ARTICLE

The importance of financial analysis in public sector decision-making

January 19, 2016 – Justin Moorhead

Public resources are routinely committed or leveraged to achieve some intended public good. Here in the Virgin Islands this usually involves land leases, concessions or preferential use agreements and/ or the awarding of tax benefits conveyed as elements of our economic development programs. When committing or leveraging public resources (and in discussing these I include the forgoing as well as others), optimizing the choices among the cost of these concessions granted and the derived benefits requires a careful assessing of the true net benefits to the granting entity, and in turn the public.

Our community has limited resources. Maximizing return must be a foremost consideration when it concerns the use of public resources. Financial analysis ensures that the appropriate evaluations and choices are made commensurate with the proposed commitment of resources.
When decisions are made without appropriate financial analysis, there is legitimate reason for concern. Results that fall short of representations communicated or expected short change the community. Repeated occurrences foster public cynicism about the decision-making process and send signals that there is an opportunity to exploit public resources for personal gain because of those inadequacies.

From a good intention perspective, pubic sector decision-making most often proceeds with the public good solidly in focus. Government laws and practices exist to safe guard this. Laws allow for public recourse when this is not done. However, absent financial analysis, the side armed with appropriate analysis is better positioned to effectively negotiate on its own behalf.

Time constraint is always a concern in negotiations. The proponent has had the luxury of time while developing the proposal to think through all aspects of the transaction and determine what is in his or her own best interest. Reversing that advantage requires slowing the negotiating process down and allowing time for thorough analysis. Recognizing and addressing analytic limitations by engaging experienced and specialized assistance ensures the appropriate evaluation of complex and demanding initiatives. The cost of engaging knowledgeable practitioners is a cost of doing business and where necessary can supplement internal staff review. A side benefit of securing that analysis is that it provides decision makers a buffer against criticism of the basis on which a decision is made.

Good decision-making does not occur without the benefit of sound financial analysis. That analysis quantifies cost and benefits and assesses the intrinsic value of a given proposal. Doing it correctly, however, requires time to assemble information, understand the various aspects of the transaction, and complete the appropriate analysis. The higher the stakes the more thorough is the required review.

Each of us employs financial analysis when we choose among options. Most personal decisions are reached after using basic common sense with tinges of financial analysis. We consider the merits of each acquisition taking into consideration our available alternatives, the associated cost and desired benefits. However, when a decision involves multiple variables, there is need for comprehensive and sophisticated tools of analysis. Crunching multiple variables requires the application of those tools equal to the complexity and importance of the decision.

What we personally do is even more important when it involves community resources. These commitments sought, and when granted, are costly and the decisions made more often than not binary. Making one choice often precludes another. The complexity of the decision and the associated commitment of resources frequently define the community’s direction for years to come. Getting it right is critically important.

Why then does financial analysis receive such limited consideration? Possibly it is because we do not appropriately value public resources. Because we view taxes as unavoidable we do not make the immediate linkage between those dollars paid in and tax dollars expended. This is even more the case when non-local resources are involved. In short, where we would not consider committing our own resources, we are more likely to commit public resources.

Whatever the reason, public resources are often undervalued. What is overlooked, however, is that in this under valuing community expectations go unfulfilled and frustration is created for opportunities lost. Someone looses and it is those with the least to lose who loose most. Poor decisions disproportionately impact economic well-being and the community’s future ability to address needs and challenges of those most in need.

What then are the basic techniques that should be employed in financial analysis? Let me suggest four: Cost Benefit Analysis, Return on Investment, Net Present Value, and the shadow pricing of intangible social benefits. Each of these techniques complements the others, and together they offer an appropriate framework within which to evaluate the merits of any initiative.

When these analyses are performed, the choice among options is better understood and an objective assessment of outcome, which sets aside personal preferences and opinions, is possible.

Financial analysis, therefore, provides the information needed to understand the choices we make. What is important is that we have the needed information to make informed decisions. What is not important is that the analyses dictate our decisions. Other reasons may recommend alternative choices. However, armed with the product of sound financial analysis we understand the tradeoffs necessary to realize benefits important to the community. Decisions concerning the making of tradeoffs are reasonable determinants. What is unreasonable is being unaware of the implication of our choices. Analysis affords transparency and informed discussion.

Return on Investment evaluates what is received relative to what is invested. When we purchase an automobile we take money from savings or divert it from some other possible expenditure to complete the purchase. Our return is the attributes of the vehicle acquired and what that vehicle allows us to accomplish, whether that is basic transportation, status, convenience or increased productivity. Return on Investment, therefore, considers what we receive in return for the dollar committed.

Because the benefit received at some future time from the dollar invested today to acquire those future benefits is not of similar worth as it is today (consider inflation or the temporary loss of the ability to make an alternative purchase), Net Present Value lets us evaluate future benefits against the value of benefits derivable today. Net Present Value involves a complex discounting methodology, which is not particularly important to this discussion. What is important is the appreciation that what may appear as a reasonable return at a future date may in fact have less value than appearance suggests. Net Present value, therefore, allows a comparison of future value with today’s reality.

Cost Benefit Analysis looks at the full picture of cost and benefits. It takes into consideration all the benefits to be received and considers them in terms of all the cost involved in acquiring those benefits.

When transactions are considered the focus is often on the primary financial benefits and cost. Secondary and indirect cost and benefits are often ignored or inappropriately discounted. Some of these costs and benefits are intangibles. All, however, need to be considered in evaluating cost and benefits. And, a comprehensive cost benefit analysis allows evaluating all the component elements of an initiative.

Combining Cost Benefit Analysis and Net Present Value provides us information on the real value of those future benefits in return for the dollars committed today.

Coming together around shared values greatly aids in determining priorities, pursuing desired outcomes, and evaluating desired benefits from any initiative.

Quantifying, measuring and analyzing intangible cost and benefits are, therefore, also important elements in public sector decision-making and need to be evaluated in a well-developed analysis. The value each individual assigns to those benefits will differ based on individual priorities. However, accepting that there is intrinsic value to those benefits acknowledges shared community values. In bringing these benefits into our analysis we allow an opportunity for discussing the relative value of each to the community whose resources are being utilized.

Shadow Pricing allows us to assign a numerical value to benefits, more readily discussed qualitatively, yet, for the purpose of analysis, require quantifying. Shadow pricing offers us a technique for bringing intangible social benefits into our analysis. As previously mentioned, we open the door to constructive discussion of the tradeoffs we are willing to make to advance those benefits.

Consider environmental preservation. The importance of this social benefit to members of our communities is hopefully a shared value. It enhances the quality of life as well as ensures the attraction of our community to visitors. Quantifying this benefit is extremely difficult. We can, however, use a surrogate that is more easily quantifiable and use it as a stand in for this intangible benefit.

Visitors are attracted to our communities because of the esthetics of our natural environment. Visitors through their spending, expand our economy. As such, we can use visitor spending in part as a surrogate value for environmental protection and enhancement. We can then introduce this social benefit into our analysis. Visitor spending will increase or decrease as a function of how well we preserve our environment. By being able to assign a dollar value we are able to bring quantitatively the qualitative benefit of environmental protection and enhancement into the analysis.

I began by suggesting that financial analysis is important in the review and decision making process involving the commitment of public resources in pursuit of community good. In an environment of limited resources, there are no projects with long-term implications that should escape this analysis. Decision makers should require that these analyses be completed. Its absence must be highlighted and corrected. In a community with limited assets, financial analysis provides us a tool for ensuring we maximize return on all our available resources.