Resource Management: 7 – Managing the Finances 2

Managing the Finances 2

The Features of Sound Financial Management

 

Having outlined the nature and scope of the integrated planning and control cycle, we will now turn to the key issues that modern businesses have to consider when planning and managing their finances. These issues straddle the different planning time profiles that we have been discussing.

Fig.7

The key elements of financial planning and control

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1. Cash management

Cash management is about balancing the desire to earn interest (or avoid paying interest) with the need to ensure that monies are available to meet the known and reasonable requirements for liquidity. All businesses have to manage the month-by-month flow of cash in and out of the transaction accounts. This means that once set, internal budgets have to be monitored and managed. For each cost centre, adjustments may have to be made during the budgetary period to ensure that receipts can cover payments. At certain times, it may be necessary to delay certain payments until the cash-flow situation improves, or reschedule spending programmes, or abandon or increase planned spending, or acquire short-term finance to cover impending costs. The analysis and monitoring of cash-flow is particularly important with respect to capital budgets where the sums of money are likely to be relatively large.

When an organisation borrows it does so at a margin over a reference rate (e.g. London Inter-Bank Offer Rate, Bank Base Rate, mortgage rate, or a gilt yield). This margin between the reference rate and the rate charged to the borrower represents the lender’s return on the loan. From the borrower’s point of view, it represents a revenue charge. This charge is likely to be higher than any interest that could be earned from holding cash in a deposit account. This means that organizations with debts will generally want to pay them off rather than hold large cash reserves. Having said this there are two motives for holding some cash in a savings reserve.

  1. The transactions motive: to maintain a degree of liquidity in order to transact its business and meet its regular financial obligations.
  2. The precautionary motive: to maintain a degree of comfort over and above the transaction needs (a) in case of an unforeseen call for cash, or (b) an unanticipated opportunity arises that needs immediate access to cash.

Because some organisations are fairly ‘risk averse’ (see below), they will tend to hold any cash reserves in UK- or EU-based institutions that have been given a high security rating. Such ratings are provided by a specialist bank or ratings agency. For example, Fitch IBCA Ratings, Standard and Poor’s, and Moody’s Investor Services all provide such assessments of credit worthiness. Unfortunately, each agency has its own way of describing its ratings – though most use a letter system.
Some examples of letter ratings include:
AAA – reliable and stable
AA – quality with a bit higher risk
A – economic situation could affect finance
BBB – middle class-an acceptable risk
BB – more prone to economic changes
CCC – vulnerable, dependent on current economic situation
D – has defaulted before, high risk to again
All the agencies classify short and long-term viabilities differently.

Moddy’s add a numerical modifier to their ratings – e.g. Aaa; Aa1; Aa2; Aa3 A1; A2; A3; etc.

Risk averse organizations will tend to deposit surplus cash reserves in banks with a rating of A2 or above. A support rating of A2 means a bank for which (in the opinion of the ratings agency) state support would be forthcoming even in the absence of a legal guarantee. This could be, for example, because of the bank’s importance to the economy or its historical relationship with the borrower.

It is possible for property businesses themselves to become credit rated. This would enhance their financial reputations and could become part of their borrowing strategies (see below). This would be particularly helpful if and when they seek overseas funding or become involved in large-scale, complex development or take-over activities that require sophisticated funding arrangements.

In ending our short discussion on cash management, we need to stress the following point:

because it determines short-run business viability, the constant monitoring of cash flows constitutes an essential element in both performance review and risk management.

 

  1. Borrowing strategies

The CIPFA[1] Code of Practice suggests that public sector borrowing organizations (and social businesses) define the loan instruments they intend to use clearly in their business plans.

For large, long-term loans, borrowing often takes the form of loan facilities and overdrafts. Other instruments could include bond issues, leases, hire purchase, and credit agreements with suppliers.[2]

 

Loan facilities

In devising a longer term effective borrowing strategy, a clear distinction has to be made between two discretely different borrowing decisions:

  • the decision to arrange a loan facility, and
  • the decision to draw on that facility and actually borrow funds.

The arranged facility is an agreement that sets in place an entitlement to borrow up to a maximum and subject to any preconditions that were established prior to the agreement (‘conditions precedent’). In many cases the landlord will only draw down part of this potential loan, keeping the rest as an ‘insurance’ against future needs. This approach adds stability to the organisation’s long-term finances. However, such a policy may incur a ‘non-utilisation’ fee on the undrawn part of the facility.[3]

A loan facility can be arranged with any lending institution (bank, building society, etc.). Once established, money can be drawn down, so long as the period of availability has not expired and the ‘conditions precedent’ can be met. Drawings would normally be made in tranches of a minimum amount.

Although repayment would normally cancel that part of the facility, it is possible to negotiate what is called a ‘revolving credit facility’ that allows repaid amounts to be redrawn. This type of ‘revolving’ arrangement will normally be available only for a limited term (e.g. five years) and only for a fixed amount.

Some firms use the services of specialist investment banks to arrange highly flexible loan packages that cannot be provided directly by the more traditional clearing banks and building societies. These specialist institutions may be able to arrange ‘designer loans’ that include special features that allow the business to operate more finely-tuned debt management. These specialist loans can include facilities such as a ‘reduction arrangement’, whereby the business borrows an agreed sum for an agreed period but is given the facility to reduce the debt (and thereby lower the interest charges) for set periods within the term. This can prove useful if sometime in the future, unexpected cash flows emerge or cheaper sources of finance become available. In such circumstances, part of the loan can be redeemed and then taken out again at some later date if the need arises. These specialist arrangements tend only to be available for longer-term loans (in excess of ten years) and will require more ‘up front’ time and money to arrange. However, they can prove to be cheaper in the long-run.

 

Overdrafts

Borrowing can operate in a more flexible fashion through the use of an overdraft facility. This will allow the organisation to borrower up to an agreed amount at short notice by creating a ‘negative extension’ on its current account. In this case, interest payable is calculated on a daily basis. Unlike a credit facility, an overdraft facility can be cancelled by the bank at any time and without giving a reason.

 

Other forms of borrowing

Over the years the financial mechanisms for borrowing funds have expanded. Most private borrowing is still in the form of traditional mortgages from banks and building societies, but over time some businesses have sought new ways of borrowing. Bonds are well-established. A bond is simply an IOU agreement under which a sum is repaid to an investor after a fixed period. Bonds can be issued by anyone but their issuing costs are relatively high for small amounts of money borrowed for short periods.[4] For this reason bonds are normally issued by public bodies or companies wishing to borrow relatively large sums for relatively long periods. They can be thought of as loans that repay a fixed rate of interest over a specified time and then also repay the original sum at par in full after an agreed period – i.e. when the bond ‘matures’. Bond debt appears in the balance sheet as a liability. The debt should be stated at its current value (net amount) in ‘long term creditors’.[5]

Bonds can be traded (i.e. they are transferable instruments) so that the original investor can pass them on at a discount before the maturity date. The trading market for bonds is sometimes referred to as ‘the debt capital market’. Bonds provide an appropriate form of finance for larger, more active companies in that they produce long-term (i.e. 20-40 years) fixed rate funding that matches the economic life of the assets they help to fund. Where large sums are involved they can prove to be (incrementally) the cheapest form of secure funding. Local authorities have always sought to achieve financial economies of scale by financing major assets over a 60-year period. By accessing the large pool of institutional monies available from pension funds and life companies, businesses and local authorities may be able to acquire longer-term financing than is available in the bank market. It should be understood than bonds constitute an inflexible mechanism for borrowing funds in that their terms cannot be renegotiated and it is difficult, though not impossible, to close out early (i.e. prior to the maturity date). For this reason bond funding should only be considered for secure and sustainable projects that have a known and stable cost profile.

