Financial Planning and Management in Public Organizations by Alan Walter Steiss and Chukwuemeka O'C Nwagwu
FINANCIAL MANAGEMENT: AN OVERVIEW
Private and public organizations have experienced significant changes in recent years in both size and complexity. As a consequence, the management process has become more difficult, requiring greater skills in planning, analysis, and control--skills aimed at guiding the future course of organizations faced with accelerating rates of evolution in technical, social, political, and economic forces. This book examines a major segment of these skills: the theory and practice of financial planning and management in public organizations and, in particular in local government. The purpose of this initial chapter is to provide a broad overview of the components of financial management, building on the three basic cycles of cash management, financial planning, and management control (see Exhibit 1).
Objectives of Financial Planning and Management
In theory, the objectives of financial planning and management are quite simple--they are difficult only in practice. In theory, one merely has to decide what is wanted (specify goals and objectives), measure these wants (quantify the benefits sought), and then apply the means available to achieve the greatest possible value of the identified wants (maximize benefits). The means are the resources of complex organizations. Therefore, the primary objective of financial planning and management is to maximize benefits for any given set of resource inputs.
Managing Public Resources
A basic tenet in financial management is that costs should be incurred only if by so doing, the community or organization can expect to move toward agreed-upon goals and objectives. Determining whether the commitment of governmental resources improves conditions in the broader community can get complicated, however, particularly when no basis exists for assessing the value to individuals of such actions. The Pareto criterion suggests that the welfare of a community is improved if some members are made better off while no one is made worse off. This criterion has no logical flaws and does not require interpersonal comparisons of utility. Not all members of the community are likely to benefit equally from a given government action. however. Therefore, many public choices are still open to political decision. Despite the best efforts to achieve rigor and sophistication, scientific analysis cannot provide definitive answers to many of the questions involved in the allocation of government resources. Nevertheless, a continuous search must be maintained for more productive ways to operate public organizations and to assess their capacity to meet changing conditions and demands for the delivery of services.
The common denominator among the various resources of any organization is the cost involved in their utilization. The production of public and quasi-public goods and services requires the acquisition and allocation of relatively scarce resources, the values of which are measured and compared in the common unit of dollars. Consequently, the focus of management most often is on financial resources.
Basic Components of Financial Management
The essential tools for managing financial resources include techniques for assessing the long-term fiscal needs of the organization and for acquiring these resources, rational procedures for allocating resources and managing costs, and appropriate mechanisms for recording and disseminating relevant financial information. Given the increasing role that government and other not-for-profit organizations play in the economy, the public's stake in effective performance of these organizations and institutions is mounting. In the absence of the verdict of the marketplace, the role and responsibilities of financial management in the public sector are even greater than those in profit-oriented organizations.
Exhibit 1. Linkages Among the Financial Management Cycles
Financial management involves the acquisition and allocation of organizational resources and the tracking of performance resulting from such allocations. In a profit-oriented enterprise, financial statements form the basis for the stockholders' assessment of performance of management. In not-for-profit organizations, management seeks to satisfy the needs and desires of its constituents within a set of financial (budgetary) constraints. In either case, financial resources are the focal point for managerial decision making, action, and accountability. Methods and techniques utilized in the performance of these financial functions are relevant to managers in all types of organizations.
Financial management in the public sector borrows liberally from the tools and concepts of business management. The transfer of techniques cannot be complete, however, because of the basic features of government services which include the need to provide for the common welfare and safety of the community and to allocate basic public services on other than the criterion of the ability to pay. These same features limit the extent to which business management techniques can be applied in the management of public resources. Several functions are common to financial management, however, whether in the private or public sector.
A traditional role for financial management is that of score keeping. Reports of past performance are prepared for internal management as well as outside groups, such as stockholders, creditors, and the general public. The extent to which these reports can pinpoint responsibility for any deviations from anticipated performances largely depends on the degree of sophistication built into the accounting and related management control mechanisms. If financial control mechanisms become overly rigid and lose sight of their operating objectives, countermeasures and subterfuges will emerge that may destroy the effectiveness of the system (and possibly the organization itself). To remain effective, score keeping functions must achieve organizational compliance by demonstrating their utility to all levels of management.
