Results of 2016–17 Audits: Local Government

Tabled: 29 November 2017

4 Financial sustainability

Rate capping introduces an annual rate cap set by the Minister for Local Government, which controls general rate increases for all councils.

In this part, we analyse the financial sustainability risks that local councils face, including the impact of emerging funding challenges due to rate capping and reduced government grants.

We discuss the trends in key balances, such as types of revenue, expenses, capital expenditure and borrowings. We also analyse the sector against seven financial sustainability risk indicators, from financial years 2012–13 to 2019–20. The information is drawn from councils' audited financial reports for the five years 2012–13 to 2016–17, and the unaudited 2017–18 budget for the three future financial years.

We include a new sustainability risk indicator this year—the adjusted underlying result. Our analysis of this indicator is based on six financial years' data from 2014–15 to 2019–20, sourced from councils' published performance statements.

Appendix F details the seven financial sustainability indicators, risk assessment criteria and benchmarks we use in this report. Appendix F also contains the results for each council against the seven sustainability risk indicators.

4.1 Conclusion

As at 30 June 2017, we assessed the local government sector as having a relatively low financial sustainability risk. The sector as a whole continues to generate positive results, display strong liquidity ratios and hold low levels of debt.

The sector's short-term financial sustainability risk indicators remain strong. However, our analysis of the data shows a declining trend in the financial sustainability risk indicators for asset renewal and maintenance. Councils are reducing their capital spending in response to rate capping and a reduction in government grants. To meet community expectations, they need to identify and respond to long-term asset replacement and renewal requirements for infrastructure in a timely manner.

We note that rural and regional councils have a higher financial sustainability risk than metropolitan councils. This is mainly due to smaller year-on-year revenue increases, steady increases in expenditure, and their relative inability to generate significant own-sourced revenue streams.

4.2 Financial sustainability risks

To be financially sustainable, councils should make enough money from their operations to meet their financial obligations and fund their asset management plans.

Figure 4A summarises the sector's financial sustainability risk indicators for 30 June 2017.

Figure 4A
Financial sustainability risk indicators, by cohort, 2016–17

Table showing sustainability risk indicators across the sector

Source: VAGO.

4.3 Overall analysis

The sector, overall, generated a surplus from operations this year.

At 30 June 2017, councils collectively held current assets valued at $4.4 billion in the form of cash and term deposits ($3.4 billion at 30 June 2016) and borrowings of $1.2 billion ($1.2 billion at 30 June 2016). Those councils with debt are able to service it.

The indebtedness indicator shows that, as a sector, councils prefer not to borrow funds. Instead, most prefer to accumulate cash to replace or expand their asset base. This raises questions of intergenerational equity, as the investment in new assets is effectively being funded by past and current ratepayers.

We note that the asset renewal and maintenance indicators are gradually declining and are forecast to decline further.

Box showing increase in the liquidity ratio and decrease in indebtedness

4.4 Analysis of council categories

Financial performance analysis

Net result indicator

The net result indicator measures the net result of the council as a percent of revenue.

In 2016–17, councils collectively recorded revenue totalling $10.5 billion ($9.3 billion in 2015–16). Rates revenue of $5.4 billion ($5.2 billion in 2015–16) makes up more than 50 per cent of total revenue. The second largest revenue stream for the sector was government grants revenue, totalling $1.9 billion is ($1.4 billion in 2015–16).

Combined, employee expenses of $3.3 billion ($3.2 billion in 2015–16) and a materials and services expense of $2.9 billion ($2.7 billion in 2015–16) make up 77 per cent of councils' total expenses.

Figure 4B shows the split of revenue and expenditure.

Figure 4B
Sector revenue and expenditure for 2016–17

Donut chart showing revenue ($10.5b) and expenditure ($8.1b)

Source: VAGO.

Figure 4C shows a summary of the net result indicator from 2011−12 to 2019−20.

Normalised result is net result adjusted for receipts of Commonwealth financial assistance grants ahead of need.

Figure 4C
Net result compared to normalised result for the local government sector, 2011–12 to 2019–20

Line chart showing net result indicator from 2011-12 to 2019-20

Source: VAGO.

Taken as a whole, the local government sector has been able to generate a surplus from operations in each of the past five years. The sector is budgeting a surplus over the next three years. However, the net result indicator is forecast to decline over this period as the impact of rate capping on revenue growth takes effect. The impact of rate capping and the sector's response is discussed in Part 5.