If it is big enough, an organisation can issue a bond in its own name. Another approach is to be associated with a ‘haven’ type bond that is issued by a specialist agency on behalf of a number of clients, none of whom would be big enough to issue a bond in their own name.

Increasingly, specialist bankers are arranging sophisticated packages for clients that can include a core funding element in the form of a bond issue with complementary funding in the form of a long-term (e.g. 25 year) banking facility. This sort of arrangement establishes opportunities for renewing and extending loan facilities into the future, thereby achieving one of the key borrowing objectives (see below).

 

The key borrowing objectives

Experience shows that success in raising private finance can often be traced back to sound planning long before approaches are made to lenders. The objective of loan planning and management is to secure loan finance that balances in an appropriate way the following factors.

  • Cheapness – low interest charges.
  • Certainty – a degree of fixedness of interest rates.
  • Coherence – matching cash-flow and debt service obligations.
  • Renewability – an opportunity to extend the loan if this becomes necessary.
  • Redeemability – an opportunity to cancel the loan if the needs arise.
  • Security – a balanced loan portfolio in terms of loan type and term.

These features have to be negotiated with lenders whose priorities are somewhat different from those of borrowers. Lenders are primarily concerned with balancing the return on their investment with the risk of default. As a general rule, lenders tend to charge higher rates of interest for higher risk projects. This means that in negotiating a loan with manageable interest charges, the borrower has to underwrite the debt in some way that satisfies the lender’s desire for an appropriate ‘risk-reward’ relationship.

 

Negotiating loans

Loan negotiations involve making a contract that strikes an equilibrium between the borrower’s and the lender’s objectives. A key factor in this negotiation is the ability of the business to persuade the potential investor that the loan is secure over its term. This involves establishing the following:

  1. The legal and managerial competence of the borrower.
  2. What collateral is being offered and what cover ratio is allowed.
  3. How the value of the collateral is to be measured.

 

Status and legal and financial competence

Lenders require evidence of the corporate status of the borrower and its capacity to service the loan over its term. The lender will want to inspect a current copy of the borrower’s rules and constitution. Having satisfied the lender that it has the power to take out the loan, the borrower must then show that it has carried out the necessary actions to exercise that power. The lender’s solicitors are likely to require documentary evidence, such as minutes of an authorised committee of the borrower, that delegated powers are valid comprehensive and relevant to the loan conditions. Audited accounts will have to be presented for inspection so that the lender can be satisfied that the borrower is in a position to service the debt. Supplementary statements may be required from the borrower’s auditors confirming that there has been no material change in financial status since submission of the last audited accounts.

Lenders will be interested in the borrower’s overall debt profile and their ability to cover that debt if things go wrong. This means that they will wish to compare the loans outstanding with the total reserves. When expressed as a ratio this relation is called the loan gearing.

The lender will be concerned to monitor the borrower’s continuing financial robustness. This is typically done by establishing an ‘interest cover ratio’ for each year of the business plan. This in effect, is a measure of the ease with which the organisation is able to meet its loan repayment responsibilities (see below – covenant conditions).

Lenders are always concerned with the managerial competence of those to whom they lend. For this reason the association should be able to demonstrate that it has in place mechanisms for maintaining the value of its built assets over the long term. For example, the financial planning of repairs and renewals is prudent in itself, but it is also necessary if the organisation wishes to borrow investment funds. Lenders will want to see projections of future costs (such as repair costs) to ensure that the agreed (covenanted) loan interest cover ratios and revenue break-even points are not likely to be breached.

 

Covenant conditions including collateral and effective loan cover ratio

Covenants stipulate the loan conditions. In particular, they specify how the loan is to be secured by collateral and effective cover ratio; penalties for default or for early redemption; and any penalties for changing the loan conditions. Covenants may also specify the financial performance borrowers are expected to achieve. For example, the lender may require the business to generate enough revenue to meet its interest charges one and a half or two times over. Covenants result from contractual negotiations and in practice they differ substantially.

Collateral constitutes the lender’s security against default on the loan. It takes the form of an identified asset that is pledged as guarantee for repayment of money lent. Typically, property is put forward as the security, although in recent years some deals have been struck that pledge the organisation’s income flow. The idea of pledging say the rent or cash sales flow, sometimes termed securitisation of receivables or rental securitisation, or revenue securitization, is an idea that was first developed in the USA. Under these arrangements, the revenue income is paid direct to the lender, via a financial intermediary. This gives the income flow a ‘first charge’ status (see below) thereby providing sound collateral for the loan. Once the debt service charges have been deducted, the surplus revenue income (e.g. rent or sales revenue) is then paid back to the borrower.

Where existing properties are pledged, security can be given by means of a ‘fixed charge’ or a ‘floating charge’. If the loan is secured by a fixed charge, it is tied to specific, identifiable assets owned by the business. If the loan is secured by a floating charge, it may be covered by all or a range of the business’s properties or other assets. A floating charge security may change over time as it can include any equity growth on properties already subject to fixed charges. Whether property or revenues are put up as collateral, lenders will prefer fixed charge security to cover their loans. They will normally expect to have a fixed first charge. This means that they will want assurance that the asset is free from any existing prior claims so that they have first claim on the asset in the event of default.

The cover ratio stipulates what the lender is prepared to accept as a ratio between the value of the asset collateral and the agreed debt. So, for example, the lender may stipulate a 1.2 cover ratio meaning that a debt of £1 million will have to be covered by £1.2 million worth of assets. In the case of floating charge securities, lenders will normally require a greater effective cover ratio – e.g. (say) 2.5. Clearly much depends on how the properties are valued. For these reasons, the questions of valuation and depreciation will now be discussed as separate issues.

 

  1. Valuing and depreciating tangible assets

Commercial valuations are simply based on market values. However the tangible assets of social businesses are more difficult to value. To illustrate the point we will consider how to put a value on units of social housing.

 

Social housing valuations

There is no one definitive way of valuing a unit of social housing. Broadly, the value could be measured against its costs of production or acquisition (historic cost value); or it could be measured against its vacant exchange value (open market value); or it could be measured against its tenanted transfer value (existing use value). The tenanted transfer value can be calculated in a variety of ways. The traditional way was to discount the open market value by an amount that reflected the embedded tenancy rights that were being transferred with the sale. With the growth of large-scale voluntary transfers (LSVT) the discounted open market method was largely replaced by a formulaic valuation method (EUV-SH) devised by the Royal Institution of Chartered Surveyors (RICS). The traditional discounted open market approach is now once again being considered as part of wider reform considerations designed to deregulate social landlords. The idea here is to transfer full property rights over the stock in return for paying back the embedded grant element to the Exchequer. If this is introduced it is likely to be part of a wider reform that will involved negotiating a major rethink about the regulated rent formula.

The type of valuation used will depend on the purpose for which it is being applied. The basis for rent restructuring for example, is simple open market value (but based on a base year values to prevent constant alterations). Right to buy transactions are also based on open market values (reduced by a sliding scale discount). By contrast, a lender will not accept an open market valuation but will require the value to reflect the social nature of the asset.

So long as social landlords were deemed to be located in the welfare sector of the economy and were publicly funded, there was little or no pressure put upon them to value their housing assets in terms of current values. As welfare agencies, so long as they covered their costs over the long-term, there was little concern about whether or not their assets had appreciated in value thereby generating equity growth. This meant that housing units were simply valued by reference to their historic costs of provision. However, now that social landlords have to borrow funds it has become necessary to put a value on the properties that are being put up as collateral. The possible return to an open market based valuation method (mentioned above) could have the effect of enhancing stock values thereby creating more collateral to underpin loans taken out to build and improve the nation’s stock of social housing (this partly why it is being considered).

 

Summary of the current situation:

Currently, there are a number of ways in which a unit of social housing might be valued. For accounting purposes (i.e. balance sheet valuations), properties are normally valued in terms of existing use – sometimes they are valued at historic cost. The accounting principle behind giving a book value to a housing property is that it should represent the lower of replacement cost (i.e. of an identical development today) or recoverable amount (its net realizable value or value in use). Under normal circumstances social tenanted properties will only be disposed of to another social landlord. Therefore, for all intents and purposes, the value of such properties is limited to Existing Use Value for Social Housing (EUV-SH). For social landlords the Royal Institution of Chartered Surveyors has introduced the EUV-SH into its Practice Statement within its Appraisal and Valuation Manual. EUV-SH seeks to estimate what another RSL would be prepared to pay to acquire the asset and keep it in existing use. This involves valuing the asset(s) on a ‘going concern’ basis.[6] EUV-SH has now also been adopted as the basis for resource accounting for local authority housing.

The basis of valuation for secured lending purposes can differ from that for accounting purposes. The lender tends to be interested in the property as an ‘investment asset’. Lenders are concerned with cover ratios (see above), and ease of acquisition and disposal in the case of default. Most lenders have private sector experience of securing loans against properties valued in terms of vacant possession open market prices. However, it has to be recognised that open market vacant possession is not a relevant basis of valuation for social landlords because the rights of the tenants have to be taken into account.

In the past, money has been lent to social landlords against housing assets that have been valued in rather rough and ready ways. Arguably the simple valuation would be ‘discounted open market value’ (OMV minus social discount). The discount is applied to reflect the continuing social nature of the asset. When this simple valuation has been used, the discount has tended to be fairly hefty (e.g. 50 per cent).

When an ‘historical cost’ approach to valuation is used, the question of how to represent any embedded capital grant (e.g. HAG/SHG), is brought to the fore. In such cases, associations have traditionally favoured the practice of deducting the grant element from the value but showing it in the balance sheet so as to record the extent to which government support contributed to an association’s development.

In valuing a stock of dwellings for the purpose of large-scale transfer, a business planning approach is taken. This involves estimating a capitalised figure that represents the difference between the costs of managing, repairing and maintaining the assets and their potential to generate a rental income over the business planning period. This sort of calculation can result in the stock having a negative value. In such a case, for the transfer to occur, the transferring agency (typically a local authority) may need to provide a ‘dowry’ to allow the new landlord to achieve a viable business plan.

 

Depreciation of the value of tangible assets

Depreciation measures the reduction in the value of an asset with the passage of time, due in particular to wear and tear. In the past, some have argued that regular maintenance and periodic refurbishment of their properties and other assets have the effect of maintaining values thereby eliminating the need to provide for depreciation. With the shift in emphasis towards resource accounting, the Accounting Standards Board now does not accept this practice. For accounting purposes, all buildings and vehicles are regarded as ‘tangible fixed assets’ rather than ‘investment assets’. As such, they are primarily valued for their economic usefulness rather than for their potential to appreciate in exchange value. Good accounting practice requires all tangible fixed assets to be depreciated to reflect the consumption of their economic benefit. This requires that both the commercial and the social business make a charge for the depreciation of their assets to the income and expenditure account on a systematic basis over their useful economic lives.[7]

Property valuers and accountants argue that few buildings can be regarded as having a limitless life, and that a point will eventually come at which redevelopment (full replacement) rather than maintenance, repair and refurbishment will be the most economic course. A depreciation charge puts an estimated value on the wearing out, consumption or other reduction in the useful economic life of a tangible fixed asset that has occurred during the accounting period.[8] Depreciation is concerned to take account of the declining use value that occurs with the effluxion of time (wear, tear and obsolescence). The principle here is that an increase in the exchange value of a property does not justify ignoring depreciation.

The depreciation charge is based on the balance sheet carrying value. Freehold land should not be depreciated and so the current value of the land should be deducted from the carrying value before assessing the need to depreciate. In different cases different methods of calculating depreciation may be deemed appropriate. There are several acceptable depreciation methodologies. The two most commonly used are:

  • the straight line (annuity) method – where the asset is written off in equal instalments over its estimated economic useful life; and,
  • the reducing balance method – where a standard percentage of depreciation is applied to the reducing depreciable amount of the asset.

The reducing balance method has more economic logic in that it assumes that the consumption benefits of the assets diminish at an increasing rate as they age. However, in order to prevent undue fluctuations and avoid the expense of continually having to value properties, the straight line method is often employed. We will return to the question of depreciation when we consider the issue of stock management (see below).

 

Impairment of the value of tangible assets

The notion of depreciation has to be distinguished from that of impairment. With the passage of time, factors other than condition obsolescence (wear and tear) can come into play that ‘impair’ the utility of a tangible fixed asset such as a dwelling and thus reduces its value. In other words, events or changed circumstances may occur that cause the value of the assets to decline at a faster rate than that allowed for by the depreciation methodology. This is a problem because good accounting practice requires the landlord to ensure that properties are not shown in the books at an amount exceeding their exchange value, called the ‘recoverable amount’.[9] For this reason businesses may be required to address the issue of impairment of asset values in addition to depreciation. The financial manager should instigate an impairment review where there is an indication that carrying values may not be recoverable.

 

  1. Debt Management

The price that the borrower pays for the loan is determined by the rate of interest. The rate of interest is composed of three elements. The first is determined by the money markets; the second by the lender’s risk-return ratio; and the third relates to loan regulation costs.

  • The market element (e.g. LIBOR): This is by far the largest component and fluctuates with money market trends. This underlying market element is determined by when the loan was taken out. The actual interest charged by the lender will be based on this market rate of interest but will, however, be influenced by other factors. These are other ‘mark up’ factors are determined by the loan negotiation.
  • The lender’s mark up (e.g. the premium over and above LIBOR): In broad terms, the negotiated price of servicing a loan will also depend on how much is borrowed, the nature of the investment product, the lender’s perception of the risk of default, the term of loan, what security is being offered to underwrite the debt, and the status of the borrower (including the quality of its management procedures).
  • The mandatory costs charge: This is an addition to the rate of interest to compensate lenders for the cost of compliance with the requirements of the Bank of England and/or the Financial Conduct Authority or the European Central Bank charges for European dealings. The supervisory fees associated with these regulatory procedures are incorporated into the negotiation and passed on to the borrower through the interest charge. These costs are no longer set formulaically and constitute a small element the cost of borrowing. It can be though of as a charge that passes on to the borrower administration charges imposed on the lender.

Long-term versus short-term borrowing

All businesses are financed by a mixture of long and short-term borrowing. Of the many issues that need to be considered when deciding the structure of the debt portfolio, the following are of central importance.

  • Coherence. This involves matching the type of borrowing with type of asset held, so that long-term debt is generally NOT taken out to pay for current assets or to pay for revenue spending.
  • Flexibility. Short term debt is easier to arrange and redeem.
  • Cost. Because lenders will expect a higher reward for venturing funds for a longer period, long-term debt is normally more expensive to service.
  • Risk. Much of the financial risk hinges on external factors such as inflation and interest rate fluctuations. In the case of longer-term debt, this brings up the key question about whether to opt for floating of fixed interest rates.

 

Variable versus fixed interest debt

The level of risk associated with debt will depend, to some degree, on how it was set up. The key distinction here is between viable and fixed interest rate agreements.

The overriding management objective is to ensure that debt liabilities do not become unaffordable and thus endanger the business plan. We can therefore think of debt management as an aspect of the wider issue of risk management. Floating-rate debt carries an inherent interest rate risk while fixed interest debt carries an inherent inflation related risk.