The allocation of existing resources and the management of costs to derive future benefits are key responsibilities of financial managers. The relationship between current resource allocations and future benefits is asymmetrical, however. Whereas existing resources are expended with certainty, the anticipated stream of benefits often is uncertain. This stream may fall considerably short of the expected results or may exceed initial estimates. In financial management, this deviation from expected returns provides an important definition of uncertainty and risk.
The tendency is to think of cost strictly in terms of quantifiable inputs--the financial resources required to support personnel, equipment, materials, and so forth. Costs that cannot be conveniently measured in dollars all too often are dismissed as non cost considerations. Future costs may have important implications beyond their measurable monetary value, however.
To determining the financial feasibility and desirability of resource commitments, an analysis of future costs and benefits must be undertaken rather than the mere reconciliation of past expenditures. In the allocation of resources, the following question must continually be examined: Are anticipated long-run benefits (adjusted for risk) of a given project commensurate with the long-run costs that may be incurred?
Financial managers must also be concerned with the long-term asset requirements of the organization. A prime function of financial management is to identify the resources required to attain the overall objectives of the organization. A financial plan is a key ingredient in the long-term strategies of any organization. The main purpose of financial planning is to project resource requirements for specific time periods and to identify the likely sources of the funds needed.
A view of the future is required before any plan can be formulated. This forecast lays out explicitly and implicitly the political, economic, and environmental conditions that are likely to affect the programs and activities of the organization. Sound professional judgment is an essential ingredient in the development of forecasts because of the difficulty in predicting future conditions and events.
Financial management must identify the magnitude of future needs, determine the timing, and negotiate with potential sources of external capital. Decisions of whether to engage in short-term bank borrowing or long-term bond issues are dependent on cash flow expectations, capital structure determination, and cost-of-capital considerations. To discharge these functions effectively, financial managers must be sensitive to macro-economic developments that may influence the availability and cost of the capital to be acquired.
Cash Management Cycle
Cash management involves: (1) analyses of revenues and expenditures; (2) financial analysis of the utilization of assets; (3) short- and long-range forecasts of resource needs, (4) cash mobilization; and (5) formulation of sound short-term investment strategies. The basic objectives of cash management are to maximize the effective use of resources and minimize opportunity costs, while at the same time, maintaining a sufficient cash balance to meet the day-to-day needs of the organization.
Analysis of Revenue and Expenditure
The United States has relies on a mixed private-public economic system--on the "invisible hand" of supply and demand in the market place, with public sector economics applied only when the market system fails to satisfy broad social goals. Governments produce and supply public goods and services and may encourage or discourage the production and consumption of other goods and services through the regulation of economic behavior (e.g., through tax incentives or tax levies, performance standards, codes and inspections). When economies of scale (lower costs and/or greater efficiencies) yield social benefits, government may assume ownership to regulate the pricing of goods and services and/or to circumvent monopolistic pricing (for example, by establishing a public utility).
The demand for public services and facilities changes as a function of growth and the social and economic characteristics of the community. Local revenues have tended to increase at a rate slower than demand, however, creating an ever widening "fiscal gap" for many localities. Most local sources of revenues are not particularly responsive to changes in the overall economy. This relative inelasticity of public revenues is attributable, in part, to the tax structure which forces local governments to rely heavily on property taxes. Under fiscal pressures, property taxes have proven to be relatively unresponsive in meeting increasing demands for public services and facilities.
Ownership of property has long been considered a fair index of wealth. Therefore, since colonal days, it has been customary for real and personal property to be subject to taxation. Real property taxes are levied on the assessed value of land and improvements, while personal property taxes may be levied on a wide variety of tangible (e.g., furniture and equipment) and intangible (stocks and bonds) personal property.
Significant reforms are required in the administration of property taxes if local governments are to meet the demands for public services and facilities. The most serious local administrative fault is inaccurate assessments, in terms of: (a) underassessment (as a percentage of true market value), and (b) deviation of individual property values from the general assessment ratio of the taxing jurisdiction.