The net result indicator for the sector during the last five years is distorted by the timing of Commonwealth financial assistance received by the sector. In Figure 4C, the spike in the reported net result indicator during 2014–15 and 2016–17 is mainly due to the advance receipt of Commonwealth grant funds and does not reflect operational performance. Figure 4C also presents the normalised net results—that is, after adjusting for the advance receipt of Commonwealth grant funding.

Graphic showing the average forecast increase in expenses and decrease in revenue

Looking forward

Over the budget period, our analysis shows that councils are forecasting an average increase in rate revenue of 3 percent—in line with rate capping—and an average 10 per cent reduction in government grant revenue. However, over the same period, expenses are budgeted to increase at 2 per cent.

Figure 4D summarises the key changes to councils' revenue and expenditure over the next three years.

Figure 4D
Council revenue and expenditure going forward

Infographic showing rates revenue, grants, employee benefits, and materials and services for the next three years

Source: VAGO.

Councils must formulate effective strategies to manage the impact of this growing funding gap on the key services that they provide to the community. Councils need to engage and assess community expectations to critically review the services they provide.

We analysed councils' responses to a rate capping questionnaire, which show that councils are planning to reduce spending in response to the new rate capping environment. This is more pronounced within the rural and regional councils due to their limited ability to increase alternative revenue streams.

We note that the average increase in expenditure projected to occur over the next three years is less than 1 per cent for rural and regional councils, against a rate cap of 2 per cent in 2017–18.

Adjusted underlying result indicator

This indicator measures a council's ability to generate surplus from its ordinary course of business. Figure 4E shows the results of this indicator across two categories of councils.

The adjusted underlying result indicator excludes non-recurrent capital grants, non-monetary asset contributions, and other contributions to fund capital expenditure from net result.

Figure 4E
Adjusted underlying surplus analysis for the local government sector, 2014–15 to 2019–20

Line chart showing adjusted underlying surplus

Note: Councils began preparing performance statements in 2014–15.

Source: VAGO.

For metropolitan councils, the actual and forecast adjusted underlying result are consistently above 5 per cent. This highlights their ability to generate surpluses from various revenue streams and service larger populations.

Rural and regional councils are budgeting to spend more that they can raise. More than 30 per cent of councils in this category are forecasting deficits for the next three years. The majority of councils in this category are facing additional financial pressures due to smaller year-on-year revenue increases and steady increases in expenditure.

A longer-term negative trend in this indicator will have an adverse impact on the services that these councils are able to offer to their communities. It is important that councils can generate positive surpluses, and councils' ability to do so will assist them in the longer term to generate sufficient funds to keep delivering the service levels that their communities expect.

Analysis of financial position indicators

As at 30 June 2017, the sector held $4.4 billion in cash and term deposits ($3.4 billion at 30 June 2016). This compares to borrowings of $1.2 billion ($1.2 billion at 30 June 2016). Councils' ability to adequately service their borrowings varies. Figure 4F shows the split of cash and borrowings held across the two categories.

Figure 4F
Cash and borrowings held by the sector at 30 June 2017

Donut charts showing cash ($4.4b) and borrowings ($1.2b)

Note: Cash refers to both cash and term deposits.

Source: VAGO.

Short-term assets

As at 30 June 2017, the local government sector had a strong current asset position and held a high level of cash and term deposits. Figure 4G shows the cash and term deposit balances held by the two categories of councils at year end. Overall, this has been increasing at more than 25 per cent annually. This is partly due to the advance receipt of Commonwealth financial assistance grants.

Figure 4G
Cash and term deposit balance held by councils, 2012–13 to 2019–20

Column chart showing cash and term deposits

Source: VAGO.

As shown in Figure 4G, metropolitan councils holds substantially more cash than the rural and regional category. However, we note that the majority of associated liabilities for metropolitan councils are longer term, to fund the infrastructure needs of growing communities.

Rural and regional councils show a stable level of cash and term deposits in the forecast period.

Indebtedness indicator

The indebtedness indicator looks at whether entities are able to meet their longer-term liabilities from their own‑sourced revenue.

Our indebtedness indicator assesses whether councils are able to meet their debt servicing and repayment obligations from their own-sourced revenue. Figure 4H details the results of this indicator for the sector.

Of the 79 councils, 69 had some level of debt on their balance sheet at 30 June 2017. Analysis of these councils shows:

  • interest-bearing liabilities to total revenue of 12 per cent
  • net borrowing costs to total revenue of less than 1 per cent and net borrowing costs to rate revenue of less than 2 per cent.

Figure 4H
Indebtedness indicator analysis for the local government sector, 2012–13 to 2019–2020

Line chart showing debt as a percentage of revenue

Source: VAGO.