The obvious risk of floating-interest debt is that an unexpected fluctuation in the interest rate can affect the viability of the business plan in both the near future and intermediate future periods. Because interest rates can change at short notice, this sort of debt brings with it a degree of cost uncertainty. The risk of fixed-interest debt is that the borrower might become locked into relatively high debt charges if variable rates turn out to be lower than expected in the intermediate period. Fixed interest rates bring a degree of certainty but, depending on the rate of inflation, may turn out to be more expensive to service in the end. The key point is that both types of debt carry risks and the object of treasury management is to achieve an appropriately balanced portfolio of fixed and floating debt that provides the necessary funds without exposure to unwarranted risk.

Money market interest rates are defined by reference to specific measures such as the London Inter-Bank Bid Rate (LIBID) or the London Inter-Bank Offer Rate (LIBOR). These ‘reference rates’ can be thought of as the rates of interest at which the banks and building societies themselves borrow wholesale funds or lend to each other.

The uncertainties associated with floating-rate debt can be modified by ‘hedging’. A hedging arrangement seeks to reduce the risk associated with a particular action by taking some form of counteraction. This is done by taking out what is called a ‘derivative contract’.[10] A derivative contract enables one party with exposure to unwanted risk to pass some or all of that risk to a second party in return for a fee.

Under such a contract the borrower in the original contract (from which this new contract is ‘derived’) purchases a ‘hedging instrument’ (or ‘derivative’) such as a ‘cap’ or a ‘collar’. An interest rate cap will, in return for a premium, cover any difference between the so-called ‘strike rate’ and the reference rate (e.g. LIBOR). The strike rate is the rate at which the cap is evoked. If the reference rate (the rate of interest you have to pay) exceeds the cap strike rate (the nominal trigger rate set in the agreement), the seller will pay the buyer the difference. The payment will be made on the agreed ‘strike date’ (e.g. quarterly) and the agreement will run for a fixed term (the capping period). An interest rate floor is simply the opposite of a cap. It provides insurance for any organization lending funds that its return will not fall below a certain level. By putting the two mechanisms together into a ‘collar’, it is possible to negotiate lower premiums for capping insurance.

Although fixed-rate debt tends to be somewhat more expensive than floating-rate debt, it brings a degree of certainty into the process of financial planning. For this reason, many organizations operate loan facilities that build some periods of fixed rate security into their longer term debt. For example, as part of a 30 year loan facility, they might negotiate set periods of fixed, or maximum ceiling, rates covering limited periods (typically 4-6 years).

 

Debt profiling

In chapter 6 we discussed the strategic approach to financial planning and control in terms of a ‘rolling analysis’ that involves projecting current and future revenues and costs over the full business planning cycle (typically 30 years). The strategic approach to debt management needs to take a similar ‘profiling’ approach.

Any organisation that has long-term debt must consider how that liability will be managed over the business planning cycle. To illustrate the principles, fig.6 assumes that at year 0 it sets up a loan facility that it plans to amortize (extinguish) over a 30 year business planning period.

 

Fig.8

Profiling debt in relation to revenues and costs

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Assume that a loan facility has been arranged to help finance a 30 year business planning period.

 

Key to figure 6

0-30 (horizontal axis) represents the business planning period. This sets the anticipated loan term.

0-A (vertical axis) represents the negotiated loan facility. This sets the maximum amount that can be borrowed.

A-B indicates that this ceiling on borrowing operates throughout the planning period.

E-F represents expected revenue income (in this case conceived of as a flow of rent) projected over the planning period.

C-D represents projected costs over this period.

0-G represents initial debt at the start of the planning period.

G-y-30 represents the anticipated debt profile projected over the full term.

 

Commentary to figure 8

All financial models are based on assumptions about costs and revenues. The cost line C-D, for example might assume an inflation rate of 2.5% whilst the revenue projection (in this case rental income) might assume an annual increases based on inflation + a certain figure. This would explain why E-F is steeper than C-D.

Note that at the start of the business planning period costs are assumed to be higher than revenues (C>E) which means that indebtedness increases. Eventually, however, the income flow outpaces the business costs and a surplus occurs that allows the debt to diminish. In this example, the break-even point (y) is expected to occur in year 12. In the period up to year 12, the organization is making an accumulated loss (GEy). This pushes the debt profile up towards the ceiling allowed for in the loan facility. The debt peaks at the top of the curve (y), but remains below the negotiated ceiling (x). The gap between the ceiling and the peak (x-y) is called the “headroom” and represents a sort of comfort or contingency zone in case things do not work out and the organisation needs to borrow a bit more.

After year 12 the plan assumes that revenues will exceed costs so that surpluses accumulate between years 12 and 30 (yFD). These are then used to pay off the debt so that after year 12 the curve begins to dip and eventually falls to zero in year 30 thereby amortizing the debt.

 

Refinancing

Figure 8 represents a one-off ‘snapshot’ of a debt profile associated with a single loan arrangement. In reality, as time passes and the business plan unfolds, it is likely that new loans will be continuously negotiated so that new initiatives can be progressed and the long-term financing of the business can roll on beyond the original 30 year planning period. In other words, the organization will not finance its activities once and for all and for ever with a single one-off loan that it seeks to repay over 30 years. As time passes, new loan facilities will be arranged and come on stream sequentially so that the business can perpetually grow and develop into the distant future. However, in negotiating a loan facility at a particular moment, it will need to provide a ‘snapshot’ analysis of its capacity to deliver the business plan at that point in order to reassure its stakeholders (particularly lenders) that it is able to meet its liabilities.

Fig.8 is, of course, an over-simple, highly stylized representation. It nevertheless encapsulates many of the principles of debt management. It has to be understood, however, that such a profile is grounded in a set of assumptions about the future. Not only does it make assumptions about external factors such as future inflation and interest rates, but it also makes assumptions about a whole range of internal management issues that will affect cost and revenue levels. The revenue and cost curves might, for example, be plotted on the basis of assumptions about future sales, bad debts, building costs, salary levels, etc. If these assumptions turn out to be pessimistic, the business plan may perform better than expected and the peak debt may be lower than anticipated and the loan itself may be extinguish before its term. On the other hand, if the assumptions turn out to be optimistic, then the peak debt may be higher than expected and it may take more than 30 years to amortize the loan. If things go badly wrong and the peak debt breaks through the ceiling (A-B), eliminating the headroom, it will be necessary to renegotiate the loan facility. By subjecting its underlying assumptions to sensitivity analyis, the model can help to highlight aspects of risk assessment and management. Sensitivity analysis is discussed below (see section headed ‘Discounting and sensitivity analysis’.)

This brings us to the fifth of our seven key elements of financial planning and control (refer fig.7).

 

  1. Risk assessment and management

The relationship between risk, enterprise and sound management

The CIPFA code of practice for treasury management emphasises the point that the effective employment of money always involves a degree of risk and that money management decisions need to be explicit about the relationship between financial risks on the one hand and returns and benefits on the other. Enterprising organisations necessarily operate in a risk environment because risk is implicit in all areas of commercial activity. Well-managed organisations will inevitably take risks both in pursuing their corporate plans and also in adapting their plans in response to changing external circumstances. An organisation pursuing a policy of total risk avoidance would soon experience corporate stagnation and decline – ‘nothing ventured, nothing gained’. This means that the enterprising business should not be seeking total risk avoidance so much as effective risk management.

Although, for reasons of analysis, we are here considering the question of risk as a distinct issue, in practice, risk management is an integral part of good general management. Everything we have said so far in this booklet about the presentation of financial information, borrowing strategies, and debt management, underlines the importance of an approach to management that minimises unwarranted risk and reduces uncertainty. Having said this, risk planning and management is increasingly seen as a subject in its own right. In recent years it is a topic that has come to the fore both in commercial and social enterprises.

