Introduction

GCR's Criteria For Rating Local Authorities

GCR is the leading rating agency in Africa, rating more organisations than any other rating agency. GCR's expertise in the local authority sector spans across southern, eastern and western Africa. As definitions vary widely, this methodology covers metropolitan councils, municipalities, local authorities, regional councils, local governments and district councils.

GCR's rating approach employs analytical techniques that incorporate quantitative and qualitative factors. Our rating reflects an evaluation of the organisation's current financial position, as well as how the financial position may change in the future. In addition, our analysis focuses on a range of administrative, economic and system factors. GCR examines the ability of the organisation to meet its obligations under reasonable and stressful scenarios. Although this methodology focuses on rating general obligations, it is also relevant to specific debt issues.

The following guidelines provide a general overview of the quantitative and qualitative factors that GCR considers when analysing a local authority. For the sake of simplicity, this methodology refers to local authorities, although this term may be used interchangeably with metropolitan councils, municipalities, regional councils, local governments and district councils.

Fundamental analysis is the basis for ratings assigned by GCR. GCR's opinions are based on a clear understanding of the fundamentals of the rated organisation and the industry in which it participates. These guidelines are intentionally broad in scope, recognising that assigning credit ratings is a dynamic process and each entity possesses unique characteristics and assumes varying levels of risk.

GCR's analytical process focuses on the following key areas:

Our analysis of the economic structure revolves around a fundamental understanding of the local authority's key economic drivers. In order to ascertain the local authority's fiscal health and stability of revenue growth, GCR will examine the magnitude, diversification and other key characteristics of the economic base. Sound economies are typically underpinned by a growing revenue and output base, private and public investment, construction activity and a diversified retail sales sector.

Our first step is to establish the local authority's relative economic position, both from a regional and a national perspective. Factors considered include geographic location, size (both in terms of population and land mass), income levels and infrastructure development.

The diversification of the underlying economic base is considered and the nature of the largest industries and/or employers is taken into account.

This takes cognisance of studies that have demonstrated the correlation of concentration and default, especially with regards to smaller entities. Local authorities that are dependant on a single sector or employer are also more exposed to seasonality and volatility.

The nature of the labour market is also evaluated, including unemployment levels, income levels (measured by per capita income and per capita GDP), stability of the employment market and employment growth trends. In general, higher income per capita income levels translate into increased flexibility to increase taxes.

Another consideration is the trend in the local authority's infrastructure and private and public investment. This is performed in conjunction with an analysis of the demographics and growth prospects, in order to ascertain that the long term structural needs of the entity can be met. Economies that grow too rapidly usually place excessive strain on infrastructure, while declining economies are also viewed unfavourably due to diminished revenue receipts and increased concentration levels.

Lastly, GCR analyses the geographic location of the entity and the proximity to major economic hubs within the area, bearing in mind the strategic importance of the entity from a national perspective. Access to transportation facilities, both locally and nationally, is a key consideration, including transit facilities such as railways, ports and airlines. The state of the local public transport system is also assessed.

The demographic composition of a local authority is analysed in conjunction with its economic structure. This is especially pertinent when viewed in the context of the ability of the population to influence the demand for public services and future revenue growth. GCR recognises that the local authority's size itself is not a decisive factor, although size may be reflective of other favourable attributes, such as diversification.

Some of the factors that are taken into account include:

Our analysis of the demographic composition is viewed in conjunction with the economic and infrastructural development in order to gain a thorough understanding of the socio-economic status of the local authority. This takes into account the energy sources used per household, as well as the availability of water, sanitation, refuse removal, dwelling type and telephone and other communication services. This is particularly important with regards to emerging or under-developed economies, and cognisance is taken of the ability of the local authority to extend these services to its population. In this regard, GCR will closely examine the capital expenditure budgets of the local authority and key utility companies within the area.

Although fundamental analysis of the local authority forms the cornerstone of our assessment, it is important to stress that GCR does not subscribe to a ‘box' approach. This implies that we do not simply infer a rating based on our fundamental analysis. Rather, the approach is to integrate our fundamental and quantitative analysis with a strategically based qualitative analysis.

Revenue

Our analysis in this area focuses on the source of revenues, particularly the diversification and volatility. A distinction is made between internally and externally generated sources of income and the relative contribution from each source.

For the most part, internally generated funds (such as taxes) are directly under the control of the local authority and a greater proportion of internally generated funds is therefore indicative of enhanced financial flexibility. Local authorities that are more reliant on external sources of revenue (such as grants or subsidies) are considered more vulnerable. However, there are exceptions to this; for example, GCR would consider it favourable if such external sources were guaranteed for a certain minimum amount of time.

An assessment of the current tax base is made, as well as the sustainability thereof. For example, tax revenues from property are viewed in conjunction with the historical and forecast trends in the property market. Although property taxes tend to be the most stable, a more diversified revenue base may allow the local authority to access additional sources of income.

A key criteria in this area is the ability of the local authority to collect its revenue, a factor which is usually more pronounced in emerging markets. GCR will evaluate the distribution losses in utility accounts (such as water and electricity), as well as the existence of low payment levels on rates and taxes.

The assessment of expenditure revolves around fixed versus variable expenses and whether these expenses are discretionary or non-discretionary. At all times, a comparison is made with the local authority's historical trends, as well as local and national norms. The relationship between discretionary expenses (such as redundant capital expenditure) and non-discretionary expenses (such as debt service payments) is important. Our aim is to assess the minimum level of expenditure necessary to maintain the current operations and cater for expected future growth.

Staff costs often make up the single largest portion of expenditure and special attention is placed on the local authority's ability to rationalise these costs if they are out of line with industry norms. Other variable costs are analysed in a similar manner.

Finally, we assess the ability of the local authority to meet any major budgeted expense items, such as large project financings or debt maturity concentrations.

Debt burden

An appraisal of the debt burden commences with the quantum and maturity profile of the debt, which is then segregated into long term and short term debt. Particular emphasis is placed on any undue maturity concentrations, and the ability of the entity to meet these obligations in the absence of available refunding options.

The unique characteristics of each local authority dictates that there are no hard and fast rules with regards to the debt position. Cognisance is taken of the local authority's lifecycle – a growing entity will usually require additional debt in order to expand its infrastructure. Our analysis also takes into account the need to repair or replace infrastructure that has deteriorated.

As an indication, total debt above 75% of income may indicate an excessive debt burden. Other pointers include the ratio of debt to the ratable value of property, which, once again, is viewed in the context of that particular local authority.

Our analysis of the local authority's liquidity position focuses not only on year end balances, but also takes into account the entity's liquidity needs during the year, bearing in mind the seasonality of liquidity requirements.

The main items considered include the actual cash flow generated and retained by the local authority (versus accounting earnings), as well as the quantum of cash and equivalent investments that are held.

Particular emphasis is placed on the quality of these investments, taking into account GCR's ratings (if available) of the counterparties. The key ratios include gross and net debt service coverage, operating cash flow to debt service, current ratio and days cash on hand. Although these ratios may vary by country, ratios that are less than 60 days cash on hand and/or less than 2.5x gross interest coverage are usually indicative of some liquidity constraints.

Efficiency

The management and administration capacity (discussed further on in this report) of a local authority can directly impact on the entity's efficiency, in tandem with the composition of revenue and expenses. As such, these areas are all evaluated concurrently.

In essence, our aim is to gain an understanding of the local authority's financial, administrative and operating capabilities. In common with many other areas of analysis, the entity's efficiency statistics are compared with relevant benchmarks, including local, national and international norms.

Firstly, an analysis of the actual debtors book is performed in order to ascertain the quality of the portfolio; including the adequacy of provisions, bad debt policies, collection procedures and historical trends. Thereafter, the ratio of debtors (or collection) days outstanding is calculated in order to determine the entity's ability to collect from its debtors. Debtors over 90 days in arrears usually warrant further attention. Other indicators of poor credit quality may be derived by comparing the ratio of the gross debtors book (by value) to revenue.

In the event that the local authority is a reseller or supplier of utility services (such as electricity or water), the extent of distribution losses must be determined. In general, losses should not be greater than 10%, although water losses are typically higher than electricity losses in Africa.

