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Setting the Right Fund Balance

City and town officials often debate the appropriate level of their fund balance — the municipality's current net assets minus its current liabilities. A fund balance is similar to the working capital of a business, necessary for ongoing operations, but municipal fund balances use public funds instead of private dollars. These balances are sometimes misunderstood and criticized as an unnecessary accumulation of money, but they are necessary for cash flow and risk management.

Value of a fund balance
A fund balance can smooth the cash flow from revenue cycles. Municipal services have recurring costs — personnel, utilities, fuel and other operating expenses. Many revenue sources, like property tax and business licensing, have annual payment cycles that do not match with the timing of expenses, creating a need for available cash.

Fund balances can also serve as an alternative to tax anticipation notes and their associated expenses. Balances also impact the municipality's credit rating, which influences loan decisions. Historically, both banks and credit rating agencies have relied heavily on the size of a municipality's fund balance level when determining credit worthiness. Having a reasonable fund balance makes borrowing money easier and less expensive.

Maintaining a healthy fund balance can also help a municipality weather revenue shortages, such as from economic downturns or natural disasters. Disasters often require spending local funds before insurance reimbursements or state and federal aid can flow into the municipality. Expending 20% to 25% of the annual budget before assistance becomes available is not unusual.

Determining the right amount
Determining an appropriate fund balance requires looking at the weaknesses, risks and financial goals of the  municipality, as well as understanding the local political beliefs and risk tolerance on funding matters.

Other things to consider in the analysis are the relationship to the beginning of the fiscal year to the timing of major revenues and large expenditures, the volatility of both expenses and revenues, natural disaster vulnerability, desired creditworthiness, and local economic conditions.

The Government Finance Officers Association recommends that "at a minimum, those general-purpose governments, regardless of size, maintain unrestricted fund balance in their general fund of no less than two months of regular general fund operating revenues or regular general fund operating expenditures." This minimum equates to a fund balance of at least 17% to 20% of the general fund, before taking into consideration any unusual local factors that may require higher or lower fund balance levels.

Fund balance policy
Cities and towns should adopt, by ordinance, a formal fund balance policy. It should specify:

  • a mandatory minimum level of funding,
  • when use of the balance is appropriate, and
  • what items can be funded if the fund balance exceeds the minimum level set by council.
  • Thoughtfully created fund balance policies can counteract criticism for maintaining a fund balance.

In the long run, a municipality will be well served by maintaining a reasonable fund balance, which helps to bridge cash flow, avoid interest costs from short-term borrowing, preserve a credit rating, and provide a buffer against revenue shortfalls or expenditure overruns.

The Municipal Elected Officials Institute of Government addresses key aspects of local government finance in its on-demand course "Basic Budgeting and Municipal Finance." Learn more at www.masc.sc (keyword: MEO Institute).