By Kris Sikes

A long-term financial analysis (LTFA) is intended to provide insight into how financial conditions are likely to appear in the future, which in most cases consists of the next five years, so that appropriate planning can begin in the present. The overall objective of LTFA is to assist local managers and leaders in crafting a plan that meets the needs of a community without sacrificing its financial future.

Local governments understand the value of looking at historical trends in revenues generated from such various sources as taxes, fees, and fines to project expected future revenue levels. It can also be important to understand how these revenues are tied to community factors that include population, inflation, and income level.

Understanding the relationship between how a community has changed over time and the revenues that have resulted from those changes gives governments a sense of how much money they can expect to have in the future to support government operations.

Governments also understand that it can be beneficial to then compare those revenue trends to the historical trends of the expenses incurred in providing the services their residents desire. Again, it may be useful to relate those expenses to the community’s profile and how that profile has changed over time.

Understanding the drivers behind revenue and expenditure streams and planning for potential gaps allows governments to develop a game plan to ensure there is sufficient funding to operate the government in the future. Yet, many communities also think it can be difficult or expensive to develop and use forecasting tools in their budgeting process and therefore forgo this forward-looking approach to budgeting.

This article discusses the benefits of forecasting, provides some important drivers that communities need to think about when planning for the future, and gives examples of two types of governments that have used long-term financial analysis to help solve budgeting problems.

This should give small- to medium-size communities the confidence to incorporate LTFA into their normal financial routines and enable them to begin planning now for their future.

Revenue Forecasting

The objective of the revenue forecast is to provide an analysis and forecast of the revenues to determine the capacity of a local government to provide services. Under ideal conditions, revenues would grow at a rate equal to or greater than the combined effects of inflation and expenditures.

To forecast revenues, historical data is needed for the streams of revenue the government wants to analyze. Depending on the size of the government, the level of aggregation of revenue that gives the "best" picture to local leaders will vary. A bigger government might want to look at revenue streams at a more granular level than a smaller government.

In case studies described in this article, readers will see that leaders of a medium-size city (population approximately 30,000) felt that the best picture of their city's financial condition would be revealed by analyzing 16 revenue sources, whereas a small city (population approximately 5,000) felt that revenue forecasts for four distinct categories would provide the needed information.

Since LTFA is a tool to help manage a community's finances, it is important to always remember that the tool that works best for your government is one that is easy to use, while giving you enough information to make decisions. This tool will therefore look a little different for each community.

In addition to historical data, other relevant factors to consider are population growth or decline; the overall state of the economy that can be modeled using something as simple as an inflation index; and your community's general wealth as expressed by the median income.

Again, the number of additional factors that you may want to include in LTFA will vary based on the level of detail your community needs.

Expenditure Forecasting

The objective of the expenditure forecast is to provide an analysis and forecast of primary operating expenditures. Expenditures are a measure of local government's service output. Generally, the more a government spends in constant dollars, the more services it is providing.

Most local governments are required by law to have a balanced budget; however, operating expenditures often outpace operating revenues and adjustments to budgets are necessary throughout the year. This is why it is important to anticipate expenditures in advance and build the appropriate levels of expenses into the budget.

On the expenditure side, it is important to first determine if the current level of service being provided is the appropriate level. Forecasts provide estimates of likely expenditures in the future based on the historical amount spent by an entity.

A forecast, therefore, will tell managers what to expect holding the level of service constant. Any desired enhancements to the level or type of service will need to be overlaid on the analysis of the historical trend.

Just like on the revenue side, other relevant factors to consider are population growth or decline; the overall state of the economy that also can be modeled using an inflation index; and a community's wealth as expressed by the median income. As with the revenue side, the number of factors that you may want to include in LTFA is specific to community needs.

Gap Analysis

The objective of the gap analysis is to review the combined scenario of the revenue and expenditure projections and determine gaps. This is where a government takes a hard look at the expected revenues and the anticipated expenditures and determines if there will be sufficient funding to cover the level and type of services the government is planning to offer.

Gaps identified can be planned for by either determining a way to increase revenues through tax or fee increases, as much as local governments might dislike this, or by cutting expenses. Knowing ahead of time that a community is expected to experience a budget shortfall allows community leaders an opportunity to engage residents in a discussion about priorities.

