Identifying shortfalls: the importance of cash flow analysis in times of fiscal stress.

• Author: Swanson, Christopher J.

Local governments face increasing challenges to fiscal sustainability, making an effective methodology for forecasting and monitoring cash flow more important than ever. Cash is critical for short-term operations. It pays the salaries and buys the equipment that produces public services. A balance sheet may carry plenty of assets, but without cash, a government is effectively bankrupt. Converting annual financial budgets into monthly variance analysis reports can provide an early warning system for identifying cash shortfalls.

Cash flow--a measure of the difference between cash sources and uses--is a key indicator of an organization's fiscal health. Cash flow variables are also contained within an organization's budget, which is a good starting point for building a cash flow model.

Typical budgets divide financial sources among operating or general government revenues, cash flow from investment activities, and proceeds from financing. Financial uses include expenditures on salaries and benefits, services, materials and supplies, capital projects, debt service, and related obligations. Depending on the governmental entity, revenues and sources less expenditures and uses yields a surplus or deficit, a net change to fund balance, and/or operating income or loss.

To derive the net cash provided or used by governmental activities (i.e., net cash flow), adjustments should then be made for non-cash items including depreciation and net effects of changes to accounts receivable, prepaid accounts, accounts payable, and obligations such as postemployment benefits other than pensions (OPEB).

ANNUAL VERSUS MONTHLY ANALYSIS

Every local government prepares an annual budget, and some include a multi-year financial forecast. However, far fewer governments prepare detailed monthly budgets. Instead, they track monthly actual revenues, expenditures, and associated cash balances against a rough estimate of a monthly "budget" based on a straight-line proration of the annual budget across 12 fiscal months. This methodology can be inadequate and misleading, as revenues and expenditures seldom materialize on a level monthly basis.

For example, property taxes might appear in two large installments, and numerous smaller amounts throughout the year, based on the payment schedule of the responsible jurisdiction. Sales tax revenues might appear in major quarterly installments, again based on tax collection and disbursement schedules, combined with seasonal factors affecting retail sales. Seasonal factors, consumption patterns, and periodic tax and fee due dates also affect revenue sources such as utility taxes and franchise fees, charges for services, licenses and permits fees, fines and forfeitures, and other common governmental revenue sources. Grants and intergovernmental transfers are another revenue source typically received on a more sporadic timeline.

On the expenditure side, salaries and benefits typically comprise the largest part...