Lastly, the revenue and expense accounts are analysed in order to determine if there are any undue inefficiencies. For example, we examine the ratio of trading income to total income and staff expenses to total expenses.

4. Political and legal considerations

Our first step in this area is to gain a thorough understanding of the legal environment in which the local authority operates. Factors that are considered include the role of the regulatory authority, interaction with other government departments and the legal dispensation under which the local authority operates.

GCR also takes cognisance of whether the local authority can rely on central government support in the event of stress or financial difficulties, which will be factored into our rating decision. GCR will also examine any potential limitations or exclusions on the local authority. For example, a local authority may not be able to increase its taxes beyond a certain percentage. Another consideration is the political environment and how this impacts on the local authority. For instance, the central government may be able to impose its power over the local authority.

Undue political influence can affect the ability of the local authority to act effectively and efficiently. Lastly, the general political arena can affect the macroeconomic environment, such as the interest and inflation rate, which can ultimately affect the local authority.

In line with the definitions put forward by the International Swaps and Derivatives Association (“ISDA”), GCR generally recognises a standard credit event as either failure to pay, bankruptcy, repudiation or moratorium, acceleration, or restructuring. However, in the case of a local authority, it is important to distinguish between default and long term insolvency. Although a default can occur, it is usually highly unlikely that the central government will allow the entity to enter liquidation proceedings. It is in this context that the legal and regulatory framework is carefully analysed. Careful attention is also placed on the ‘importance' of that specific entity from a regional and national perspective. Typically, no provision for the ‘bankruptcy' of a local authority will be made and, in these circumstances, some form of implicit support from central government will be factored into our rating. This anomaly is overcome by differentiating the long term and short term rating of the local authority – the long term rating may be positively affected (typically by one or two notches), while the short term rating will remain unchanged.

In terms of the most recent default studies, the statistics indicate that the recovery time for local authorities tends to be longer than corporate defaults, although this is counterbalanced by the higher recovery rates on local authorities.

5. Management and administrative structures

Management represents the final area of analysis, although all areas of analysis discussed above in some way reflect an evaluation of management's strengths and capabilities.

Success or failure in the previously discussed areas often represent the best ‘report card' on management. GCR evaluates management's strategy in relation to the entity's overall strengths and the current market environment. Management's policies and procedures can add stability to weak credits, or, alternatively, can negatively affect strong economies.

Our specific evaluation of management focuses on the following key areas:

GCR analyses the ability of management to adjust to changing conditions in an efficient and effective manner, recognising that flexibility is crucial. The relationship between the management structure and key political and governmental entities is evaluated. The local authority should also not be exposed to ‘key man' risk.

Our assessment of the control environment dovetails with all other areas under the management and control environment. The reporting and control structure is evaluated in order to assess any ‘weak links'. Expenditure controls, revenue collection procedures, cash management systems and investment policies are evaluated. A thorough understanding of management's appetite for risk is gained, from a financial, operational, structural and technological point of view. Of particular importance is an analysis of the borrowing capacity of the local authority and how this authority is exercised and regulated.

The analysis of this area focuses on the budgetary forecasting and monitoring systems and management's track record of meeting its forecasts.

Particular emphasis is placed on the ability of the entity to generate timely and comprehensive financial reports, including an assessment of the thoroughness and consistency of budgets. The most important issue in this regard is the variance between initial budgets and actual performance. An analysis of the information technology platform is undertaken in order to ascertain the capabilities of the system, with reference to the relevance and timeliness of the information.

The overall strategic vision is reviewed, taking cognisance of the current and projected circumstances of the entity. GCR appraises the operating, capital expenditure, revenue, allocation and staffing budgets.

The increased demand for credit ratings reflects the growing role played by local authorities in capital markets, particularly in emerging and under-developed markets.

While thorough quantitative analysis is important, the qualitative characteristics of our analysis cannot be overemphasised. It is critically important to look “beyond the numbers” to evaluate the intangible strengths and weaknesses of an entity. An important aspect of GCR's analysis is an understanding of the strategic characteristics of an organisation and the quality of management. Our emphasis is on determining how these strategic aspects will affect the organisation's credit rating.