Part 12: Developing our tool kit: Financial analysis framework and indicators
12.1
In this Part, we outline how we are developing our financial analysis framework, set out that framework, then present our initial findings from applying our analysis to government departments and Crown entities.
12.2
Government departments and Crown entities are grouped together simply based on legislative form, which does not necessarily render the most meaningful comparisons and aggregate view. However, our intention is to share the framework and to stimulate debate about how we can develop our framework and associated tools to enhance the value of our work.
Background
12.3
We have been working to develop and expand the tools we have available to improve our understanding and analysis of the entities we audit. The audited financial statements of the entities we audit are rich sources of information. This information is particularly useful if we can build up a picture of financial performance over time and can use this to provide independent assurance to Parliament and the public.
12.4
We have focused on developing a framework that we can apply across groups of entities or sectors, and a consistent agreed approach to collecting and analysing data. As we build the data set over time, we expect the value we can extract from our analysis to grow. We want to share our framework now so that we can test and fine-tune the framework before investing further in its development. We invite you to provide your thoughts on:53
- the hypotheses or questions we could usefully test (for example, entities are maintaining their assets, entity Y is not typical of similar entities in the sector);
- the financial ratios and indicators we should focus on in our analysis of specific groups of entities or sectors;
- the groups of entities to which we could most usefully apply this analysis; and
- where, and in what contexts, you would expect us to apply this analysis.
12.5
The judgements we make may differ from other monitoring approaches and perspectives. As we develop our financial analysis framework and tools, we intend to engage closely with the Treasury, COMU, and monitoring departments to test our approach.
12.6
In this Part, we provide a brief overview of the analysis we can provide. Over time, as the data set grows and we integrate our financial analysis with our analysis of service performance and assessment of entities' environment systems and controls, we expect to be able to provide a more comprehensive perspective on entity and sector performance.
Our framework for analysing financial performance
12.7
In general, performance is about achieving objectives in an uncertain environment. Measuring and analysing performance in a comprehensive way requires a good understanding of an organisation's objectives, the risks to achieving those objectives, and the relationship between the two.
12.8
Audited financial statements play an important role in informing readers about the performance of public sector entities. Although objectives in the public sector are not always measurable in monetary terms, over a period of time, the financial statements can provide information on the risks of achieving public sector objectives.
12.9
Risks for central government entities arise from many different sources, including commercial, economic, political, and structural changes, both within and outside of an organisation. Our framework does not attempt to identify and understand the root causes of risk. Instead, it uses financial statements to assess how some of these risks are reflected through the financial activities of the entities. For example, we consider how well entities:
- apply their financial resources in the short term – we call this stability;
- respond to medium-term unanticipated events – we call this resilience; and
- deal with longer-term uncertainties – we call this sustainability.
12.10
To gauge the potential risk for a group of entities delivering on public sector objectives, we looked at, over a six-year period, various indicators (or ratios) relating to each of these three areas.
12.11
Figure 18 summarises the indicators we used to analyse government departments and Crown entities, as set out in paragraphs 12.20 to 12.39.
Figure 18
Our indicators of financial performance for government departments and Crown entities
Stability | Resilience | Sustainability |
---|---|---|
Budget to actual cash flows applied to operations | Fixed costs to operating and investing cash outflows | Capital expenditure* to depreciation and amortisation |
Budget to actual cash flows applied to asset-related activities | Current assets to current liabilities | Equity to assets |
* Capital expenditure also includes expenditure on intangible assets.
12.12
Other indicators can be used for particular sectors. For example, total liabilities to total assets, and current assets to operating expenditure.
12.13
In terms of aggregating the analysis (for a group of entities), we look at each indicator and determine:
- whether the average values each year are within or outside what we consider to be a reasonable range;
- how these average values are trending over time (that is, direction); and
- the number of entities that lie outside the "typical" range. To understand what is typical for a sector, we use a standardised measure of variation on either side of the average (plus and minus one standard deviation). The number and distribution of these entities determines our assessment of low to high variability. If the number of entities outside a typical range is high, this suggests greater uncertainty or variability in the group's or sector's financial stability, resilience, and sustainability.
