WATER GLOBAL PRACTICE USER MANUAL COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide MAY 2020 About the Water Global Practice Launched in 2014, the World Bank Group’s Water Global Practice brings together financing, knowledge, and implementation in one platform. By combining the Bank’s global knowledge with country investments, this model generates more firepower for transformational solutions to help countries grow sustainably. Please visit us at www.worldbank.org/water or follow us on Twitter at @WorldBankWater. About GWSP This publication received the support of the Global Water Security & Sanitation Partnership (GWSP). GWSP is a multidonor trust fund administered by the World Bank’s Water Global Practice and supported by Australia’s Department of Foreign Affairs and Trade, Austria’s Federal Ministry of Finance, the Bill & Melinda Gates Foundation, Denmark’s Ministry of Foreign Affairs, the Netherlands’ Ministry of Foreign Affairs, the Swedish International Development Cooperation Agency, Switzerland’s State Secretariat for Economic Affairs, the Swiss Agency for Development and Cooperation, U.K. Department for International Development, and the U.S. Agency for International Development. Please visit us at www.worldbank.org/gwsp or follow us on Twitter #gwsp. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide MAY 2020 © 2020 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Please cite the work as follows: World Bank. 2020. “COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide.” World Bank, Washington, DC. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@ worldbank.org. Cover design: Jean Franz, Franz and Company, Inc. Contents Preface iv Acknowledgments v Abbreviations vi Section 1 1 1.1 Purpose of This Guide 1 1.2 Software Requirements 2 1.3 Presentation of the Financial Statements 2 1.4 Data Requirements 2 Section 2 3 2.1 Installation 3 2.2 Moving Around the Model 3 2.3 The COVID Financial Impact Statement Worksheet 3 2.31 Identifier Information 3 2.32 Revenue Section of the Income Statement 4 2.33 Cost Section of the Income Statement 5 2.34 Cash Flow Statement 5 2.35 COVID CAPEX Response Program 6 2.4 The Revenue and Cost Build-Up Worksheet 6 2.41 Production & Connection Program for Households and Commercial Customers 6 2.42 Sewerage Treatment, Connection Program & Other Revenue 8 2.43 Water Supply Service Operating Costs 9 2.44 Wastewater Service Operating Costs 10 Section 3 11 3.1 Useful Financial Terms for Water and Sanitation Providers 11 Note 17 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide iii Preface In response to the new demands that the novel coronavirus has placed on water and sanitation providers (WSPs) in emerging markets, the World Bank Water Global Practice, with support from the ­ Global Water Security and Sanitation Partnership, has developed a simplified financial planning tool to help such WSPs quantify the financial impact on their operations and, make evidence-based justifi- cations for additional funding as a response to the pandemic to maintain and expand water resources during this critical period, regardless of the source of that additional funding. The financial planning tool has been specifically designed for the stated objective and may not con- form to more customized financial models that would be used by a WSP to develop long-term projec- tions for project financing or other purposes. Moreover, the tool has been designed to allow most WSPs to be able to use it for the intended objective. As such, it has been purposely simplified. If existing finan- cial models or other instruments can help quantify the financial impact of the pandemic on water ser- vice operations, they can be used, as this is not intended to be the only tool. The tool is designed to first provide a baseline monthly financial projection of the WSP’s cash flow under normal operating assumptions. A second projection is then warranted by altering various operat- ing and financial assumptions related to the contagion effects of the COVID-19. The financial impact is then determined by deducting the baseline cash flow from the COVID-19 Assessment Cash Flow. The tool is intended for a 12-month projection period, and it can be updated monthly or when infor- mation on revenue and operating expenses become available. If the impact of the pandemic on opera- tions runs longer than 12-months, an update could be made for the following year or other, more sophisticated models should be considered. Finally, this tool is the product of the World Bank staff with external contributions and is subject to copyright. Any findings, interpretations, and conclusions derived from this tool do not necessarily reflect the views of the World Bank, its Board of Executive Directors, or the governments they represent. Because the World Bank encourages dissemination of its knowledge, this tool is made available for pub- lic use as long as full attribution to the World Bank is given. Users are strongly encouraged to provide feedback on the tool itself and the major findings resulting from the tool. It is recognized that some organizations may want to customize a version of the model for more detailed analysis. For any of these points, please contact Aileen Castro (acastro2@worldbank.org) at the World Bank for further informa- tion and discussion. iv COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide Acknowledgments This guide and accompanying financial tool was developed by Aldo Baietti (consultant) with contribu- tions from Carlo Alberto Amadei and overall review and guidance from Joel Kolker (TTL), Patricia Lopez (Co-TTL), Midori Makino (CO-TTL), Josses Mugabi, Gustavo Saltiel, Christine Ochieng, Fook Chuang Eng, Pascaline Wanjiku Ndungu, Jean-Martin Brault, Rado Russev, Stephane Dahan, Rajesh Advani, Aileen Castro, Erin Ann Barrett, Ye-rin Um, and Dominick Revell de Waal. The team would like to thank the water utilities, Bank TTLs, and consultants who participated in the piloting of the financial impact tool and provided valuable feedback for its improvement. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide v Abbreviations CAPEX capital expenditures DFI development finance institution DSCR debt service coverage ratio EIRR economic internal rate of return ENPV economic net present value FIRR financial internal rate of return FX foreign currency IRR internal rate of return NPV net present value NRW non-revenue water OCCR operating cost coverage ratio ODA official development aid O&M operation and maintenance OPEX operating expenditures PCG partial credit guarantees PFI private financial institutions PPP public-private partnership PRG partial risk guarantees ROI return on investment SFR self-financing ratio VGF viability gap financing WSP water and sanitation provider WSS water and sanitation sector vi COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide Section 1 1.1 Purpose of This Guide The COVID-19 pandemic is placing enormous additional constraints on water and sanitation providers (WSPs) across emerging markets. While hand washing is universally recognized as a frontline infection prevention control measure, the practical reality for the water service continuity is that they will be confronted with a series of new challenges, particularly in urban environments in lower-income countries. The additional pressure on WSPs stems from lower revenues (as households struggle to pay bills and public mandates for water supply increase), increased costs (overtime, bringing in agency labor and importing inputs like chemicals), limited service delivery and coverage (where rationing is routine), debt service pressures (to repay international financial institution financing, local banks, and PPPs), challenges with the need to ramp up hours of supply, and the need to secure safe working environments for their management and staff. While the emergency needs of the health sector are well established, the additional pressure on water utilities to respond to this emergency has been considered secondary. To fully respond in the emergency phase, WSPs need to be able to articulate, demonstrate, and justify an ensuing financing gap associated with the pandemic and justly claim additional resources in order to effectively respond to the service requirements of their customers. In response to the new demands that the novel coronavirus will place on WSPs in developing countries, a simplified financial planning tool has been developed to help such providers quantify the financial impact on their operations and, as appropriate, make evidence-based justifications for additional public finance support as a response to the pandemic. The financial planning tool should be utilized to first provide a baseline monthly financial projection of the service provider’s cash flow under normal operating assumptions. A second financial projection is then warranted to assess the financial impact due to the virus by altering various operating and financial assumptions related to the contagion effects of COVID-19. The financial impact assessment is then determined by deducting the baseline cash flow from the COVID-19 Assessment Cash Flow. The final process for service providers is to develop a brief financial impact assessment report documenting the various assumptions taken in each financial projection with conclusions that would be offered to ministries responsible for water, the Ministry of Finance, legislatures, regulators, and debt holders. This user guide provides a step-by-step process for understanding the workings of the financial model and for populating the different assumptions that will be needed to produce a coherent Baseline Projection and a COVID Financial Impact Assessment. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 1 1.2 Software Requirements The financial planning model was created as an Excel file and requires the hardware and software configuration that would be needed to support the use of Microsoft Excel. No additional software is needed. 1.3 Presentation of the Financial Statements The model produces a COVID Impact Assessment Statement and a revenue and cost build-up sheet. The results of the cost and revenue build-up sheet become inputs to the COVID Impact Assessment Statement. 1.4 Data Requirements This simplified version of the COVID financial model assumes minimal data requirements and draws on data inputs that are largely available to most WSPs in emerging markets as part of their normal water and sanitation operations. The intent of the model is not to replace the financial planning model that a WSP may have developed for its long-term planning but rather to be used as a tool by water operations to develop a financial impact assessment that may result from the COVID-19 crisis. That said, the model incorporates input cells for revenues and expenses that can be used by individual WSPs to approximate their total operations. 2 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide Section 2 2.1 Installation There are no specific installation requirements other than to open the file in Microsoft Excel. Copy the original version of the model in your files in case errors arise while you are inputting the assumptions. The likely reason for this is that you may have inputted a number or value in a formula cell, which would create a cascade of errors on your worksheets. 2.2 Moving Around the Model The model incorporates a simple color-coded legend for easy identification of cells that may require input versus those that are formula cells and should not be altered or modified. As shown below, light blue cells with blue numbers or letters are input cells, while white cells with black numbers or letters are ­formula cells. 2.3 The COVID Financial Impact Statement Worksheet The COVID Financial Impact Statement includes several sections including: •• