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Financial Management and Analysis of Projects : 4. Financial Management of Executing Agencies
4.4.5. Selecting Indicators and Covenants4.4.5.1. Introduction4.4.5.1.1. This section provides advice
and guidance on the selection of performance indicators and financial
covenants that are likely to advance and secure efficient and effective
financial viability and financial integrity for the wide range of
EAs that seek funding of revenue-earning projects from ADB. This section
does not apply to FI. Specific advice and guidance on FIs is provided
in section 6.4.
4.4.5.2. Questions before Selecting Performance Indicators and Covenants4.4.5.2.1. The following checklist
should be consulted when selecting performance indicators and covenants:
4.4.5.3. Objectives of the Use of Financial Indicators and Covenants4.4.5.3.1. The primary objective is to achieve and or sustain the financial viability and integrity of public and private sector projects and EAs that are financed by ADB. Borrowers and ADB that jointly agree on the achievement of this objective at loan negotiations recognize that its accomplishment may extend at least over the period of project implementation, commissioning and achievement of a steady state of operations. This period will probably cover a minimum of 5 years.4.4.5.3.2. Meaningful performance and financial forecasting over extended periods of time is not possible. Projected financial performance information can only be indicative, rather than realistic. There will be inherent risks that not only the designed project content and performance may change, but that the prevailing financial and economic conditions in which the project is to be constructed and operate will change. Recognition of the inherent risk means that ADB's and a borrower's agreed definition of the type of financial indicators and financial covenants with their specific measurement criteria at loan negotiations must change as physical, financial and economic conditions change in the future. The following references to PAI 5.03 are included to draw attention to ADB's facilities to address the modification of a performance covenant under changing circumstances. 4.4.5.3.3. PAI 5.03, Part B (Review of Covenants) recommends that ADB staff should report on the continued validity of special loan covenants (such as those used to prescribe financial performance) and, as standard practice, attach to the BTOR an appendix detailing the status of compliance with all covenants. In addition, PAI 5.03 (Part C: Follow-up Actions) addresses a borrower's failure to comply with loan covenants and recommends, according to circumstances, that staff should consider whether the covenant should be amended, whether an extension be granted, whether alternative measure should be introduced, or whether the covenant should be waived or deleted. It should be noted that a borrower may continue to comply, but the performance required may have changed to become more severe or constraining (for example, increased efficiency of inputs and/or outputs), thus reducing the validity of the covenant concerned. In such cases, ADB staff should also use the provisions of PAI 5.03 to introduce more meaningful performance requirements into a covenant. 4.4.5.3.4. The financial covenants should also enable reviewers to specify an agreed date or dates for subsequent reviews. The covenants should provide for earlier review in the event that the borrower/EA is not in compliance with the covenant at any time. 4.4.5.4. Financial Viability and Integrity of Projects and Executing Agencies4.4.5.4.1. The achievement of this goal requires that the EA meets targets of physical, economic, and financial performance as specified in the RRP and agreed with ADB at loan negotiations. Specific definitions of financial viability and integrity should be defined in the RRP. These may be extensive, but as a minimum should include one indicator selected from each of the following ranges: (i) revenue indicators, (ii) capital structure indicators, and (iii) liquidity indicators.4.4.5.4.2. The selected indicators should be the subject of financial covenants where agreement is essential to achieve the objectives and financial viability of the project and/or the EA. Noncovenanted indicators should be agreed with the EA and included in the reporting requirements provided by ADB to the EA at project start-up. Where appropriate, additional indicators should be included, either within covenants or in ADB's financial reporting requirements. 