12.14
Because a degree of judgement is involved in the assessment of these areas, we use a traffic-light system to present the results of our analysis of each of the indicators (see Figure 19).
Figure 19
Traffic-light system to summarise the results of our assessments
Average value | Direction | Variability |
---|---|---|
Within a reasonable range |
Positive |
Low to moderate |
Moderate to high |
||
Outside a reasonable range |
Negative |
High |
12.15
By considering the three areas of stability, resilience, and sustainability, we get some insight into the financial risk involved in delivering on the Government's objectives for a group of entities. In our model, the sustainability of a group, sector, or entity builds and depends on the stability and resilience of the entity or entities within the group or sector.
12.16
As with all financial analysis, there are limitations to what can be inferred from our analysis. Our approach does not provide a comprehensive assessment of a sector or indeed a group of entities' performance. Importantly, any entities that fall outside what is considered typical for the sector may simply warrant further investigation and analysis. The value of the framework and application to our work will come not only from what we may be able to glean from the data but also from the follow-up questions and the broader discussion about the range of factors that may affect and drive sectors and other groups of entities.
Underlying data used in our analysis
12.17
We are drawing on data contained in the audited financial statements of public entities. The data used represents the financial activities of the parent organisations, and does not include any subsidiaries.
12.18
To build our data set for the past six years, we have had to capture the relevant data manually. Over time, we expect to build and develop the data set and will explore options to move to electronic data capture.
Applying the framework – government departments and Crown entities
12.19
We have applied our framework and reported the resulting analysis for local authorities, TEIs, CRIs, and DHBs.54 We will continue to develop our framework by further analysing all these sectors. For central government entities, we can apply the analysis to entity type – government departments and Crown entities. However, we realise that, although entities might have a similar organisational form in common, they might have little else in common. Therefore, some caution is needed when drawing inferences from our analysis. Our objective in this report is to demonstrate our framework and approach, and the potential inferences that can be drawn.
Our overall analysis of government departments
12.20
Overall, our findings suggest that the potential financial risk to delivering on the various central government objectives is moderate. Government departments' relatively high fixed-cost structures suggest that, without external intervention (such as additional government funding, changes in appropriations, or legislative change), they will require more time to adjust or respond to unforeseen or unplanned events.55
12.21
Our analysis indicates that, across government departments, there is consistent and sizeable over-budgeting and/or under-spending on assets. This, coupled with a declining trend in capital expenditure compared with depreciation and amortisation,56 suggests (among other things) that government departments may not be investing enough in major assets. As already noted (see paragraph 12.16), we intend to use the indicators as a means of identifying areas for further investigation. Alone, they are not enough to draw definitive conclusions.
12.22
Asset management and investment in capability in the public sector are areas we will continue to keep on our radar. In particular, we will continue to look at the:
- consistent and sizeable over-budgeting of capital expenditure; and
- declining trend in capital expenditure compared with depreciation and amortisation.
12.23
A summary of our underlying analysis about government departments' stability, resilience, and sustainability follows.
Stability
12.24
The two indicators used show that, as a group, government departments over-budget for, and/or underspend on, both their operational and asset expenditure needs. Although over-budgeting is small for operations, it is sizeable for capital expenditure. The number and variability of those falling outside what is considered typical for the group suggests that the approaches to, or issues around, the application of financial resources across government departments are similar. Given a common funding model and governance and accountability frameworks, this is to be expected. However, it may be worth investigating this further to better understand what government departments can do to improve the application of financial resources.
12.25
Figure 20 sets out a traffic-light summary of the two indicators used to analyse government departments' financial stability.
Figure 20
Traffic-light summary of stability indicators for government departments
Government departments: Budget to actual operating expenditure | ||
From 2006/07 to 2011/12, there is a small but consistent trend of underspending. The average over the six-year period is 1.06. | Average value | |
From 2006/07 to 2011/12, the average has remained reasonably consistent. | Direction | |
Over the six-year period, there is low to moderate variability within the sector. | Variability |
Government departments: Budget to actual capital expenditure | ||
From 2006/07 to 2011/12, there is a consistent and sizeable over-budget trend of 1.41 on average. | Average value | |
From 2006/07 to 2011/12, the direction is irregular and increasing. | Direction | |
Over the six-year period, there is moderate to high variability within the sector. | Variability |
Resilience
12.26
The two indicators used suggest that government departments' ability to respond to medium-term unanticipated events is supported by high current assets relative to current liabilities. However, government departments' fixed-cost structure is also moderately high,57 indicating less operational flexibility in times of change. The number and variability of those falling outside what is considered typical for the group suggests that the ability to manage unanticipated events is similar across government departments.
