By: Fran David, Avenu Advisory Board Member
Jurisdictions at all levels of government are experiencing or planning to experience serious gaps between revenue and expenditures related to COVID-19. These deficits may be caused by a shortfall in revenue due to the economic shutdown in response to the coronavirus, unexpected costs necessary to respond to the pandemic, or both. The most difficult and perplexing question many jurisdictions are asking is “when or if we should use financial reserves to address these deficits?”
Why is this such an important question when managing an immediate crisis? What difference does it make – the money has to be spent; the crisis must be addressed. The answer may be critical to the long-term financial health of the organization, indeed to its very long-term existence.
Two Types of Financial Challenges
Almost all public organizations face two kinds of financial challenges throughout their existence. One is cyclical is short term in nature, caused by a one-time or short-term event (e.g., unplanned-for occurrences such as a bridge collapse or a natural disaster or a drop in market demand.) A cyclical crisis can be addressed using short-term tools with the understanding that the financial need will be short-lived (i.e., will occur in the current fiscal year only or over a defined and known short period). The second type of fiscal challenge is a structural deficit, which is longer term and will not disappear in one to two years, but rather continues across multiple budget periods. It is a fundamental flaw in the organization’s operating structure that has likely been building under the surface and cannot be corrected by a one-time infusion of cash (e.g., escalating employee costs like healthcare or retirement).
When to Use Reserves
In the public sector, financial reserves have always been a topic of frustration, temptation, and potential misuse. Rarely are they maintained at levels recommended by public finance experts such as the Government Finance Officers Association (GFOA) and many others. Too often reserves provide a convenient, but inappropriate, solution for temporarily mitigating a negative impact of long-term financial problems. The consistent or long-term use of financial reserves usually masks a more serious underlying structural issue in the organization. And the matter can be further exasperated by the availability of one-time funds such as proceeds from asset sales, one-time state, federal grants, or “pay-backs”, or court settlements, etc. These short-term cash infusions also help mask the dangerous underlying cracks in the organization.
When a major crisis occurs, it raises the question of whether to use financial reserves to meet the needs of the organization. There are four tests that should be applied within the decision-making process of the organization’s leaders when making that decision:
- The Organization’s General Financial Health: Does leadership have a consistent and firm understanding of the organization’s long-term financial health?
- Was the organization on solid financial footing before the crisis occurred?
- Is there a structural deficit hidden within?
- Does the organization normally maintain adequate or better reserves (i.e., is there a “reserve policy” and does the organization normally adhere to that policy)?
- Does the organization have and use a well-constructed, up-to-date long-term, financial plan for all funds (i.e., based on tested assumptions, that are intelligently projected into the future, and which span at least five years)?
- Maintenance of Reserves: Is the use appropriate and can the reserves be quickly replenished without financially crippling the organization in the process?
- Does the organization have existing policies for the use of reserves and is the intended use of reserves consistent with those policies?
- Can the immediate crisis-related need be met with only a one-time use of reserves, or is there likely to be an on-going annual need?
- If reserves are used, can they be restored to healthy levels (according to policy) within a short time of the expenditure (e.g., one to three years)?
- Operational Health of the Organization: Does the crisis offer opportunities?
- Was the organization operating efficiently and effectively before the crisis?
- Does the crisis offer opportunities that the organization should be taking advantage of instead of funding business as usual?
- Are any of the changes in processes or practices forced by the crisis considered to be “keepers” (i.e., teleworking, virtual meetings, etc.)?
- What are the resulting costs or savings?
- Do they require an investment to make them robust and fully productive?
- Alternatives: Are there good alternatives to using reserves or is leadership simply taking the easier path?
- Change in services or service levels
- Innovation or pivoting
The Complexities of the Pandemic
The conundrum of COVID-19 is not knowing the length or severity of the virus threat compounded by not knowing when the economy will return to “normal”. This makes it almost impossible to determine when the costs associated with the epidemic will diminish or stop and/or when the revenue stream will return to pre-epidemic levels, if at all. This in turn clouds the choices available to policy makers and their executive leadership to cover the financial gap.
We already know that jurisdictions are being affected differently by the COVID pandemic. Some communities have a better chance of a quicker recovery than others. Many cannot easily identify when their revenue stream may return to pre-pandemic levels or when their economy will grow to its previous robust health.
All this confusion provides both demanding challenges and opportunities. The use of reserves to mitigate the destructive impact of COVID-19 should not be employed lightly. Those organizations that can see a light at the end of the tunnel may be well within good financial management to use reserves to help their community survive the negative impacts of the pandemic and maintain service levels to their community. These would be communities whose tax base is not severely eroded by the pandemic, who can realistically project a swift return to pre-pandemic revenue levels; or communities that can securely identify an end to the need for spending from reserves, and have rigorously asked and answered Questions 1-4 affirmatively and honestly.
Communities that are experiencing a deep erosion of their revenue streams due to COVID-19 may need to strenuously avoid the use of reserves except in the most demanding and critical of circumstances. An example of such communities might be those dependent on revenue from the hospitality, convention, or restaurant industries. It is highly unlikely that those revenue streams will return to “normal” levels in the short term. At the very least, it is currently impossible to determine when the revenue stream may even begin to flow again. These communities should also rigorously ask and answer Questions 1-4.
However, after doing so, these communities will most likely need to focus on Questions 3 and 4 and plan for a vastly different future going forward. In this case, financial reserves should only be used as a small part of a much more dramatic survival plan. Such a plan may mean drastic cuts in staff or services, dramatic changes in service delivery, implementation of high-risk innovation processes, investments in new technology or processes, or even bankruptcy.