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Your Utility Balance Sheet Part 2: Liabilities, Equity, and Ratios

A Drop of Knowledge E-Newsletter
RCAP

Your Utility Balance Sheet Part 2: Liabilities, Equity, and Ratios
Keep your utility finances on track in the New Year
by Mark Rounsavall, Communities Unlimited (Southern RCAP)

Did you see Part 1 of our Utility Balance Sheet Series?  If not, click here to check it out.

Liabilities

Liabilities are what the system owes to others. The liabilities section is divided into two components – current liabilities and long-term liabilities. Current liabilities include current maturities of long-term debt, accounts payable, accrued liabilities, and other short-term notes to be paid.   Long-term liabilities are loans expected to be paid back over several years.

Current liabilities can be further broken down into the following:

  • Accounts payable are what the system owes to others for the normal operations of the business. Examples include utility bills, office supplies, and reimbursement to employees for travel expenses.
  • Current maturities of long-term debt, or current portion of long-term debt, is the principal amount the system will be required to repay on long-term loans during the next twelve months. This does NOT equal the total payment amount. The total repayment amount includes both the interest and the principal. The current maturities will only record the principal amount that is being repaid.
  • Accrued liabilities are basically the same as accounts payable – they represent amounts the system owes to others. However, the difference between accrued liabilities and accounts payable relates more to whom the amounts are owed. Accounts payable usually are for items the system has purchased in the normal course of operations to support the ongoing activities of the system. They also are called trade payables. Accrued liabilities normally are items that would be owed to employees, such as salaries, unpaid vacation/sick time. They also include payroll taxes withheld from employee’s checks but not yet remitted to the taxing agency and security deposits from customers (these are considered liabilities because the expectation is that the system will have to return them to the customer).
  • Accrued interest is the interest that has been incurred but not paid. For example, many systems have long-term loans or bonds that only require annual or semi-annual payments. Even though the system has not paid interest during the months between payments, they have incurred the interest and owe it to the lender. The system will be required to pay this incurred interest with the next regular payment. The system should record the interest as it is incurred on their balance sheet as an accrued, current liability.

Long-Term Liabilities

These include investments and the portion of payments to be made over the next several years that are not included in the current liabilities. For example, if you took out a capital improvements loan that you were scheduled to pay back over the next five years, the principal amount to be repaid within the next year would be recorded in current liabilities as a current maturity. The remaining principal scheduled to be paid back in years 2 through 5 would be listed as a long-term liability.

Equity

The final section of the balance sheet covers equity (or net assets). Depending on the legal structure of your system (for profit vs. governmental unit vs. nonprofit), this section will have various names. Other names include: net assets, fund balance, or owner’s equity.

Equity is the net value of the system over time. Equity is what should be left if the utility closed its doors, paid off all of its outstanding bills, collected everything that it was owed, and sold all of its assets for exactly the same price as they were recorded in the financial statements. The system increases its equity each year it earns a net income – or has more revenue than expenses. On the other hand, equity decreases for each year that the utility has a net loss.

Reviewing the Balance Sheet

There are two primary ways to analyze the information on a Balance Sheet to better understand where the utility stands financially:

First, Look for Changes

Look for significant changes from one year to the next on a comparative statement. It’s important to know why changes are taking place so you know if corrections need to be made immediately to keep the system in the black. Questions to ask include:

  1. Why did the value of fixed assets increase or decrease?
  2. Was new equipment purchased and installed?
  3. Was equipment sold or otherwise disposed of?
  4. Why did account receivables rise or drop dramatically?
  5. Was there a breakdown in bill collections, or an increase in efforts to collect outstanding bills?
  6. Were new customers added, or were large water consumers lost?

Second, Calculate Important Ratios

Calculating a few common ratios can also provide a better picture of the system’s overall financial health. The two most important are liquidity ratios and leverage ratios.

Liquidity Ratio or Current Ratio

The liquidity ratio (or current ratio) measures the system’s ability to pay off current liabilities. Systems with less than a 1.5 liquidity ratio are considered to be in financial distress. To calculate the liquidity ratio, you simply divide the balance sheet’s current assets by the current liabilities:

Current Assets ÷ Current liabilities = Liquidity Ratio

Leverage Ratio

The leverage ratio measures how much the system relies on debt. A Leverage Ratio below 0.30 indicates the system may be in financial distress. The Leverage Ratio is determined by dividing the equity by total assets:

Equity ÷ Total Assets = Leverage Ratio

These ratios are only indicators. They should be used as tools to help guide the review of financial statements. One ratio alone won’t determine the financial health of a system; these and other ratios should be considered together.

For more on balance sheets and other tools to assess your utility’s financial health check out our guide!

The Basics of Financial Management for Small Community Utilities

This how-to guide provides an overview of financial management for small-community water utilities, from developing and balancing an expense budget to estimating and collecting revenue. This primer is ideal for a board member of a drinking water or wastewater utility who needs to understand the financial aspects of a utility’s operations. The guide explains in very simple, easy-to-understand terms how to read and interpret the common financial statements so more informed decisions can be made with the information that can be gained from them.