of total income.

The Agency should understand its net financial liabilities ratio and set its target based on future community needs and long-term financial sustainability.

What does it mean?

Where the value is falling over time, it indicates that the agency’s capacity to meet its financial obligations from operating income is strengthening.

Reasons for an increase in the net financial liabilities ratio will sometimes also result in an agency incurring higher net operating costs (e.g. from additional maintenance and depreciation costs associated with acquiring new assets). This will detract from the agency’s overall operating result.

An agency with a healthy operating surplus could quite appropriately decide to allow its net financial liabilities ratio to increase in order to provide additional services to its community through the acquisition of additional assets without detracting from its financial sustainability.

Nationally consistent measure of the significance of the net amount owed by a council.

5. Interest Cover Ratio
(not included in IPWEA 2015b)

The proportion of day-to-day income used to pay interest on loans net of interest income. Indicates the extent to which an agency’s operating income is committed to meeting interest expenses.

Net annual interest expense divided by operating income.

Finance/borrowings cost = $0.2M Investment income =$0.5M

Operating income = $48.3M Interest cover ratio = 1% [($0.5M – $0.2M)/$48.3M]

Interest cover ratio is between 0% and 10% of operating income.

Target to be set in conjunction with targets for indicators 3 and 4 above.

What does it mean?

As with all indicators associated with measuring indebtedness and its associated costs, there is no right or wrong ratio.

An agency needs to manage this ratio within a range acceptable to it, having regard to its long-term financial sustainability and strategic management plans and financial management policies.

6. Asset Sustainability Ratio

The ratio of current replacement expenditure relative to depreciation for a period. It measures whether assets are being replaced at the rate they are wearing out. Indicates whether the agency is replacing or renewing non-financial assets at the same rate that its overall stock of assets is wearing out for the period.

Capital expenditure on replacement/ renewal of existing plant and equipment and infrastructure assets divided by their annual depreciation expense.

Capital renewal expenditure =$6.2M (hypothetical) (not disclosed in financial statements but assumed for illustrative purposes). Depreciation expense =$8.8M

Asset sustainability ratio = 70%

[$6.2M/$8.8M = 70%]

Often suggested to set at 100%. This is reasonable on average over the long term, but for any shorter period, the target should be set having regard to the relative age and replacement/ renewal profile of the entity’s asset portfolio.
What does it mean?

If capital expenditure on renewing or replacing existing assets is at least equal to depreciation on average over time, then the entity is ensuring the value of its existing stock of physical assets is maintained.

Entities should be replacing/renewing assets at the time they need to be replaced. When assets portfolios are young, this can be 50% or less. When the assets are old, the ratio may be more than 100%.

7. Asset Consumption Ratio
(not included in IPWEA 2015b)

The average proportion of ‘as new condition’ left in assets. Shows the DRC of an agency’s depreciable assets relative to their ‘as new’ (replacement) value.

DRC of property, plant and equipment and infrastructure assets divided by current replacement cost (CRC).

Asset class CRC DRC
Property, PE $92.9M$79.5M
Infrastructure $212.14M$155.94M $221.43M$163.89M

(CRC not disclosed in financial statements but should be available from the agency’s records. Amount above has been assumed for illustrative purposes)

Asset consumption ratio = 74%

[$163.9M/$221.4M]

Asset consumption ratio is between 40% and 80%.

Target to be set having regard to the relative age and the replacement/ renewal profile of the agency’s asset portfolio.

What does it mean?

This ratio seeks to highlight the aged condition of an entity’s stock of physical assets.

If an agency is responsibly maintaining and renewing/replacing its assets in accordance with a well prepared AMP, then the fact that it’s Asset Consumption Ratio may be relatively low and/or declining should not be a cause for concern – providing it is operating sustainably.

It makes no sense to replace perfectly serviceable assets, just because they are old. In such circumstances, the decline in the value of an agency’s physical assets will be offset by a reduction in its net financial liabilities (either by an increase in its financial assets or preferably wherever possible, a reduction in its debt) as result of operating income generated being sufficient to cover its depreciation expense. Its Statement of Financial Position overall will be unaffected and it will be in a strong financial position and able to fund the future renewal/replacement of these assets when optimal to do so.

8. Asset Renewal Funding Ratio

Ratio of asset renewal and replacement expenditure for a period relative to the asset renewal and replacement expenditure identified as warranted in an AMP for the same period.

May be calculated for several periods, e.g.:

financial reporting period

current budget period across 10-year lifetime of LTFP

individual years within lifespan of LTFP.

If the indicator is significantly higher or lower than 100%, i.e. substantially outside the indicative target range, this indicates a mismatch of the asset management pan and expenditure patterns. A low asset renewal funding ratio may be due to an ambitious AMP which is not in line with affordable service levels. It may also arise where the council is reluctant to spend the amount required by the AMP as it is averse to incurring substantial levels of debt.

Capital renewal and replacement funding outlays for a period divided by capital renewal and replacement expenditure identified as warranted in an AMP for the same period.

Depending on reporting requirements/practice, the past and proposed capital renewal and replacement expenditure may not be disclosed in the entity’s financial statements or LTFP.

For illustrative purposes, assume expenditure of $6.2M in a period vs a need indicated in an AMP of$8.0M

Asset renewal funding ratio = 78%

[$6.2M/$8.0M = 78%)

Asset renewal funding ratio lies between 90 and 110%.
What does it mean?

Measures the extent to which the entity accommodates asset renewal and replacement in an optimal and cost-effective way timeously relative to the risk it is prepared to accept and levels of service it wishes to maintain.

Nationally consistent measure of a council’s performance in its asset renewal and replacement.

Note: there may be good reasons for variation in entity’s the asset renewal funding ratio between individual years, and this does not mean that asset management performance at the entity is not optimal over a longer term, as long as the target is met over time, e.g. over 3–5 years.

9. Future Renewal Funding Ratio
(not included in IPWEA 2015b)

The ratio of the net present value of asset replacement funding accommodated over a 10-year period in a LTFP relative to the net present value of projected capital renewal expenditure identified in an AMP for the same period. Indicates whether the agency has the financial capacity to fund asset renewals as required and therefore continue to provide existing levels of asset-based services in future without additional operating income or reductions in operating expenses or increases in net financial liabilities above that currently projected.

The net present value of projected 10-year capital renewal funding outlays in a LTFP divided by the net present value of projected 10 year capital renewal expenditures in an AMP in current values.

NPV of LTFP projected outlays = $29.9M NPV of projected expenditures =$31.8M

(not disclosed in financial statements but assumed for illustrative purposes)

Future renewal funding ratio = 94%

[$29.9M/$31.8M]

What does it mean? This indicator is a measure of the ability of the entity to fund its projected asset renewals/replacements in the future.

Source: IPWEA (2015b).