Ratio Analysis, Simplified: An Alternative Framework for Analyzing the Financial Condition of a Government Using Mead's 10-Point Ratios.

• Author: Khan, Aman

Financial ratios are a valuable tool for analyzing an organization's financial condition. While the 10-point ratios and their extensions continue to provide the foundation for much of the discussion on the subject, the methodology underlying the approach has an important weakness: it is heavy on data requirement, which could be extremely time-consuming. Also, the choice of the scale--as used by Ken Brown and subsequently by Dean Mead--to determine the overall financial condition of a government needs further refinement. In this article, we develop a composite measure, an index, based primarily on Mead's ratios, that is simple and easy to analyze and interpret. (1)

Methodological overview

Several important characteristics of both Brown and Mead's ratios are worth noting. (2)

* Like Brown, Mead uses 10 ratios but refines them considerably in light of the changes in the reporting procedures introduced in 1999, under the Governmental Accounting Standards Board [GASB] Statement 34, Basic Financial Statements --and Management's Discussion and Analysis for State and Local Governments.

* The refined ratios are inherently financial in character, which better reflects the financial conditions of a government, for example, financial position, financial performance, liquidity, solvency, revenues, debt burden, debt coverage, and long-term fixed [capital] assets.

* The use of purely financial ratios makes it possible to collect the relevant data directly from the annual financial reports.

* Both Brown and Mead use a large number of similar-size governments as a benchmark against which the ratios of a government are compared to determine its overall financial condition, as noted previously. For instance, Brown uses 750 small cities of similar size and Mead also uses a large number of cities. It can require an enormous amount of time to gather the relevant data, analyze it, and compare the results.

From a methodological perspective, both Brown and Mead use quartile analysis, an ordered statistic that divides data into four quarters, with each quarter containing 25 percent of the data [Q1 = lowest 25 percent; Q2 = between 25 and 50 percent; Q3 = between 50 and 75 percent; and Q4 = the highest 25 percent] to determine where the ratios of a city in question would fall on a particular quartile. Both authors also use a four-point Likert-type scale that ranges between -1 and +2. For example, if the ratio of a city falls on Q1 it will receive a value of -1; if it falls on Q2 it will receive 0; if it falls on Q3 it will receive +1; and if it falls on Q4 it will receive +2. Finally, to determine the overall ranking of a city relative to the database cities, both authors use a scoring system that ranges between -10 and +20, where 10 or more is considered among the best, 5 to 9 is better than most, 1 to 4 is about average, 0 to -4 is worse than most, and -5 or less is among the worst. It is unclear why this particular scoring system was used, along with, more importantly, the cut-off points for determining the overall financial condition. Brown recognizes this apparent weakness, however, and suggests that individual researchers could modify the scoring technique if necessary.

The approach suggested here is based on Mead's ratios, rather than Brown's, because they are predominantly financial in character. Also, the information can be easily obtained from a government's annual financial report, which makes the data collection considerably easy. In fact, Mead does a great job of indicating the specific statement in the report, which contains the information one would need to construct a particular ratio. On the other hand, our approach does not require a large number of governments of comparable size to determine the overall financial condition of a government. Additionally, it avoids the ranking system both Brown and Mead use, which is somewhat inconsistent as to the arithmetic distance between the ranks, with a scale that is consistent. The product of this approach is an index, a single measure, based on the same 10 ratios Mead uses. (3) Operationally, a single measure such as an index is more efficient than a measure that compares each individual ratio against a benchmark based on many similar governments. The process, as we noted, can be extremely time-consuming.

Constructing the index

The index suggested here has several important characteristics:

* It ranges between 0 and 1 [for...