Understanding Financial

Statements of Water Utilities

Session 3

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 Contents

• Learning Objectives
• How are Financial Statements Useful?
• Financial Statements and their Components
• Extracting Information Needed for Financial Analysis
• Exercise

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Learning Objectives
 Learning Objectives

• Understand how to read and interpret utility financial

statements
• Understand how to extract information needed to
analyze the financial performance of a water and
sanitation utility
• Understand how to project cash flows and
• Understand how to identify risks

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How are Financial Statements
Useful?
 How are Financial Statements Useful?

• They are the only independently audited financial

information available for a utility
• They are prepared in accordance with national or
international financial reporting standards
– Making them comparable - generally - with other utilities, and
between periods
• The financial amounts in the statements reflect real-
world events
– They reflect what happened to the utility during the period,
stated in financial terms

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 Financial Statements Help Users to ...

• Understand the utility’s financial condition/position

• Understand how the utility has performed financially in
the past, including how much cash flow it generated
• Predict how the utility will perform financially in the
future, including future cash flows
• Identify existing obligations and commitments that must
be covered by utility’s future cash flows
• Identify existing risks that will impact the utility’s future
financial performance, including its cash flows

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Financial Statements and Their
Main Components
 Basic Components of a Financial Report

Management’s Management’s representation expresses its responsibilities regarding for the accounting system
Commentary/ and controls and accounting estimates and judgements used. Management discusses past
performance and future outlook. Management may also discuss significant events, effects of
Representation inflation, off-balance sheet financing, and changes in accounting policies

Independent review of an utility’s financial statements.

• Unqualified opinion: that financial statements present a fair and accurate picture of the company
and its compliance with accounting/ financial reporting standards
Auditor’s Opinion • Qualified opinion: financial statements make exemptions to accounting principles
• Adverse opinion: financial statements are not presented fairly
• Disclaimer of opinion: there are not enough information to provide an opinion
The auditor’s opinion could draw reader’s attention to some financial situation that may endanger the
continuity of the business, or makes some numbers unreliable

Provides financial information on the utility. Financial statements presented in an audited report
Financial Statements include: balance sheet, income statement, cash flow statement, statement of comprehensive
income, and statement of changes in equity

Provides a background on the utility. Provides information about accounting policies, relevant
Notes to Financial assumptions and estimates used to prepare financial statements. Provides additional information
Statements about the financial statements and the main accounts

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 Accrual-basis vs. Cash-basis Accounting

• Accrual-basis accounting
– Financial statements should reflect transactions at the time
they actually occur, not when cash is received or paid
– Matching principle: Expenses and revenues should be
recognized in the same period
– International Financial Reporting Standards require companies
to use accrual-basis accounting
• Cash-basis accounting
– Financial statements should reflect transactions at the time
cash is received or paid, not when they occurred

A company bills for the services in December 20X8

The client pays the bill in January 20X9
– Accrual-basis: Revenue is recognized in December 20X8
– Cash-basis: Revenue is recognized in January 20X9
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 Financial Statements Overview

• Balance sheet
– Financial position at the end of the reporting period
• Income statement
– Financial performance during the reporting period
• Cash flow statement
– Cash receipts and payments during the reporting period
• Statement of Changes in Equity
– Changes in equity (Government’s contributions) and retained
earnings during the reporting period
• Notes to the Financial Statements
– Are an integral, and important, part of the financial statements

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 Financial Statement Relationships

Beginning of the Period During the Period End of the Period

Income
statement

Beginning Statement Ending

balance of Changes balance
sheet in Equity sheet

Statement
of cash
flows

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 Balance Sheet

Assets = Liabilities + Equity

Assets: resources controlled by the

firm. Expected to provide economic
benefits in the future

Liabilities: amounts owed to lenders

and other creditors. Expected to require
outflows of economic resources in the
future

Net Assets/equity: residual interest in

the assets after deducting the liabilities

12 Balance Sheet usually shows two years, sometimes three

 Balance Sheet Basics

• Current Assets
– Generally, resources available to pay obligations coming due in
the next year
• Current Liabilities
– Generally, obligations due within the next year
• Long-term Assets and Liabilities
– Resources available to be utilized or obligations due, beyond
one year
• Net Assets/ Equity
– Owner contributions, retained earnings/(losses), valuation
adjustments

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 Income Statement

Revenue - Resources earned from the provision of

utility services
O&M Expenses - Resources used to provide
services, General and Admin functions (OPEX)
EBITDA - Earnings before, interest,taxes,
depreciation, amortization
Depreciation - allocation of fixed assets