12.27
Figure 21 sets out a traffic-light summary of the two indicators used to analyse government departments' financial resilience.
Figure 21
Traffic-light summary of resilience indicators for government departments
Government departments: Fixed costs to operating and investing cash outflows | ||
From 2006/07 to 2011/12, the annual average of fixed costs to operating and investing cash flows ranges from 0.55 to 0.58. | Average value | |
From 2006/07 to 2011/12, the average has remained reasonably consistent. | Direction | |
Over the six-year period, there is low variability within the sector. | Variability |
Government departments: Current assets to current liabilities | ||
From 2006/07 to 2011/12, the annual average of current assets to current liabilities ranges from 1.43 to 1.70. | Average value | |
From 2006/07 to 2011/12, there is a consistent upward trend. | Direction | |
From 2006/07 to 2011/12, there is low variability within the sector. | Variability |
Sustainability
12.28
Government departments' ability to deal with longer-term uncertainty is mixed. Although there is a strong and consistent level of equity to assets, the average spending on assets for the last three years (2009/10, 2010/11, and 2011/12) is below the level that depreciation and amortisation would suggest is reasonable. The number and variability of those falling outside what is considered typical suggests that the ability to manage longer-term uncertainties is mixed across government departments.
12.29
Figure 22 sets out a traffic-light summary of the two indicators used to analyse government departments' financial sustainability.
Figure 22
Traffic-light summary of sustainability indicators for government departments
Government departments: Capital expenditure to depreciation and amortisation | ||
From 2006/07 to 2011/12, the annual average of capital expenditure to depreciation and amortisation ranges between 0.92 and 1.46. | Average value | |
From 2006/07 to 2011/12, on average there is an irregular pattern with an overall small downward trend. | Direction | |
From 2006/07 to 2011/12, there is low variability within the sector. | Variability |
Government departments: Equity to assets | ||
From 2006/07 to 2011/12, the annual average of equity to assets is consistently around 0.57. | Average value | |
From 2006/07 to 2011/12, the average has remained consistent. | Direction | |
Over the six-year period, there is moderate to high variability within the sector. | Variability |
Crown entities
12.30
Overall, we found that the potential financial risk is generally low to moderate for the group of Crown entities to which we applied the framework. As might be expected, because Crown entities are so diverse, there is greater variability across the group than for government departments. Therefore, it would be necessary to look at the underlying analysis for specific entities or apply the framework to "like" groups of Crown entities.58
12.31
Most of the indicators analysed show that Crown entities have a good ability to plan for their operations and are reasonably well placed for responding to uncertainties in the medium and longer term.
12.32
As for government departments, we noted consistent and sizeable over-budgeting of, and/or underspending on, assets, which may (among other things) indicate that Crown entities are not investing enough in major assets.
12.33
A summary of our underlying analysis about Crown entities' stability, resilience, and sustainability follows.
Stability
12.34
The ability of Crown entities to plan, budget, and deliver their financial resources is mixed, with good accuracy for operating expenses but consistent (and sizeable) over-budgeting for capital expenditure. The number and variability of entities falling outside what is considered typical suggests that the group's ability to deal with uncertainties in the planning and budgeting of financial resources is mixed also.
12.35
Figure 23 sets out a traffic-light summary of the two indicators used to analyse Crown entities' financial stability.
