A financial condition index for Nova Scotia municipalities.

The importance and increasing demand for local government financial condition indicators
is well evidenced by the many recent articles and studies devoted to the subject by practitioners
and academics in north America and throughout the world. In Canada, where municipalities are
legally, (creatures) of the provinces, the need for reliable and consistent financial information at
the provincial level of government is essential to the formulation of fair and effective public policy.
This is especially true in the province of Nova Scotia where recent changes to provincial
legislation, including the amalgamation of urban municipalities and provincial municipal service
exchange, have had a significant financial impact upon the povince’s 55 remaining local
governments. Thus, in the fall of 1995, the Nova Scotia department of municipal affairs undertook
a research study to establish a single comprehensive index by which it could compare the financial
health of various local governments and monitor the condition of specified municipalities over
time.
Identifying potential indicators
In developing this index, examples from various jurisdictions were reviewed to ensure that
the wheel was not being reinvented. In Canada, with the exception of the province of
Saskatchewan, existing indicators tended to focus almost exclusively on borrowing limits and
levels of municipal debt. The overriding purpose of many of these indicators seems to have been
the provision of aquasi credit rating to provincial lending agencies of other nongovernmental
investors. While the “10-point test of financial condition” featured in the December 1993 issue of
government finance review was arguably the most practical model encountered, its emphasis on
simplicity of use contradicted Nova Scotia’s goal of establishing a comprehensive index.
Conversely, an index rating for local governments, developed by the Harvard institute for
international affairs and Indonesia’s department Keuangan, appeared to be extremely cumbersome
and reliant upon a great deal of qualitative information. Somewhere between these two models it
was hoped that an index could be developed which would include as many measures of financial
condition as possible while at the same time avoiding excessive complexity.
The first step towards realizing this end was the identification of potential indicators. The
goal was to develop a truly comprehensive list and then eliminate those which were deemed to be
irrelevant or not susceptible to quantitative measurement. More than 100 measures of financial
condition were identified and categorized initially as revenue and expenditure, taxation, debt
burden, economic, or service-level indicators. In the final analysis, service-level indicators were
eliminated, as these were deemed to reflect individual municipal expenditure preferences as
opposed to actual measures of financial condition. Many more were eliminated due to the absence
of consistent data at the municipal level in Canada.
Seventeen indicators of financial condition, illustrated in Exhibit 1, were considered to be
both relevant to the structure of municipal government in Nova Scotia and amenable to statistical
comparison and manipulation. Many of these indicators appear to measure the same general
dimension of financial condition; for example, it can be argued that debt per taxable assessment,
per capita debt, and debt service burden all measure the general level of indebtedness of a particular
municipality. Rather than simply select one of these indicators and disregard the remaining two,
analysts used a process known as factor analysis, which made it possible to include the information
contained in all 17 indicators in the final index and to weigh them according to their value as a
measure of financial condition.
Applying Factor Analysis
Factor analysis is a complex statistical procedure which is now available in easy to use
formats on many microcomputer statistical software packages. The advantage of factor analysis is
that it allows the user to determine the number and nature of the broad dimensions that underlie a
larger number of measures. The disadvantage is that it involves mathematical formulas that are
often too cumbersome to perform by hand. As a consequence, results are often abstract and
difficult to justify in plain language. In terms of scientific rigor and reliability, however, few
alternatives compare.
In the Nova Scotia example, factor analysis provided a means of assessing whether the 17
variables in Exhibit 1 were actually measures of the five preconceived categories of dimensions.
When the variables were arrayed and weighted, as illustrated in Exhibit 2, it was concluded that
the initial categories of revenue and expenditure, taxation, debt burden, and economic indicators
were, for the most part, inappropriate. In their place, factor analysis created a different set of factors
without assigning names to them. These five factors were used to statistically divide the concept
of financial condition into a unique set of underlying components, which were labeled simply
“factor 1, factor 2, etc.
 The numerical entries in Exhibit 2, known as factor loadings, are the result of a complex
process performed by the computer whereby each of the variables is compared to every other
variable in multidimensional space. Simply stated, these numbers measure the extent to which a
given variable is related to each of the five factors or dimensions which identify the five columns
of the table. The higher the factor loading (i.e., the closer to 1.0), the stronger the relationship
between the variable and the underlying dimension. A negative loading indicates that the variable
is negatively related to the factor in question. The boldface entries in Exhibit 2 represent the factor
upon which each of the variables loads most heavily (i.e., the highest loading in each row). All
loadings less than 2 in absolute value have been eliminated from the analysis for ease of
interpretation; thus, the total number of variables was reduced to 15. Each of the variables seems
to load heavily (i.e., greater than 0.5) on at least one of the five under- lying factors.