Other Income and Expenses - interest on debt,

foreign exchange loss, other income

Operating Subsidy - resources received from the

Government to pay for operating costs

Net Income

14 Income Statement shows two years

 Income Statement Basics

• Should separate operating activities from others

– Matching operating revenues with operating expenses
• Key operating expenses usually include:
– Costs of water supplied to the system (e.g. purchased water,
energy, chemicals)
– Labor
– Depreciation
– Repairs and maintenance
• Depreciation is an allocation of Property, Plant &
Equipment cost
– Usually using a straight line method over the asset’s useful life

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 Depreciation: Allocating Costs over an Asset’s Life

Depreciation: the measure of the cost of the tangible fixed

asset that has been consumed during the reporting period
• To calculate depreciation we need:
– Cost of the fixed asset
– Estimated useful life
– Estimated residual value (value at end of useful life)
• Depreciable amount
– Straight line method: annual depreciation =
(depreciable amount / estimated useful life)

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 Construction Work in Progress Issues

• Interest may be capitalized

– Depending on accounting standards followed, and
– Accounting policies of the utility
– Meaning that interest amounts may be record in more than one
place in the financial statements
• Utility labor costs and other overhead costs may also be
capitalized
– Meaning that operating costs can fluctuate from year to year
due to capitalization of costs that would otherwise be recorded
as operating expenses

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 Cash Flow Statement

Operating cash flows: cash generated or

used by operating activities

Financing cash flows: cash inflow or

outflows from the issuance or repayment
of debt, or from utility’s owner

Investing cash flows: cash outflows or

inflows for the construction, purchase or
sale of property, plant, and equipment; or
of a subsidiary or other long-term
investment

Net change in cash and net cash balances:

at the beginning and end of the year

18 Cash Flow Statement shows two years

 Cash Flows Statement Basics

• Two Cash Flow Statement methods used

– Indirect method: cash flow is determine partly by the change
in current non-cash assets and liabilities - used because it is
easier to prepare
– Direct method: cash flow is shown for specific activities
generating or using cash (e.g. cash received customers, cash
paid to suppliers - much more useful
• Indirect method operating cash flow starts from net
income
– Which lumps everything on the income statement together
– Including government subsidies and grant revenues

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 Statement of Changes in Equity

Statement of Changes in Equity shows two years

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 Statement of Changes in Equity Basics

• Give users running totals of the utility’s equity

– Since the beginning of the entity
• Classified by major component
– Government’s contributions
– Accumulated income (surplus) or deficit
– Other items (e.g. valuation adjustments)
• Equity = Net Assets
– Assets minus liabilities equals net assets, equals equity

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 Notes to the Financial Statements (1/3)

• Can’t understand financial statements without reading

the notes
– Don’t assume that you can understand a financial statement
line items from its label
– Be concerned when major line items don’t have an note
• Notes to read before studying the actual financial
statements
– Organization (describes the entity and usually its enabling law)
– Basis of preparation (i.e. the accounting standards used)
– Summary of significant accounting policies (which helps to
interpret the numbers and to identify adjust needed to make
comparable with other utilities)

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 Notes in Utility Financial Statements (2/3)

• Operating Revenue
– Tariffs, how water usage or sewerage flows are determined
(e.g. whether metered), and how meters are read
• Property Plant and Equipment
– Detailed asset type helps to separate water and sewerage
assets for analysis
– Depreciation by detail asset type
– Construction Work in Progress (assets not yet in service)
• Operating Expenses
– Details by type of expense and whether water, sewerage or
general and administration related

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 Notes in Utility Financial Statements (3/3)

• Accounts Receivable
– Customer bills not recovered, but potentially recoverable
– Estimated value of those bills that probably will not be
recovered
– Customer bills written off as unrecoverable during the year
• Long-term Debt
– Amount borrowed, currency
– Terms and major conditions
– Purpose of loans
• Financial Risks
– Liquidity
– Credit
– Market
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 Other Notes in Utility Financial Statements

• Financial statement users should read all notes to fully

understand the financial statements
• Since they help us to understand risks not obvious in
the financial statements themselves, or adjustments we
need to make to analyze financial performance
– Accounting estimates and judgements
– Finance charges
– Pension Plan
– Commitments
– Related Party transactions
– Valuation adjustments

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 Questions Not Answered by the Financial Statements

• Are assets performing to their design capacity?

• Are maintenance expenses and capital expenditures
sufficient to sustain service levels, revenues, cash flow?
• Is the utility being operating efficiently?
– Is most of the water produced being sold and billed for?
– Are the staffing levels appropriate? For water service, for
sewerage service, for administration?
• Why is the utility being subsidized? (If it is.)
• Why are customers not paying? (If they aren’t.)