 

A strategic approach to risk management

A strategic approach to risk management emphasises the dual nature of business risk. In a business context, risks can be thought of as negative or positive. A negative risk refers to the danger of something going wrong and endangering the business plan. A positive risk refers to the danger of missing an opportunity that might enhance the business plan. In developing a coherent risk management strategy the organization needs to be aware of the four broad approaches for dealing with specific negative risks (Baldry, 1998). These are risk transfer, risk retention, risk reduction, and risk avoidance.

 

Risk transfer. Insurance is the most obvious way of transferring a negative risk. Decisions have to be made about which risks should be moved to an insurance company in return for an annual premium. Some insurance companies specialise in providing defect insurance for housing agencies. What insurance cover to purchase is very much a matter of judgement. It involves assessing the probability and impact of something going wrong and then weighing the insurance premium costs against the costs that would be incurred if the undesired event happened. The general principle is that the higher the probability the higher the premium. And the more catastrophic the even, the higher to premium. From the business’s point of view, if the impact is likely to be catastrophic (though improbable), serious consideration should still be given to taking out insurance cover.

In recent years, firms have developed other ways of transferring risks. In attempting to minimise commercial risks many organisations have moved to contractual arrangements that specifically off-load some of the jeopardy to others. In the property development field, for example, this can be done by such things as fixed price design-and-build contracts and/or the purchasing ‘off-the-shelf’ designs. Such arrangements afford the commissioning organisation less detailed control over the nature of the scheme and inhibit them from experimenting with designs and materials or from negotiating ‘improvements’ in detail once the scheme is underway. Interference from any in-house officials, such as the organisation’s own architect, could undermine the shift in development risk to the builder that was the whole purpose of the chosen contractual arrangement. Extended product liability deals might also be struck with manufacturers and suppliers as a way of passing on the risk of early product failure.

 

Risk retention. The idea here is to make an informed decision about whether or not to tolerate the risk. A decision might be made to retain risks that could be insured on the assumption that the organisation’s reserves and control frameworks are so sound that the probability of problems arising is insignificant and the consequences of failure are in any event covered by resources. Some risks are difficult or impossible to transfer: significant amongst these are the disruption risks arising from postponement or cancellation of projects, a change in corporate policy, unexpected external changes in interest rates, the costs of production, or changes in the regulatory framework (in the case of social businesses).

 

Risk reduction and avoidance. Risk avoidance is synonymous with a refusal to take risks. Certain risks can only be avoided by non-activity. However, we have already made the point that enterprising businesses have to take risks to prosper. The objective should be to achieve a defined outcome with minimum risk. There is no one technique for achieving this optimum position. It involves the cultivation of a general management culture that at all times and at all levels demonstrates an awareness of the need to (a) avoid exposure to unnecessary risks and (b) be clear about defensive procedures and contingencies. Risk reduction strategies can be particularly important at certain times. For example, they come to the fore when negotiating or renewing a contractual relationship.

 

Risk reduction and debt management. One way of reducing risk is to negotiate a degree of stability into contracts. Given its significance, this may be deemed particularly important in the field of loan management. As we have seen, in order to bring a degree of stability into the cost structure, businesses often develop ‘hedging’ strategies and seek to negotiate loans on a fixed interest basis (see above).

 

Putting the risk management strategy into operation

The total approach to risk management. Most firms have to take a variety of decisions involving both negative and positive risks. Some major decisions associated with strategic and business planning carry self-evident risks. For example, major shifts in policy are inevitably embedded in uncertainties about the future. Similarly, decisions involving the raising of private finance are risk sensitive. Major contracts to develop land and buildings or to provide services are also seen to carry significant risks. However, we need to make the point that focusing on such major decisions can give a misleading impression about the nature and scope of risk management. Activities at all levels carry risks. Almost all activities can go wrong. Poor maintenance could result in an injury to an employee or client or to a much more expensive repair at a later date. Sloppy procedures could encourage a fraud. Under-insurance could lead to significant loss. A development opportunity might be missed because there is no cash reserve. A badly trained member of staff may alienate an important client. The list is pretty well endless.

All of this points to the need for the organisation to take a total approach to risk management. A total approach requires the business operations to be planned and managed effectively at all levels and across all planning time periods. It also requires them to give consideration to both negative and positive risk factors.

 

A balanced approach to risk management

It is argued (Garnett (1995); Flynn (1997); Baldry, (1998) that risk management in welfare and public service organizations has to take into account a wider range of considerations than is the case in private enterprise firms. This is because the values underlying the provision of public services are discretely different from those underpinning successful commercial businesses. Public service agencies are often required to consider broad questions of public policy that would be deemed to be irrelevant to most private businesses. They are also required to take more direct account of questions relating to distributional equity and social justice in their investment and management decisions (refer to Figs.3 and 4 and previous discussions on the topic of ‘best value’). This means that risk management in welfare agencies has to balance a broader range of factors than is often the case with private free-enterprise firms. Whether operating in a purely commercial or a public services environment, risk management should always begin with a systematic analysis of the risks and uncertainties confronting the organization.

A systematic approach to risk analysis: risk mapping. Effective risk management requires the organisation to have a systematic approach to its analysis of total balanced risks. Some regulated social businesses are now required to undertake an annual risk appraisal or review exercise that involves the management team compiling a comprehensive list of risks to which it feels they are exposed. The exercise seeks to tackle the multi-faceted nature of risk by requiring the organization to map the areas of risk that they consider most pertinent. It involves identifying the risks in relation to specific categories such as development, maintenance, finance, fraud, information technology, staffing, etc., and then allocating a ‘risk ranking’ to each one identified. Each broad category of risk can then usually be broken down into an extended sequence of sub-categories. For example, within the specific category ‘maintenance’, it should be possible to identify the sub-category ‘heating systems‘. Within this sub-category we can then identify a sub-sub category ‘ gas boilers’: in turn this can be broken down further into ‘specific model’ and then ‘component failure’. Decisions have to be made about the appropriate level of risk analysis. Decisions about what to itemise should be informed by reference to probability, incidence and impact.

The probability factor (the chances of occurrence) can be analysed by reference to in-house data or published research by other firms in the same line of business, manufacturers, insurance companies, the professional bodies and academic institutions. Incidence refers to the occurrence rate (probable frequency) of the risk event. The scale of the loss (the consequences of occurrence) is referred to as the risk impact. The impact should be analysed and quantified in some way. If possible, an attempt should be made to place an appropriate money value on the loss. Experience from the commercial world shows that the impact of the incidence of most risk events can be measured in financial terms – e.g. as the effect on turnover, market share and profitability (Baldry, 1998, p.36). Given their more complex social objectives, providing a money value may be more problematic for welfare and public service agencies such as providers of housing, health or education. Even if the effect of the risk event is on some intangible operational feature that is difficult to measure, such as reputation, staff morale, or firm-client relations, if it is felt to be important, then its impact has to be measured and recorded in some way. In risk analysis there is always a temptation to measure what is easy to quantify rather than what is relevant to the organization’s mission. The principle has to be, however, that it is better to measure the right thing in a rough and ready way than to measure the wrong thing with impressive refinement. If it is not possible, or sensible, to put a money value on the relevant loss, then it should be recorded in terms of its effect on some non-monetary performance indicator target.

Avoiding ‘perception bias’. Because, to some extent, risk is a perceived phenomenon, its real significance (probability plus impact) can be under or over or under stated. Experience shows that this is particularly problematic when a ‘bottom-up’ approach to risk identification and appraisal is taken. Asking managers and their staff to appraise risks is always a sensible thing to do, but can lead to the following distortions.

  • A tendency to focus on recent experiences.
  • An over-confidence in established control mechanisms.
  • A lack of critical analysis resulting from a desire to support colleagues.
  • A tendency to focus on negative problems occurring rather than positive opportunities being lost.

 

Risk perception can also be affected by the ways in which risk data is presented. In particular, we need to be clear about the distinction between ‘base-line’ and ‘relative’ risk analysis. If the risk of a particular harmful event occurring rises from one chance in a million to two chances in a million, then incidence factor will have increased by 100% from the base line. However, in relative terms, it still remains an insignificant risk.

We will say more about risk perception later (see below sections ‘Option generation, judgement and multiple criteria analysis’ and ‘Harnessing Stakeholder Perceptions’. Refer also to section ‘The use of experts’.)

 

Classifying and quantifying the impact

The appraisal or review exercise should make clear the appropriate managerial responses to the actual or probable occurrence of such events. These responses must seek to mitigate the damaging effects upon the corporate finances or upon specific performance indicator targets. This means that potential losses have to be clearly associated with identifiable cost centres or departments (areas of specific managerial responsibility). Any linked consequences also have to be traced. For example, in the broad managerial area ‘finance’ we may wish to analyse the risk sub-category ‘non-compliance with loan covenants’. The consequences here might be analysed as a default that will result in the withdrawal of the loan facility or a financial penalty. Within the broad management category ‘staffing’, the consequence of unanticipated sickness and absences might be measured in terms of increased workloads for other staff, service failures and/or increases in agency costs. Having identified, quantified, and ranked the risks the appraisal or review exercise should then consider the controls (policies, procedures and practices) that will reduce the probability of occurrence or the damage impact should they occur. Where they exist, controls should be tested for adequacy and, if necessary, improved. Where they do not exist, appropriate controls should be introduced.

The danger of producing a ‘risk map’ is that it may lead to complacency. Risk maps tend to be complex and need to be subjected to further analysis. The organisation should resist the belief that just because a number of potential problems have been identified, its risks have been managed. Risk mapping is only a starting point and it is the quality of the follow-up actions that determines its success as a management tool. It is only the first step in effective risk management. Any follow-up requires the application of appropriate and effective techniques.

 

Specific techniques for dealing with uncertainty and reducing risk

Risk appraisal and management involves the marshalling of evidence in order to make a judgement. The effectiveness of the exercise depends in large part on the quality and comprehensiveness of the data and the appropriateness of the marshalling and appraisal techniques employed. Risk appraisal and management is an expansive topic and it is not the intention of this text to provide a detailed and comprehensive description of the full range of techniques and approaches that have been developed in this field. We will, however, point to some key tools and ideas that are commonly used by those seeking to analyse and manage risk and uncertainty.

 

Effective information and feedback systems

Risk analysis should be an automatic element in decision appraisal. Any decision to invest new resources or to realign existing resources carries financial risks: the object is to take a decision that proves to be ‘sustainable’ through the different planning time periods identified in chapter 6. A sustainable decision is one that the organisation does not live to regret. It is well understood that when decisions are informed by sufficient and relevant information they are more likely to turn out to be sustainable than if they are informed by insufficient or inappropriate information. This means that an organiszation’s information systems, and how they are utilised, should be regularly assessed to ensure that they are contributing to the organisation’s decision processes. Well run agencies will inevitably make mistakes: the question is, ‘Do we have in place identifiable mechanisms for learning from our mistakes and successes?’ Of course, sound decision-making involves more than the acquisition of data and other types of information. An effective decision involves the application of judgement to information.

 

Option generation, judgement and multiple criteria analysis

It has to be recognised that housing investment and management decisions are multi-faceted in that they often seek to achieve a mix of financial, technical, social, legal, political, environmental and administrative outcomes. This means that appropriate options have to be generated that balance and reconcile different, and sometimes competing, proprietary and non-proprietary interests. Research shows that when there is a failure to generate appropriate options subsequent problems are likely to arise (Garnett, 2004). There is little point in using sophisticated option appraisal techniques on an inappropriate range of options. If we fail to present the most viable options for appraisal it is simply not possible to make a risk-efficient decision. Option generation involves ensuring that important development, reinvestment, or policy change decisions are justified at the outset by reference to a shared corporate understanding of the balance of interests being pursued, whether of tenants, other community interests, future generations, or whoever.

It is easy to say that option generation involves the application of judgement to information. The problem is that judgement is not an absolute quality – it is relative to the values and attitudes of the individual decision-makers. This means that project planning needs to make explicit the various personal or professional rationalities that lie behind different proposed courses of action. It may be the case that the treasurer will seek one course of action based on her understanding of the financial implications (budgetary rationality) while the estates manager is arguing for a different course of action based on his understanding of sound building practices (technical rationality). Other rationalities associated with service delivery, marketing, administrative feasibility or political expediency may point to yet other ways forward. In the context of new projects or major policy changes, risk appraisal has to involve the reconciliation of these competing rationalities by some form of multiple criteria analysis.

 

Harnessing stakeholder perceptions

It is well understood that public service organisations are subject to the influences and expectations of a diverse constituency of interested parties. Both academic research and best value philosophy indicate that the opinions and experiences of employees, clients and community stakeholders can be utilised in the appraisal and review exercise to identify and clarify the risk perception process. By widening the area of consultation we automatically widen the scope of risk identification. Conversely, a reliance on a limited range of internal managerial perceptions and professional interests may compromise the risk assessment exercise by limiting the range of objectives being considered.

 

Effective control frameworks

Control frameworks are essential weapons in any risk management armoury. They provide guidance, prescribe and proscribe certain actions, and set limits for a broad range of activities. These policies, standing orders and procedures typically require management processes to be monitored and appraised. They regulate the nature and scope of delegated authority, and declare the corporate view of what constitutes best practice.

To be effective, control frameworks have to be relevant to current circumstances, understood by those who are meant to use them, practical to operate, supported by training, constantly reviewed, and reinforced by a compliance culture. However, it must be understood that the emergence of unnecessary or inappropriate regulations and procedures itself constitutes a ‘risk’. An organisation can be over-regulated: when this occurs, the resultant compliance culture can inhibit initiative and have a deadening effect on staff morale, energy and confidence. All quality control managers should have pinned up on their walls the old West Country proverb, ‘Worrying about the future can prevent it occurring’.

 

Analysing cumulative and linked risks

In analysing the incidence and impact of risk occurrence, consideration should be given to the possibility of cumulative and linked risks. A general distinction should be made between one-off, or infrequent, major events (e.g. a theft, fire, etc.), and cumulative risks. Cumulative risks are associated with smaller scale events that may not be significant in themselves but which can have a damaging cumulative effect on the organisation’s costs. If a customer complains about some relatively trivial aspect of poor service, this in itself may not be of much concern. If however, the problem persists and they become so annoyed that they write to the press, the firm’s reputation might then be damaged in some significant way. These cumulative risks are sometimes referred to as ‘aggregated risks’ and are of particular concern to the managers of built assets.

A general distinction should also be made between isolated and linked risks. Some apparently small-scale risks can have significant knock-on effects that must be taken into account in risk assessment and management exercises. The connectedness of a linked risk might be technical: the failure of a small and cheap component might cause an entire system to fail causing expensive, inconvenient, or even life threatening consequences. The connectedness of a linked risk might be managerial: the failure of a light bulb might be regarded as a relatively insignificant event, but if the bulb is located in a dark stairwell, its failure might be highly dangerous. The connectedness of a linked risk might be environmental: we might develop a piece of land in a way that enhanced the organisation’s productivity but which was damaging to local wildlife, or created some other third party or ecological problem. The connectedness of a linked risk might be political: we might instigate a policy change that increased the cost effectiveness of our operations but which contravened central or local government guidelines thereby bringing into question our entitlement to public funds. All of this points to the need to assess risks in a way that makes explicit all the possible linked consequences.