The use of non-property taxes by local governments had its origins in the 1930's when many property owners were confronted with property taxes well beyond their capacity to pay. Local governments continually are challenged to find innovative ways to augment local revenue sources through the levy of non-property taxes and fees. Various forms of non-property taxes are identified in Exhibit 2.
Exhibit 2. Local Nonproperty Taxes
o Local sales taxes are levied on retail sales of tangible personal property. Sales taxes are not inelastic, but vary less widely during business fluctuations than do the yields of net income taxes.
o Gross receipts taxes are imposed on businesses and occupations and are measured by the gross income of the undertaking and, in some areas, have replaced former flat-rate business licenses.
o Selective sales taxes may be levy on specific commodities or services in lieu of a general retail sales tax: public utility taxes; admission and amusement taxes; motor fuel and motor vehicle license taxes; business license taxes; and local taxes on alcoholic beverages and tobacco.
o Income taxes have been applied at the local level to: (l) gross income from salaries and wages of residents earned both within and outside the jurisdiction; (2) gross income from salaries and wages of nonresidents earned within the jurisdiction; (3) net profits of professions and businesses of residents from activities wherever conducted; and (4) net profits of professions and businesses of nonresidents and of corporations from activities conducted within the jurisdiction.
o Service charges are amounts received from the public for performance of specific services benefiting the person charged and from sales of commodities and services--except by city utilities--and generally bear a direct relation to the cost of providing the service.
o Licenses and permits involve charges that are less than, or equal to the cost of the administration of a government activity.
o Interest earnings consist of earnings on deposits and securities, other than the earnings of insurance trust funds or employee retirement systems.
o The sale of property involves receipts from the sale of real property and improvements thereon, but excludes receipts from the disposition of commodities, equipment, and other personal property and from the sale of securities.
o Special assessments, while imposed on a property, differ from taxes in that they are related to a specific benefit, need not be uniform throughout the jurisdiction, and generally allow no exemptions.
The mismatch that exists among governmental levels in the provision of public services is partially addressed by intergovernmental transfers of revenues. Intergovernmental revenues may be derived from either the federal or the state government and may be given in the form of grants-in-aid, shared taxes, or revenue sharing. Many localities have become increasingly dependent on intergovernmental transfers to offset the slower growth of local revenue sources. However, these sources of support have also been adversely affected by shifts in federal policies in recent years.
Techniques for making revenue and expenditures projections, with few exceptions, have remained virtually unchanged over the past 50 years. Expectations for the coming year are determined by applying observed percentage changes in revenue collections and expenses incurred between the previous and current fiscal years. Alternatively, a trend line may be developed by fitting a series of historical data which is then extrapolated to obtain projections of revenue and expenditures. While this approach has the advantage of simplicity, it leaves many problems unresolved. Allowance seldom is made for any contingencies in such projections.
Financial analysis identifies how discretionary funds might be used to implement new programs and strategies. Baseline funds support current, ongoing operations of the organization and are used to pay current operating expenses, provide adequate working capital, or maintain current plant and equipment. Strategic funds are used to purchase new assets, such as equipment, facilities, and inventory; to increase working capital; to support direct expenses for research and development, marketing, advertising, and promotions; and in the private sector, for mergers, acquisitions, and market development. The strategic funds available to an organization can be determined by subtracting baseline funds from total assets (revenue or appropriations). The available strategic funds should be allocated to each program in priority order according to its potential contribution to the achievement of identified goals and objectives.
Various models can be used to project financial statements, to analyze cash flow requirements, to optimize financial leverage, to compare lease versus purchase options for difference depreciation schedules, to evaluate the impacts of proposed acquisitions, and to assess the impacts of risk and uncertainty on financial decisions. Many of these models can be consolidated or combined so that different managers can use the same assumptions to design models to meet their particular needs.
In recent years, computer-based methods of analysis have become a significant tool for financial analysis. Interactive software facilitates the use of the computer as an on-line, real-time decision support system (DSS). Computer-assisted methods of financial analysis provide a basis for the continuous fine tuning of financial plans so as to anticipate things to come and adjust to unanticipated events that may arise as plans and programs are implemented.