4.4.5.5. Cash Requirements4.4.5.5.1. Most operating and capital adequacy indicators are formulated on the basis of accrual information. This means that they may not adequately disclose an EA's liquidity (actual cash) position. An exception is the cash-based Self Financing Ratio Covenant that provides a definition of cash availability for performance.4.4.5.5.2. ADB's experience shows that lack of, or insufficient, cash are a major cause of nonperformance by EAs. Therefore, a liquidity indicator, preferably the Quick ratio or "acid test", should be provided for each project, but note that this is a "snapshot" view at one point in time (e.g., balance sheet date). This "snapshot" defect can be substantially overcome by calling for a periodic report to provide a table of month-end quick ratio results for the preceding 12 months (or such other appropriate period). 4.4.5.6. Managing Operating Costs4.4.5.6.1. ADB recommends to borrowers that their public and private sector revenue-earning enterprises should be required to meet a "reasonable portion" of their investment requirements from internally generated funds, after providing for costs of operation and maintenance, taxes, incremental working capital, debt service, and any dividend requirements. The generation of this "reasonable proportion" is heavily dependant on the relationship between operating costs and operating revenues. The smaller the share of revenues consumed by operating expenses, the larger the amount available for meeting taxes, incremental working capital, debt service, and any dividend requirements with the residual to provide the "reasonable portion" of investment requirements.4.4.5.6.2. It is critical that there should be an effective measure of performance for the level of operating revenues consumed by operating costs. This measure is the operating ratio. An alternative indicator, which should only be used to bring stability to a financially ill-managed EA, is the breakeven ratio and covenant. 4.4.5.6.3. Each of the projects listed in section 3.2.1 should be asked to provide an operating ratio in periodic and annual reports, and where necessary, in parallel with an operating ratio covenant. 4.4.5.6.4. In addition to seeking an overall reduction in costs, it may be necessary to select one or more categories of costs to seek specific reductions. Levels of salaries and wages frequently require specific indicators. There can be other costs, such as fuel, transportation, management and administration, etc. that should be the focus of the EA's and ADB's attention by use of indicators. 4.4.5.6.5. Where an operating ratio indicator is to be installed using a financial covenant and it is proposed that the levels of operating costs should decline in real terms over a defined period, the covenant should define the appropriate performance indicator(s) and the selected years of covenanted performance. 4.4.5.7. Managing Operating Revenues4.4.5.7.1. Where there is a need to assist an EA to improve its revenue generation, either in parallel with operating cost improvements, or with respect to improving operating revenues only, the Operating Ratio should also be used with appropriately designed performance indicators and the respective years of recommended performance.4.4.5.7.2. Indicators should be used to show the performance of each revenue category (e.g. domestic, commercial, industrial, etc. or passenger traffic, freight traffic, etc.). Typical indicators are "Percentage Growth in Revenues" and "Gross Profit Margin" together with billing performances (number of consumers billed by billing periods, or annually). 4.4.5.7.3. Where an operating ratio indicator is to be installed using a financial covenant and it is proposed that the levels of operating revenues should increase in real terms over a defined period, the covenant should define the appropriate performance indicator(s) and the respective years of covenanted performance. 4.4.5.8. Asset Revaluation4.4.5.8.1. ADB and other MDBs have, in the past, accepted the use of both historical cost accounting, and modified historical cost accounting (where assets are revalued on a regular basis). While both these accounting methods are consistent with IAS, historic cost accounting is the benchmark treatment, with revaluation the alternative. However, ADB and the other MDBs will seek to agree on a consistent policy position on the revaluation of assets, or otherwise, as part of the harmonization exercise.4.4.5.8.2. In the meantime, and in keeping with general ADB practice, asset revaluations should be undertaken where that is the standard practice of the particular country. However, if asset revaluations are undertaken: (i) the whole class of assets should be revalued at the same time (e.g., land); (ii) a robust methodology should be applied that accords with generally acceptable practices (e.g., as applied by the International Valuers' Association), the use of price indices and other less robust revaluation methods should not be used; and (iii) the assets must be revalued on a regular basis (e.g., every 3 years). 