 

Discounting and sensitivity analysis

Discounting is a technique that seeks to cost future money flows in terms of present values. When project appraisals and budgets cover an extended period, it may be necessary to put a present value on future costs/benefits or expenditures/incomes. This is because we are seeking to make rational decisions now, in the present, about impacts and monetary flows that will occur sometime in the future. Put most simply, the appraisal or the budget needs to take account of two issues resulting from the relationship between time and the value of money.

  1. Different costs and benefits and expenditures and incomes come on stream or impact at different times.
  2. A £1’s worth of income or expenditure today will not have the same real value as a £1’s worth of income or expenditure in the future.

 

Sensitivity analysis is one technique that can be used to assess the impact of particular assumptions being proved wrong. It does this by identifying those factors that have the greatest impact on the business plan and then assessing the consequences of our assumptions about these factors not turning out as expected. Because planning involves looking to the future, and the future is uncertain, all plans have to incorporate assumptions about such things as interest and discount rates, building costs, sales returns, rent projections, general levels of inflation, works completion dates, void property re-let times, and the physical life of building components. Sensitivity analysis is a technique that seeks to test the plan’s key incorporated assumptions about such variables. It asks the question ‘How sensitive is the planned or expected outcome to the assumptions being made?’ Managers and risk analysts will need some idea of the consequences that might follow from variations in these assumptions that underpin the plan’s projections, conclusions or recommendations. Sensitivity analysis plots a range of possible futures, each grounded in discretely different assumptions about such things as interest rates and the life spans of building components. With modern computer technology these futures can be presented to decision managers or committees in clear charted or graphical formats. These can then be used to help devise appropriate tactics. For example, with respect to a proposed building contract, the knowledge and understanding gained from a sensitivity analysis of building cost price projections might persuade the client to reduce the risk of price rises by insisting on a fixed price contract.

 

The use of ‘experts’

Experts provide specialist knowledge that should inform, but not determine, a decision about what constitutes best action. Consultants and professional advisors do not have a legitimate authority to make final decisions; they should be used to advise those who do have such authority. Advisors should not relieve decision-makers of the task of determining how to respond to perceptions of risk but might be used to help generate unthought-of options, or to offer new perceptions of risk, or to test, challenge and reshape the organisation’s existing perceptions. The best use of consultants is made when they understand what it is that the organisation is seeking to achieve. Research shows that where there has been little or no pre-planning before briefing consultants, the ‘experts’ may offer rational, but inappropriate, courses of action based on their own professional values and attitudes rather than on those of the client organisation (Garnett, 1996).

Experts may have information and experience that the client does not possess and they may be able to provide new insights that can be drawn upon in carrying out a risk assessment exercise. By interacting with the client they may also help to clarify the organisation’s aims and objectives – but they cannot know better than the organisation itself what values and interests constitute the bedrock of its function. This means that any expert advice should reinforce or reshape, but not replace, the organisation’s judgements about what to do. In selecting consultants we are choosing ‘expert witnesses’ to give informed opinions rather than appointing ‘judges’ to give definitive rulings.

 

Dealing with long-term structural uncertainties

There are a number of established techniques specifically designed to aggregate the knowledge and judgements of experts about possible future trends.[11] Although we cannot tell for certain what the future holds, it is possible to canvass informed opinion about external political and economic trends that may affect our long-term plans. These approaches to thinking about the longer-term are referred to as Delphi techniques – after the Greek oracle at Delphi who gave riddled answers to those seeking knowledge of what the future held in store.

A particular form of sensitivity analysis called ‘stress testing’ can be used to consider the impact implications of different possible futures. This involves asking a variety of ‘what would we do if?’ questions. For example, we might stress test our risk assumptions by asking ‘What would we do if there was a change in government?’ or, ‘What would we do if an advantageous investment opportunity comes our way in two years time?’ or, ‘What would we do if we are suddenly required to cut prices?’

We will now turn to the sixth of the key element of effective financial management identified in fig.7.

 

  1. Stock management: resource accounting, depreciation and the planning and paying for repairs, renewals and reinvestments

We have already made the point that resource accounting and budgeting (RAB) are necessary techniques for effective business planning.

As we have seen above, depreciation is a charge that reflects the loss in value resulting from wear and tear. Neither the grant funded element of a property’s value nor the land is included in the depreciation calculation. The basic idea is that the published accounts should be in line with modern plc accounting conventions so as to make the ‘true’ costs of running the ‘business’ more transparent. This will involve accounting for the life-cycle costs of each asset as they occur so that their true costs in use can be estimated.

In property owning companies, the assessment of future major repair needs forms part of sensible financial planning, and accounting policies should reflect the needs of the organisation. It is financially prudent to set aside amounts regularly to ensure that sufficient funds are available when the costs are due to be incurred.

Exactly how provisions and reserves are designated and set aside is for each organisation to decide in accordance with its own policies, external regulatory requirements and legal/contractual commitments. The over-riding objective is to prevent undue fluctuations in costs that will damage long-run financial plans or drain free revenue reserves to a point where lenders’ loan covenants are breached.

Using component life-cycle cost data and techniques of property profiling, built asset managers can establish theoretical models of future repair and renewal costs for new build schemes. For existing properties, cost models can be produced that are informed by condition surveys. Although there are many variables and uncertainties associated with life-cycle data, this form of rational planning is likely to lead to better stock management decisions than the mechanistic application of a standard formula. By using the ‘stock management planning’ approach clear forecasts of future requirements can be presented to decision-makers. To encourage strategic thinking, benchmarks can be produced that distinguish between the estate manager’s condition obligations and his or her condition aspirations. By the use of computer modelling, it is possible to build in assumptions about component life spans and future building costs so that decision committees can be presented with graphic representations of possible optimistic and pessimistic cost futures. This can help the manager or committee to clarify the risks of taking one financial decision as against another.

 

  1. Taxation and social landlords

Private sector organisations are subject to Corporation Tax and VAT. These tax liabilities have to be allowed for in their financial management arrangements. This means that the financial planning of such organisations has to take account of any tax liabilities that will occur during the accounting period. The main taxes that affect trading organisations are Corporation Tax and Value Added Tax (VAT). The detailed regulations surrounding these taxes are rather complex and constantly being changed. However, as we are simply concerned to outline how tax liabilities impinge on the organisation’s financial planning, we will focus on basic principles. The basic principles of Corporation Tax and VAT are fairly straightforward.

 

Corporation Tax

Corporation Tax can be thought of as a sort of companies’ income tax. It is charged on the profits or other ‘assessable gains’ accruing to the organisation during the accounting period. In the accounts of a business the assessable gain is recorded in the Income and Expenditure Account and is usually referred to as the surplus on ordinary activities.[12] In determining the ‘assessable gain’ a deduction may be claimed for certain types of expenditure. Repairs, maintenance and replacement expenditure that restores a building to its original condition is an allowable expense for tax purposes and can be deducted from the turnover in the assessment of assessable gain. Improvement expenditure does not qualify for relief as this adds to, rather than maintains, the quality of the assets. This means that care should be taken to determine whether or not the works are an improvement. If works that are really repairs and replacements are capitalised in the books, it is unlikely that they will be allowed as a deduction from income, and this will result in an unnecessarily high tax bill. Any monies transferred to reserves do not qualify and these are recorded after the tax has been deducted. Relief may be given for bad debts, but only so long as a reasonable effort has been made to collect them. Charitable organisations are not subject to Corporation Tax.