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Extracting Information Needed
for Financial Analysis
 Liquidity Ratios

Quick Ratio Working Capital Ratio

= (current assets - inventory) = current assets
/ current liabilities
– Indicates utility’s ability to pay
/ current liabilities
current obligation from its – Indicates utility’s ability to pay
most liquid assets current obligation from its current
assets
– Current assets could be
affected by accounts – Could be affected by accounts
receivable valuation, receivable and inventory
refundable customer valuation, refundable, customer
deposits, etc. deposits, etc.
– Current liabilities could be – Current liabilities could be
affected by classification affected by classification issues
issues (e.g. underfunded (e.g. underfunded pension
pension classification) classification)
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 Operating Cost Ratios

Electricity as % of OPEX Operating cost ratios

indicate the importance of
specific operating costs in
Purchased water as % of
OPEX the utility’s operating cost
structure

Staff costs as a % of OPEX

Maintenance as a % of OPEX

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 Operating Cost Recovery Ratios

Operating Cost Working Ratio

Recovery = ratio of operating
= operating revenues as expenses (excluding
a percent of operating depreciation and interest
expenses (excluding charges) to operating
depreciation and interest revenues
charges) – Should be below 1 (one)
– Demonstrates capacity of – Inverse of operating cost
utility to recover operating recovery
costs
– Used as a measure of Grant/ Subsidy Ratio
adequacy of tariffs
= ratio of grant revenue to
– Can be impacted by low
operating expenses
efficiency and/or low
tariffs
(excluding depreciation
30 and interest)
 Revenue Collection Efficiency Ratios

Accounts Receivable Days Collection Rate

= trade receivable/revenues = annual collections / tariff
(usually in days or months) revenue (billings)
– Shows the efficiency of revenue – Shows the efficiency of
collection revenue collection
– Must ensure use of only those – Collections (or receipts)
revenues that are subject to are not always
collection (e.g., exclude grants presented in audited
from government) financial statements
– Exclude other trade receivables – Low collection rate will
from calculation (e.g., have a direct and
receivables from employees significant impact on
– Use net trade receivables utility’s cash flow
(exclude provisions for bad
debts)
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 Debt Coverage Ratios

Debt Service Coverage Ratio Cash Flow Coverage

= EBITDA/ Total debt service = Cash flow from Operations/
(interest and principal) Total debt service (interest
– Includes capitalized interest and principal)
– Indicates the ability of the – Includes capitalized
utility to pay debt service interest
from operations – Indicates the ability to pay
– Ratio of 1(one) means that debt service from cash
utility can just meet debt flow from operations
service requirements
– Acceptable range varies with
perceived risk, in US lowest
acceptable generally 1.20 -
1.50
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 Self-financing Ratio

Self-financing ratio
= Cash flow from operations/ additions to PP&E (including CWIP)
– Indicates the utility’s ability to contribute to financing of PP&E additions
during the year
– Grants and subsidies included in cash from operations should be
removed

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 Leverage Ratio

Debt to Equity
= Book value of debt/Book value of equity
– Indicates how much debt and equity was used to finance the
utility’s assets
– It is a measure of risk as debt is a fixed obligation with fixed cash
requirements

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 Rate of Return (ROE)

= Net Income (loss)/total equity

– Indicates the return generated by the utility with the money the
owners invested

Considerations:
– Not suitable for comparing utilities in different countries. Tax and
accounting standards can affect importantly the net income
– Net income should exclude owner-provided operating subsidies

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 Adjusting Financial Statements Information

• Financial ratios used for measuring performance should

be standard across companies
– But, presentation of accounts and statements may differ widely
across companies
– Reclassification of some accounts and or greater detail than
presented may be necessary to produce useful and customized
ratios
• Information for making these adjustments may come
from:
– Notes to the financial statements
– Other reports (e.g., debt schedules, accounts receivable aging)
– Important to reconcile to financial statements

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 Questions?

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 Exercise

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 Exercise

• Participants will form small teams and answer

questions.
• Participants will extract values and calculate ratios
using the WSC Bahamas financial statements.

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 Exercise - Part 1

• What would cash flow from operations be without the

Government subsidy?
• How much of WSC’s investment in Property, Plant and
Equipment in 2011 was funded by the Government?
• WSC’s cash flow from operations was positive in 2010.
Why, when there was an operating loss?
• Since WSC’s cash flow from operations was positive,
why didn’t its net cash and bank balances increase in
2010?

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 Exercise - Part 2

• What is WSC’s Quick Ratio for 2011? Review the

components of accounts payable. Should any
adjustments be made to the ratio?
• How many days of operating revenue is in accounts
receivable - awaiting conversion into cash?
• What is the average remaining life of WSC’s fixed
assets?
• What is WSC’s Return on Equity (ROE) for 2011?

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 Thank you

www.wsp.org | www.worldbank.org/water | www.blogs.worldbank.org/water | @WorldBankWater