Across the sector, the average percentage of indebtedness over the five-year period to 2016–17 is around 24.5 per cent. This percentage is trending lower, underlining the sector's preference to avoid borrowing. The average debt balance of the sector over a five-year period from 2012–13 to 2016–17 was $1.1 billion, compared to the average cash and term deposit balance of $2.9 billion.

Figure 4I shows the borrowings balance from 2012–13 to 2019-20 by the two categories and across the sector.

Figure 4I
Borrowings balance for the local government sector, 2012–13 to 2019–20

Line chart showing the borrowing balance for the sector, and for the metro and interface cohort and the large, regional and small council cohort

Source: VAGO.

Figure 4I shows stable levels of long-term debt by rural and regional councils. In contrast, metropolitan councils are forecasting an increase in borrowings. We note that this increase in partly due to borrowings planned by Melbourne City Council for infrastructure redevelopment.

Internal financing indicator

This indicator examines the capacity of the sector to fund capital expenditure using cash generated from operations and government funding each year. Figure 4J shows the results of the sector for this indicator between 2012–13 and 2019–20.

Figure 4J
Internal financing indicator for the local government sector, 2012–13 to 2019–20

Line chart showing internal financing for all councils

Source: VAGO.

The internal financing indicator result is influenced by the timing of Commonwealth grant funding received by the sector. In most of the past five years, a proportion of this annual funding has been granted toward the end of the financial year. However, this is not always the case—the dip in 2013–2014 is due to the receipt of Commonwealth grant funding after 30 June for that year. In contrast, the significant increase in this indicator at 30 June 2017 is also due to the advance receipt of a Commonwealth funding for 2017–18 on 7 June 2017.

Asset renewal and maintenance indicators analysis

A key risk for councils is maintaining and renewing their extensive infrastructure networks while operating at sustainable levels. We assess councils' spending on assets through the capital replacement and renewal gap indicators.

Capital replacement indicator

The capital replacement indicator measures the level of spending on new and renewed assets compared to the depreciation expense associated with these assets.

The sector's result for this indicator is shown in Figure 4K.

Figure 4K
Capital replacement indicator analysis for the local government sector, 2012–13 to 2019–20

Line chart showing the capital replacement indicator for all councils

Source: VAGO.

Figure 4K shows that the sector is budgeting for a sharp increase in capital spending during 2017–18. This spending is then forecast to decline. Councils are reducing their capital spending mainly in response to rate capping and a reduction in government grants.

Although spending on capital replacement is budgeted to improve significantly in the near term for the sector as a whole, our analysis shows that this longer‑term asset planning measure has been declining across the majority of councils in the last three years.

As shown in Figure 4L, metropolitan councils are increasing their asset base at a higher rate than their rural and regional counterparts. The challenge for rural and regional councils is to generate enough cash through own-sourced revenue streams to invest in new and replacement assets. This will also have a direct impact on the level of service these councils can provide to their communities.

Figure 4L
Infrastructure, property, plant and equipment balance the local government sector, 2012–13 to 2019–20

Line chart showing the infrastructure, property, plan and equipment balance

Source: VAGO.

Renewal gap indicator

The renewal gap indicator provides more information on the types of assets being acquired by councils. It provides an indication of whether spending has focused on purchasing new assets or renewing and upgrading existing ones.

The renewal gap indicator compares the rate of spending through renewing, restoring and replacing existing assets to its depreciation expense.

Spending above the rate at which an asset is being used indicates that an entity is sufficiently renewing its assets and optimising their use.

Figure 4M shows the results of this indicator over eight financial years, for the two categories.

Figure 4M
Renewal gap indicator analysis for the local government sector, 2012–13 to 2019–20

Chart showing the renewal gap indicator

Source: VAGO.

The renewal gap indicator broadly mirrors the trend of the capital replacement indicator. Similar to capital replacement, 2017–18 council budgets for asset renewals do not reflect the historic declining trend.

With regard to the renewal gap indicator, rural and regional councils are trending below 1:1. This highlights the need for councils to prioritise asset maintenance as part of their planning processes. This renewal gap is forecast to trend sharply downward in response to rate capping. In order for these councils to meet community needs and expectations, they must actively monitor their rate of spending and remain focused on maintaining assets at serviceable levels as they age.

In the short to medium term, rural and regional councils may need to defer spending on new assets or consider adding debt as a funding measure, to improve their existing assets. This will ensure current ratepayers who are using these assets now—rather than future ratepayers— bear the costs associated with them.

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