In recent years, Corporation Tax has been levied at two rates – the full rate and the small companies’ rate. Where the assessable gains of a UK resident organisation do not exceed stated limits the full rate of tax is reduced. The application of the lower, small companies’ rate is governed by the amount of profit or gain and not by the size of the organisation.

 

Value Added Tax (VAT)

In contrast to Corporation Tax, no VAT exemptions are granted to charitable organisations. VAT is a sort of purchase or trading tax that is charged on the value of supplies made by a registered trader. Organisations are required to register for VAT once their turnover reaches a specified threshold. The tax extends both to the supply of goods and also to the supply of services. Supplies of certain goods and services are exempt from the tax. These include the provision of finance, insurance and education and burial and cremation services. The granting of a lease or license to occupy land will usually be classified as exempt. Rents are non-VATable.

VAT is charged on some services provided by social landlords: e.g. garages to private tenants and some service charges. Non-exempt supplies are subject to tax at one of three rates.

VAT rates for goods and services

Rate % What the rate applies to
Standard 20% Most goods and services
Reduced rate. 5% Some goods and services, eg children’s car seats and home energy
Zero rate 0% Zero-rated goods and services, e.g. most food and children’s clothes, water and sewage services, books, newspapers and magazines, clothing and transport.

 

In most commercial circumstances, the liability is calculated in a way that only taxes that element of value that has been contributed by that particular trader. In other words, the idea of the tax is to levy a charge on the additional value that has been added at each stage in the production process. This means that in most circumstances, a registered trader will both suffer tax (input tax) when acquiring goods and services for the purposes of a business, and charge that tax (output tax) when supplying goods and services to customers and clients. A normal commercial trader is required to calculate both the input and the output tax during the accounting period, and if the latter exceeds the former, the difference has to be paid. In this way the tax liability is passed on ‘along the line’ and eventually comes to rest on individuals or organisations who are not VAT registered, or who do not themselves charge VAT on that particular good or service. When this end point is reached, it is assumed that the production process has ended and the purchaser has to pay their suppliers VAT on the full value of the goods and services without having an opportunity to pass the burden on as an output tax.

 

VAT and building works

The current rates of VAT on building works are:

0% (zero) VAT on the cost of constructing new dwellings. The zero rating also applies to the following:

  • Substantial alterations to listed buildings used as dwellings.
  • New buildings used as children’s homes, old people’s homes and the provision of student accommodation – but not hotels and prisons.
  • New buildings to be used by a charity for non-business purposes, e.g. a church.

5% VAT on the cost of the following:

  • Renovating dwellings that have been empty for three years or more.
  • Converting properties into a different number of dwellings.
  • Works necessary to convert a non-residential building into a dwelling(s)
  • Converting a dwelling into a care home or other residential building.
  • Installing energy saving materials in all homes.
  • The grant funded installation, maintenance and repair of central heating systems and home security goods in the homes of qualifying pensioners, and the grant funded installation heating systems of the less well-off.

17.5% VAT on all other building work including the following:

  • Repair and maintenance of, or extension to, existing buildings.
  • The costs of constructing commercial and industrial buildings such as shops, offices, and factories.

 

Summary:

We have stressed that all successful businesses need to plan their financial affairs. We have made the point that social entrepreneurs operate in a regulated business environment that is characterised by political and social, as well as economic, uncertainty, and this means that financial planning and control are particularly important if the organisation wishes to make sustainable decisions and use its resources to the best advantage.

Internal treasury management is concerned to:

  • provide the financial resources necessary for the organization to achieve its purposes;
  • manage the associated risks that might threaten its ability to achieve these objectives;
  • manage the financial assets in a way that ensures that they maintain their value;
  • manage the financial liabilities in a way that ensures that they remain affordable.

The well-managed business is, among other things, risk aware, performance orientated and a ‘learning organisation’.

Treasury management is concerned with keeping the business plan financially viable. More specifically, it provides the basis upon which managers can make sound decisions and deliver the business plan’s mission in ways that are judged to be efficient, fair and effective.

Financial planning and management have to operate through time. A series of interrelated time profiles lies at the heart of strategic financial management. Together this series of time profiles constitutes an integrated planning and control cycle. This cycle links the organisation’s long-term aspirations to its immediate activities. Converting the idea of the cycle into a management process involves asking different types of policy question and creating a cascade of documents differentiated by time, scale and specific detail.

 

Further reading

Atrill P., Financial Management for Non-specialists, Prentice Hall, 2003.

Baldry D, ‘The Evaluation of Risk Management in Public Sector Capital Projects’, in International Journal of Project Management, Vol.16, No.1, pp.35-41, Pergamon, 1998.

Button F, Best Practice for Better Borrowing, NFHA, 1993.

Drury C., Management Accounting for Business Decisions, Thompson, 2002.

Flynn N, Public Sector Management, Prentice Hall/Harvester Wheatsheaf: Hemel Hempstead, 1997.

Garnett D (1996), Building Obsolescence, UWE Bristol. Reprinted as

Garnett D (2016) ‘The Needleman Rule’: in Housing and Society: https://leapingfrogpublications.co.uk/housing-society/

Garnett D (2016) ‘Building Obsolescence’, in Housing and Society: https://leapingfrogpublications.co.uk/housing-society/

Garnett D, The Theory and Practice of Cost-Benefit Analysis, Bristol: UWE, 1994. Reprinted in Housing and Society (2017) in leapingfrogpublications.co.uk

Garnett D, ‘Multiple rationality Analysis: An Approach to Reconciling the Competing Interests Associated with Housing Renewal Schemes’. Paper given to the Commonwealth Association of Surveying and Land Economy and the International Federation of Surveyors: Sustainable Development: Counting the Cost – Maximising the Value, Harare, Zimbabwe, August 1995.

Garnett D, ‘Citizens’ Panels and Absent Voices’, in Local Governance, Institute of Local Government Studies, University of Birmingham, Vol.30, No.1, pp.14-21, Spring 2004.

Garnett D, A-Z of Housing, Palgrave/Macmillan, 2015.

Moore C.M. Group Techniques for Idea Building, Sage, 1987.

[1] Chartered Institute of Public Finance Accountants.

[2] Credit agreements take the form of a deferred payment.

[3] At the time of writing, these are not normally charged. However, they could be reintroduced if the loans market becomes less competitive.

[4] For example, bond issues are sometimes guaranteed by what is called ‘monoline enhancement’. This is a form of insurance policy that guarantees investors against any default on their interest payments.

[5] The net amount is the gross redemption value less the discount net of amortisation. Immediately after issue, before any amortisation of the discount, the net amount will be equal to the net proceeds. Amortisation is charged to the income and expenditure account. Similarly, any significant early redemption costs (penalties for redeeming the debt) should be charged to the income and expenditure account.

[6] Although a logical way of recording the asset value, and recommended by SORP, work done by the NFHA in the early 1990s indicated that EUV-SH produced a relatively low valuation in so far as repossessed dwellings often raised higher sums on disposal through sales or re-renting than that represented by this ‘going concern’ valuation.

[7] The useful economic life of an asset is defined as the period over which the organisation expects to derive economic benefits from that asset. A traditionally built new building is assumed to have an economic life of 60 years.

[8] The structure of a building and items within the structure, such as central heating boilers, lifts and general fittings, may have substantially different useful economic lives and, if material, may need to be depreciated separately.

[9] The recoverable amount is defined as the higher of their net realisable value and value in use.

[10] A derivative contract is one in which the value is derived some other contractual arrangement – in this case from the obligation to pay the reference rate of interest. Derivatives are normally used to limit the exposure to risk.

[11] See, for example, Moore, C.M., 1987.

[12] This surplus is calculated by taking the operating surplus net of deductible costs, and then adding in any profits resulting from the sale of fixed assets and any income received in the form of interest payments.

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