News & Insights
Local Governments Can Make Better Decisions with the Help of Fund Balance Education
February 9th, 2023
By Rod Taylor |
Understanding an entity’s fund balance ratio and how to leverage it appropriately helps local government leaders make better short- and long-term decisions about using trusted public funds.
Below is a quick overview of key questions we field around fund balance ratios and how to ensure your city, township, village, and county is allocating appropriately.
What is a fund balance ratio?
The fund balance ratio uses the unrestricted general fund balance of the local unit. These funds are the dollars a local unit has available for unplanned events without the need for drastic cutbacks that negatively impact staffing and the delivery of critical public services. In other words, it is the working capital or savings a local unit must maintain to weather negative economic trends and unforeseen circumstances. Therefore, maintaining the appropriate fund balance level will help mitigate current and future risks and ensure stable cash flow.
The ratio is generated by taking the unrestricted fund balance and dividing it by the general fund revenue.
Why is a fund balance ratio important?
A healthy unrestricted fund balance ratio provides many benefits to a local community. These include stabilizing services without budget cutbacks, offsetting revenue shortfalls in a poor economy, reducing the cost of borrowing by using reserves and enhancing the credit rating of the local government. Each local unit must review its unique circumstances to determine what they believe a healthy level is for its community. GFOA then recommends that a local unit does this by setting a fund balance policy.
A documented fund balance policy allows the local government to set a goal or a range for their unrestricted fund balance. This helps provide a framework to guide budgetary decisions and allows for creating multi-year plans. Additionally, it provides taxpayers with information about why resources have been set aside. A good policy will help a local unit grow its fund balance over time and help reduce the fund balance if it becomes too large.
What is the optimal level of fund balance?
The number one way most local units monitor their fiscal health is through their fund balance ratio. This number is a simple metric used across local government units to indicate the local unit’s relative financial condition. When reviewing this number, the challenge that local units face is determining if their ratio is too low or adequate for their community needs. The conventional wisdom is that anything above 16.67 is appropriate, but this might not be true for many local units.
What is an appropriate fund balance ratio?
When asked the question of the appropriate level of fund balance, many experts will state that you should have no less than two months of revenue or 16.67%. This comes from guidance from the Government Finance Officer Association, established as the minimum standard for fund balances. However, if you dig deeper into recommendations, they state, “a government’s particular situation often may require a level of unrestricted fund balance in the general fund significantly in excess of this recommended minimum level.”
What should your fund balance ratio be? Unfortunately, there is no single answer, and each local unit should review its unique circumstances. To determine an appropriate ratio, each community must evaluate a number of factors to determine what is acceptable for them and their situation. Some factors that a local unit would need to consider the following:
- Local unit type. When reviewing the median fund balance for local governments across the state, there is a large difference in the median fund balance carried out by cities, counties, townships, charter townships, and villages. For example, the median for a township in the state can be between 130 to 150 percent, while for a city, it is between 30 and 40%. Note that the medians in the state are significantly higher than the MGFOA minimum recommended of 16.67%.
- Timing of cash flow. The fund balance ratio is normally measured at the fiscal year-end. Because local units have different fiscal year ends, the fund balance they may need to carry could be higher. This is because when they receive significant revenue, such as property tax, they may be at different points relative to their fiscal year-end.
- The volatility of revenue and expenditure. Local units must measure the stability of their revenue sources and expenditures. The more there is the probability of these changing significantly, the higher the fund balance the local unit should maintain.
- Size. The size of the local unit’s budget impacts the amount of money a local unit must keep in reserves. Larger local units tend to carry higher fund balances than smaller local units. A larger unit has more sources of revenues and expenditures and has more flexibility to make changes.
- Risk tolerance. Different boards have varying philosophies on how much risk they are willing to take. If a board is unwilling to take a large amount of risk, they may want to carry a higher fund balance than the medium.
- Planned Projects. Local governments, especially smaller local units, will use their reserves for the planned project. If you are saving for a new township hall or a fire engine, you may choose to have a much higher fund balance.
- Budget practices. Local units that don’t have strong budget practices may have to carry larger fund balances as they may not be able to establish revenue and expenditure streams.
Can your fund balance be too large?
Holding an extremely large unrestricted fund balance may seem like a fiscally conservative practice, but too big can be considered bad public policy. Local unit revenues primarily come from taxes in the form of property taxes, city income tax, and revenue sharing. Generally, this taxation is intended to cover the cost of providing services and cover unexpected events. If a local unit maintains a large reserve and has no documented plans for using those funds, it can face criticism from those taxpayers. In addition, community members can become frustrated if the dollars they are paying today don’t have a potential intended use. This can be translated to a feeling that residents are being over-taxed.
Maner’s Municipality Consulting Expertise
A trusted partner can help your government begin its journey to understanding and fully utilizing fund balance ratios to help maintain a healthy fiscal position. Being proactive today will reduce the more challenging decisions in the future.
Reviewing historical trends in fund balance, benchmarking against other similar local units, establishing a fund balance policy, and developing long-term budget forecasts are important elements of proper evaluation and controls we can assist with.