A forecast is an approximation of what will likely occur in the foreseeable future. The objective of forecasting is to provide a basis on which to measure differences between actual events and the plan that was adopted to achieve certain objectives. Thus, forecasts provide management with a sound basis for action as the future unfolds and events begin to diverge from the predictions. Problems can be identified quickly and the nature and extent of corrective actions clearly defined.
The notion that forecasting is impossible in the public sector is furthermost from the truth. The cash requirements of government are based on budgeted expenditures, which are finite and known in advance. Revenues are tax-based and, therefore, estimable. Public organizations must develop reliable estimates of their cash flow positions in order to maximize returns on their financial assets.
Forecasts form the basis for a cash budget, which is used to monitor how much money will be available for investment, when it will become available, and for how long. A cash budget tracks the movement of cash in and out of the treasury. An astute financial manager can use a cash budget to identify early signs of an impending cash problem and to indicate appropriate steps to avert the problem. Without a cash budget, a manager cannot obtain a long-term view of cash flow patterns and, therefore, cannot effectively plan future cash requirements. The investment strategy of any organization must also be strongly correlated with the accuracy and timeliness of its cash budget. Decisions that affect the flow of cash are summarized in Exhibit 3.
Exhibit 3. Decisions Affecting the Flow of Cash
o Operating decisions stem from the policies of the organization--such as the creation or elimination of a service unit or department, increases in the charges for services or in the tax rate in the case of local government, changes in the salaries and fringe benefits extended to staff, and so forth--and result in adjustments in the inflow and outflow of cash.
o Capital expenditure decisions that affect the infrastructure of the organization give rise to the outward flow of cash. An organization's infrastructure involves the construction, repair and maintenance of fixed, physical assets.
o Credit decisions involve the length of time an organization takes to make payments to its vendors for goods and services provided, as well as the length of time a client/customer may take to make payment to the organization without penalty.
o Investment decisions result in the use of inactive cash to purchase financial assets or the liberation of funds by the sale of such assets.
o Financing decisions involve the acquisition of new money by selling bonds, borrowing, or increasing revenues (e.g., by raising user charges, prices, or increasing taxes).
Cash mobilization techniques fall into two areas: (1) acceleration of receivables and (2) control of disbursements. Receivables are those funds that come into the organization's treasury. Cash flow can be expedited by collection systems that provide for advance billing and payment on or before receipt of goods and services. Disbursements are funds paid out to vendors and others who have provided services to the organization. The timing of disbursements is a important decision that has implications for the liquidity position of any organization. Delaying cash outflows enables an organization to optimize earnings on available funds. Good cash management practices generally dictate that disbursements are made only when due. Public organizations may find some of these cash mobilization techniques unacceptable. A local government, for example, must evaluate the possible effects on its taxpayers and clients of aggressive collection and disbursement practices. The objectives of cash management must be artfully blended with the need to maintain good public relations with vendors and the community at large.
Adequate credit must be available if any public organization is to survive in the short term. Lines of credit are commitments by banks to make loans available subject to certain mutually agreed upon conditions and are important hedges against unanticipated contingencies, such as temporary financing needs and short-term cash flow shortages.
Keeping a tight rein on bank balances has become an increasingly popular cash management principle. Money not needed to meet operating costs or for compensating balances required by banks should be invested in interest-yielding securities. All receipts--checks, money orders, and cash--should be deposited as soon as possible. Idle funds, such as checks sitting in safes, cash registers, or desk drawers overnight, could earn income for the organization if invested in short-term securities.
The ideal investment is one that yields a high return at no risk, offers promise of substantial growth, and is instantly convertible into cash if money is needed for other purposes. Unfortunately, this ideal does not exist in reality. Each form of investment has its own special virtues and short-comings. A fundamental objective of financial management is to maximize yield and minimize risk. Several exogenous considerations influence the yield on any investment, including interest rates, minimum investment requirements, and the maturation dates of investments.