Figure 23
Traffic-light summary of stability indicators for Crown entities
Crown entities: Budget to actual operating expenditure | ||
From 2006/07 to 2011/12, the average for the sector is consistently around 1.00, indicating that Crown entities consistently spend what they budgeted for on operations. | Average value | |
From 2006/07 to 2011/12, the average has remained relatively consistent. | Direction | |
Over the six-year period, there is low variability for Crown entities. | Variability |
Crown entities: Budget to actual capital expenditure | ||
From 2006/07 to 2011/12, there is underspending on assets compared with budget within the sector, with an average ranging from 1.10 to 1.33. | Average value | |
From 2007/08 to 2011/12, there is a steady increase in over-budgeting. | Direction | |
Over the six-year period, there is moderate to high variability among Crown entities. | Variability |
Resilience
12.36
The capability of Crown entities to respond to uncertain events without major structural or organisational change is supported by a reasonably flexible cost structure59 and high current assets compared with current liabilities. The number and variability of entities falling outside what is considered typical suggests that the ability to plan for and manage unexpected events varies across the group.
12.37
Figure 24 sets out a traffic light summary of the two indicators used to analyse Crown entities' financial resilience.
Figure 24
Traffic-light summary of resilience indicators for Crown entities
Crown entities: Fixed costs to operating and investing cash outflows | ||
From 2006/07 to 2011/12, the annual average of fixed costs to operating and investing cash flows ranges between 0.34 and 0.36. | Average value | |
From 2006/07 to 2011/12, the average has remained relatively consistent. | Direction | |
Over the six-year period, there is moderate to high variability among Crown entities. | Variability |
Crown entities: Current assets to current liabilities | ||
From 2006/07 to 2011/12, the annual average of current assets to current liabilities ranges between 1.94 and 2.10. | Average value | |
From 2006/07 to 2011/12, the average has remained relatively consistent. | Direction | |
Over the six-year period, there is moderate to high variability among Crown entities analysed. | Variability |
Sustainability
12.38
Our findings suggest that the ability of Crown entities to deal with longer-term uncertainty is sound, but with some variability across the group. The amount of equity as a percentage of total assets is consistent and reasonable, and the level of capital expenditure is above what depreciation and amortisation assumptions suggest is sensible.60 The number and variability of entities falling outside what is considered typical suggests that the group's ability to approach and manage sustainability is mixed.
12.39
Figure 25 sets out a traffic light summary of the two indicators used to analyse Crown entities' financial sustainability.
Figure 25
Traffic-light summary of sustainability indicators for Crown entities
Crown entities: Capital expenditure to depreciation and amortisation | ||
From 2006/07 to 2011/12, the annual average of capital expenditure to depreciation and amortisation ranges between 1.04 and 1.40. | Average value | |
From 2006/07 to 2011/12, the average is variable and the direction is also variable. | Direction | |
Over the six years, there is low to moderate variability among Crown entities. | Variability |
Crown entities: Equity to assets | ||
From 2006/07 to 2011/12, the annual average of equity to assets ranges between 0.50 and 0.54. | Average value | |
From 2006/07 to 2011/12, the average is reasonably consistent. | Direction | |
Over the six years, there is moderate to high variability among Crown entities. | Variability |
Conclusions and next steps
12.40
Audited financial statements are a rich source of information. When we can look at trends over time, the value of that information is greater. The framework presented in this Part and the underlying data will be developed based on the feedback from entities and interested monitoring agencies. Ultimately, we want to integrate the results of our financial analysis with the information and analysis generated from our audits and analysis of environment, systems, and controls across the public sector.
12.41
We plan to follow up with the central agencies and the main monitoring agencies for Crown entities to review the results of our analysis, then further refine and develop our approach.
53: Entities and monitoring agencies can provide this feedback to our sector managers. We can also be contacted by emailing [email protected].
54: See: Matters arising from the 2012-22 local authority long-term plans (2012) and Local government: Results of the 2011/12 audits(2013); Education sector: Results of the 2011 audits (2012); Crown research institutes: Results of the 2011/12 audits; and Health sector: Results of the 2011/12 audits.
55: See Appendix 2 for a list of the entities we analysed.
56: Depreciation and amortisation are accounting estimates that can be used to indicate the amount of capital expenditure required to maintain the existing asset base.
57: Fixed costs are assumed to be any interest payable, personnel costs, and depreciation (as a proxy for renewal spending on assets).
58: See Appendix 2 for a list of the entities we analysed.
59: Fixed costs are assumed to be any interest payable, personnel costs, and depreciation (as a proxy for renewal spending on assets).
60: Depreciation and amortisation are accounting estimates that can be used to indicate the amount of capital expenditure required to maintain the existing asset base.
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