Here are two local government case studies showing how LTFA has been used.

Midsize City. Problem: Balancing budget by drawing down reserves. A midsize city in Georgia was concerned about using reserves to balance the budget and wanted a better way to think about the budgeting process. Staff members approached the Carl Vinson Institute of Government to assist them in developing the city's first revenue and expenditure forecast. They wanted to be in a position of having a plan for the future rather than reacting to financial challenges as they arose.

To do this, the institute helped develop a baseline forecast model for both revenues and expenditures that looked at historical trends and projected them forward. This city is one whose population is still increasing, so population growth was also incorporated into the model.

On top of this was layered any known initiatives that would change the baseline. The planning department, for example, expected some new mixed residential and commercial projects to be completed within the forecast time frame. Thus, additional revenue was projected based on this development.

On the revenue side, the model included 16 distinct revenue sources, as well as a line for other revenue sources. The eight largest revenue streams generate 86 percent of the city's revenues. Property taxes generate approximately 33 percent of the city's revenue, with franchise fees and court fines being the next biggest drivers of revenue at 12 percent each.

The city chose to forecast revenues at this level to better understand what was driving each revenue stream. This was important because there were certain revenue streams that were disappearing based on legislative changes or other reasons. The city wanted to make sure those lost revenues were being tracked and not lost in the "noise" of a larger revenue bucket.

On the expenditure side, it is important to first determine if the current level of service being provided is the appropriate level. The city determined that it was satisfied with the level of service it was providing its residents. Therefore, the forecasts of likely expenditures in the future based on the historical amount spent were appropriate.

The city now uses the model each year to look at the forecasts and the plans it has in place to see what gaps there might be between revenues and expenses. They simply update the model with the latest revenue and expenditure amounts as well as the population and then calculate the expected revenues and expenditures for the following five years.

The city council also uses this information to help make decisions going forward as to whether the revenue it expects to generate will be sufficient to cover the services and the level of services the city would like to offer.

Small City. Problem: Tax equity disconnect between the revenue base and the residents receiving services. City staff members were concerned that revenues generated through electric fees were supporting services to nonelectric customers disproportionately. The city was interested in forecasting revenue streams from the general fund and each of the city's enterprise funds, and then comparing the expenditures within each stream to determine the cross-subsidizations between funds.

This was important because not all residents are electric customers, and the city felt it was inequitable for electric customers to be paying for services like police protection to nonelectric customer residents. Thus, aligning revenues and expenses was important.

In this case, four separate revenue streams were analyzed. The historical data were used to develop a baseline forecast model for both revenues and expenditures that looked at historical trends and projected them forward. This is a city that is not experiencing much population growth, so no population impact was included.

Once the city could see the trends and how revenues for electric services were consistently outpacing the needed expenditures, it could begin to make decisions on how to better align the revenue and expenditure streams for each fund.

Three Lessons Learned

Incorporate forecasting into the budgeting process. Knowing the trends that are driving revenues and expenditures allows local governments to have more realistic expectations of any budget shortfalls. It also allows a community to prepare for major capital expenditures in advance.

A forecast model does not need to be overly complicated to inform a locality on where it is headed. Building a model in Excel that can be maintained by simply entering new data each year is a good option for most small- and medium-size governments.

There is no additional software to purchase and updating it merely requires using data that is already generated in the course of organizational business.

Forecast revenues and expenditures at the level of granularity that is right for a community. Depending on the size of the government, the level of aggregation of revenue that gives the "best" picture to local leaders will vary. A bigger government might want to look at revenue streams at a more granular level than a smaller government.

Since LTFA is a tool to help manage a community's finances, it is important to always remember that the tool that works best for your government is one that is easy to use while giving enough information to make decisions.

Update the forecast each year with changes to the community. Once your government has built LTFA, make sure to update it each year with any known community changes that will affect either revenues or expenses. Frequently, legislative changes at the state level have impacts on local governments.

Possibly a new development is coming to your area. Going ahead and adding this information to the model and calculating the subsequent impact to either revenues or expenses will allow your community to plan accordingly.

Kris Sikes, Ph.D., J.D., is public service assistant, Carl Vinson Institute of Government, University of Georgia, Athens, Georgia (krissike@uga.edu).