Primary determinants in selecting a specific security included: (1) safety/risk, (2) liquidity and marketability, (3) maturity, (4) yield, and (5) price stability. Public officials accord safety the highest priority, followed by liquidity and yield. The money market instruments most widely used by local governments are arrayed against these basic characteristics in Exhibit 4.
Local governments and other public organizations often invest in securities that can be readily converted into cash either through the market or through maturity. The most attractive instruments that meet these criteria are securities supported by the full faith and credit of the federal government. Other relatively risk-free securities are: time deposits, time certificates of deposit, commercial paper, banker's acceptances, and repurchase agreements.
The concept of liquidity involves managing investments so that cash will be available when needed. Marketability varies among money market instruments, depending on the price stability of the instrument and on the availability of a secondary trading market. In managing an investment portfolio, the maturity dates of holdings must be synchronized with the dates on which funds will be required for capital or operating expenses.
In general, securities characterized by low risk, high liquidity, and short maturities will also produce low yields. For a security to provide high yields, one or more of the other criteria must be compromised. Although some localities are beginning to invest in high-grade, high-yield corporate bonds, many local officials still rank yield as the least important of all the criteria in selecting an investment instrument.
The majority of states allow local governments to invest in a variety of securities. Federal obligations, such as Treasury bills and federal agency securities, are practically riskless, since they are backed by the full faith and credit of the federal government. In addition, T-bills are usually issued on a short-term basis, maturing before new market conditions alter the assumptions on which the investment was based.
Other securities carry varying degrees of risk and, therefore, must offer higher interest rates. In many states, however, local governments are prohibited from investing in banker's acceptances and commercial paper which generally earn higher rates of return.
|Investment Instrument||Obligation Issuer||Denomina.||Maturities||Market||Yield Basis||Comments/ Restrictions|
|United States Treasury Bills||U.S. Government obligations||$10,000 to $1 million||3, 6, 9 & 12 months||Execellent secondary market||Discounted on 385-day basis. Also offered as tax anticipation bills through special actions||Popular investment; can be purchased in secondary market for varying maturities|
|U. S. Agency Securities||Various Federal Agencies||$1,000 to $25,000||30 days; 270 days; one year||Good secondary market||Discounted on a 360-day basis||Not legal obligtation of or guaranteed by the Federal Government|
|Negotiable CDs||Commercial Banks||$500,000 to $1 million||Unlimited; 30-day minimum||Active secondary market||Interest maturity on 360-day basis||Backed by credit of issuing bank|
|Non-Negotiable CDs||Commercial Banks/ Savings & Loan Associations||$1,000 minimum (usually $100,000)||30-day minimum||Limited secondary market||Interest maturity on 365-day basis||Lower interest rates for amounts under $100,000; 90-day interest penalty for early withdrawal|
|Repurchase Agreements||Commercial Banks||$100,000 minimum||Overnight minimum; 1 to 21 days common||No secondary market||Established as part of purchase Yield generally close to prevailing federal rates||Open: can be liquidated at any time. Fixed: maturity set for specific period|
|Banker's Acceptances||Commercial Banks||$25,000 to $1 million||Up to six months||Good secondary market||Discounted on a 360-day basis||Backed by credit of issuing bank with specific collateral|
|Commercial Paper||Promissory Notes of Finance Companies||$100,000 to $5 million||5 to 270 days||No secondary market||Either discounted or interest-bearing on a 360-day basis||Dealers will often negotiate "buy-back" agreements at a lower rate prior to maturity|
Localities have tried to mitigate risk by diversifying their holdings and avoiding investments in weak financial institutions. Smaller jurisdictions, located in remote areas with minimal amounts of funds available for investments, have minimized risk by joining state-managed investment pools, which resemble mutual funds in their portfolio composition. In seeking to improve or expand public services, local governments face: (1) the need to expand revenues, (2) already heavily burdened taxpayers, and (3) narrow restrictions on their ability to borrow to finance public expenditures. Under these circumstances, public officials can be expected to respond enthusiastically to any source of additional revenue that does not involve increased taxation or additional debt. The net return on investments can be an especially important source of revenue.
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