DEBT: HOW MUCH IS TOO MUCH?

• Author: Brock, Kristine

As its name suggests, debt capacity measures a government's ability to take on debt. It's a way that leaders and stakeholders can determine the affordability and risk of potential debt--and ensure decisions are made in the best interest of both present and future stakeholders.

Of course, debt agreements require both a lender and a borrower. This article will look at how a government can measure debt capacity, develop policies to support improved analysis, and provide examples for the measures used by the City of Franklin, Tennessee. Kristine Brock offers a nuanced take on assessing and tracking debt capacity. She draws on her experience in financial leadership for Franklin, Tennessee to explore this issue from the vantage point of the municipal borrower. Steve Murray, who heads Fitch's U.S. Public Finance Southwest Tax-Supported group, provides a deep dive into how rating agencies apply criteria to determine risk--and understand the unique circumstances of municipal borrowers.

MEASURING DEBT CAPACITY AND DEVELOPING POLICIES

BY KRISTINE BROCK

For most governments, state or provincial law prescribes a local debt limit--but this limit rarely takes local conditions into consideration. Without a sense of what is truly affordable, it is impossible to make wise decisions about the use of debt. This article will look at how a government can measure debt capacity and develop policies to support the process analysis and provide examples for the measures used by the City of Franklin, Tennessee.

As of June 30,2020, Franklin's most recent fiscal yearend, the city had a general obligation long-term debt, including unamortized premiums, of $160 million and water and sewer utility debt of approximately $85 million. The city is currently in the midst of borrowing more than $100 million from the State of Tennessee's revolving loan program to expand and rebuild its wastewater treatment plant, so water and sewer utility debt will increase significantly in the next couple of years.

STANDARD DEBT CAPACITY MEASURES

Standard debt capacity measures provide context about the ways in which governments compare with one another and how rating analysts and states look at local governments. Franklin's outstanding general obligation debt as a percentage of assessed valuation is 3.1 percent.

Although some states and local governments have debt capacity caps on general obligation debt, the State of Tennessee does not. In comparing Franklin's general obligation debt to that of other governments, we must consider the specific functions that each provide. Cities will have higher percentages of general obligation debt if they operate school districts, which the City of Franklin does not.

Franklin also looks at debt per capita, which is $2,250 per resident. This amount has increased in recent years because of the city's rate of growth, which has led to more frequent issuance of debt to fund its capital improvement program. This level isn't excessive, but the trend has increased in recent years.

Another measure the city considers is annual debt service as a percentage of total revenue or expense. The constraints created by amounts of debt service affect the level at which other operational services are funded. In fiscal 2020, approximately 21.7 percent of Franklin's general fund revenue was allocated to annual debt service. The percentage is a bit higher for expenses because the city's general fund expenses are less than revenue. Also, the FY 2020 ratio was almost three percent higher than the prior year because of revenue declines resulting from the COVID-19 pandemic that begin in March 2020.

Finally, there's an overall capacity to sustain additional longterm debt service obligations. This is somewhat complicated and subjective because it involves evaluating the revenue stability of major property taxpayers and businesses that generate significant sales tax. Determining potential longterm or near-term issues with large taxpayers can be difficult, and the city needs to determine if it's counting too much on any one large property taxpayer or sales tax source. Sales tax is also difficult to fully analyze because some states don't allow disclosure of the amount of sales per business, although it may be possible to get an idea about certain sectors.

Franklin's largest property taxpayer is a commercial office park. The city has significant office commercial valuation, and its largest property taxpayer represents approximately 2.4 percent of the total valuation. The top 10 added together represent about 14 percent of the total valuation, so the city doesn't consider itself to be highly concentrated. Some local governments have a large factory or retail shopping complex that is a top taxpayer, and that one business might be up to 40 percent of its total valuation, which can obviously be a concern as that one...