By observing the variables which load most heavily on each factor. The boldface entries in
each column a reasonable interpretation can be made by the observer as to what they all have in
common. So that an identifying label can be attached to each factor. The process of identifying
each of these factors describes is subjective; it involves examining the variables that load most
heavily on each factor and concluding what those variables have in common.
Exhibit 3 illustrates the variables that loaded most heavily on factors 1 2, and 3. Since a
total of only three variables loaded on factors 4 and 5, these were eliminated from further analysis
for ease of interpretation, and no effort was made to attach a label to them. Examination of the
variables loaded on factor 2 reveals that it is unambiguously a measure of debt burden. Factors 1
and 3 required some added interpretation. It was concluded that the five measures comprising
factor 1 were related to a given municipality's general fiscal condition, whereas the four variables
included in factor 3 related to the tax base from which revenues could be drawn. Thus, factors 1,
2, and 3 were labeled fiscal condition, debt burden, and revenue base, respectively, by the
researchers. The fact that some loadings in factor 1 (see Exhibit 2) are negative presents no
intuitive difficulty. For example, a "healthy" municipality would be expected to have a low level
of intergovernmental revenues (negative factor loading) and a high percentage of taxes collected
(positive factor loading).
Having reduced the 17 variables to three factors without the loss of any information, the
analyst’s next step was to assign weights to each of the three factors according to their relative
ability to define a particular municipality’s financial condition. The statistical software was able
to perform this otherwise complex statistical procedure with minimal effort. It was found that
factor 1 explained 50 percent of the variance in the municipal data. Whereas factors 2 and 3
explained 33 percent and 17 percent, respectively. Thus, in the calculation of the final composite
index, fiscal condition (factor 1) was given proportionately more importance than either debt
burden (factor 2) or revenue base (factor 3).
To create the final index, a system was devised whereby each municipality could receive a
maximum score of 100 points. In keeping with the various factor weights the top score was 50 for
factor, 1, 33 for factor 2, and 17 for factor 3. Thus if a given municipality ranked first on each of
the three. Factors, it would receive the maximum score of 100.
Reality Check
In general, the rankings that emerged from the combined factor score coincided with the
empirical predisposition of the researchers concerning the financial health of Nova Scotia's 55
municipalities. Nonetheless, some of the rankings were surprising and can be attributed to three
causes. First, some of the indicators used, such as rate of unemployment, average household
income, and taxes per dwelling unit, seem to measure a broad sense of community financial
wellbeing rather than the financial solvency of the municipal corporations themselves. As a result,
one municipality which is experiencing fiscal difficulty ranked high on the index.
A second source of empirical discrepancy derives from misleading extremes or "outliers"
within the data themselves. For example, several municipalities had very high total assessed
property values due to the existence of large-scale but tax-exempt properties within their
jurisdictions. This would account for a number of unexpectedly high indicator values, such as
percentage commercial assessment, fiscal capacity, and debt per assessment. In one instance, this
substantially elevated the ranking of a town that was in receipt of emergency funding from the
department of municipal affairs to enable it to balance its operating budget.
Finally, there was a pronounced empirical discrepancy among rural municipalities
(counties). This is largely a function of demographics, as some are more rural in nature than others.
The more rural municipalities traditionally have had lower levels of capital expenditure due to
their limited infrastructure requirements in comparison to urban areas. This in turn reduces the
level of capital borrowing required, improving their relative standing on factor 2-debt burden.
Conversely, others that are contiguous to the province's larger urban areas have significant capital
infrastructure needs. In this case, factor 2 rankings would be relatively lower due to greater capital
borrowing requirements.
Despite minor shortcomings, the methodology employed in the composite factor index
illustrates how a larger number of financial indicators can be combined into a smaller and more
meaningful set of dimensions without the loss of any information. Furthermore, it illustrates that
certain measures are more important and work in different directions than others. While the
methodology is considerably more complex than that used in other measures of financial condition,
it is also more revealing and, in the opinion of the researchers, more accurate.
As part of a broader set initiatives being introduced by the department in the fall of 1996,
the financial condition index for Nova Scotia municipalities described above will be revised using
current and more refined data. By applying the factor analysis methodology separately to urban
and rural jurisdictions, a reliable and comprehensive measure of municipal financial solvency will
be achieved.
In the Canadian context, where the provincial level of government is responsible for the
formulation of policies concerning municipal borrowing approvals, conditional and unconditional
operating and capital grants, and the assessment of long-term municipal viability, accuracy must
take precedence over ease of use. The financial condition index for Nova Scotia municipalities
provides decision makers with a realistic means to this end. It is also a powerful instrument for use
at the municipal level by officials who wish to make informed decisions concerning capital
expenditures, taxation and service levels, and long-term financial solvency.