4.4.5.9. Managing Funds for Investment and / or Reserves4.4.5.9.1.The rate of return on net fixed assets is appropriate under low inflationary conditions. When inflation is forecast to exceed 7% per annum over the 5 years from the date of loan effectiveness, the practice has been to require a periodic revaluation of assets.4.4.5.9.2. Where a self-financing ratio covenant is proposed, ADB's current version calls for cash generation (rather than funds generation). This change was made to reflect the need for an EA to be able to meet its commitments in cash with the objective of encouraging contractors and suppliers to provide timely support for the project. However, this modification will only be successful if the EA effectively meets the terms of the covenant, by generating cash to support self-financing. 4.4.5.9.3. Each of the projects listed in section 3.2.1 should be asked to provide either (i) a rate of return on unrevalued net fixed assets; or (ii) self-financing ratio indicator, in periodic and annual reports. One or both of these indicators may be included as financial covenants. 4.4.5.9.4. The objective of using both indicators in covenants would be to try to ensure that the EA generates sufficient cash to at least meet the self-financing ratio. This latter ratio should be established at a level that is estimated to correspond to the funds required to support the rate of return indicator. 4.4.5.10. Assuring Capital Adequacy4.4.5.10.1. All capital has a cost, even in circumstances where a government may waive interest or dividends on equity (grants), or where a donor may provide a grant. This latter case represents the cost to another worthy cause that didn't benefit from the grant proceeds and had to forego the benefit, and possibly find an alternative at a cost.4.4.5.10.2. Capital primarily comprises equity, loans, and grants. Typically the highest cost is equity, due to the risk of a failing investment. Loans are normally at a lower cost than equity although short-term funds in high risk/inflationary conditions may exceed long-term equity cost (but under such conditions, the latter may not be available). 4.4.5.10.3. An EA that seeks capital should minimize its capital costs by seeking the lowest cost selections between loans and equity; the latter can be either obtained from investors or from retained earnings (which are frequently measured by the return on investments). 4.4.5.10.4. The effectiveness of such a policy is typically judged by the debt-equity ratio. While it may be argued that a revenue-earning EA that is controlled and funded by government should not be concerned about the level of its debt, recognize that such loans usually are part of a government's borrowing ceiling, and , as such, may deprive other government agencies of scarce funds. 4.4.5.10.5. When redistribution of resources is a key element of ADB's policy for the country concerned, a revenue-earning entity should be encouraged to generate revenues to make surpluses available for redistribution by government, providing the EA is able to retain sufficient funds to assure its own financial viability and integrity. 4.4.5.10.6. A debt-equity ratio will vary according to an EA's financial policies and perhaps the government's also, where the entity is in the public sector. The long-term aim should be to sustain a level of cost of capital that virtually balances between the two sources of funds. A 60:40 debt-equity ratio should imply that the cost of equity is about 1.5 times that of loan interest rates-or (say) 12% for equity to 8% for loan interest per annum. If the equity proportion in the indicator should exceed the level of debt, this can mean that the EA should be seeking an improved return on its capital. 4.4.5.10.7. Delinquent payers with a poor capital structure, and poor earnings records will attract high loan rates. As an example, a public sector water utility with a high level of government equity and loans from MDBs and similar concessional lenders will have serious difficulty in breaking out of that pattern. Unless EAs can develop a record of timely settlements and earnings growth that will attract lower cost loans, availability of venture equity will be scarce, should it seek privatization. 4.4.5.10.8. ADB, therefore, encourages its borrowers to achieve satisfactory debt-equity ratios and debt-service coverage performance as a means of attracting other lenders to replace ADB as a lender of last resort. 4.4.5.10.9. In addition, ADB may wish to limit the debt that a borrower/EA may incur, sometimes to encourage the use of equity, usually through internal cash generation, but also to prevent an EA from borrowing for noncapital purposes, such as supporting declining operating revenues. 4.4.5.11. Deciding on Indicators4.4.5.11.1. The financial analyst should:
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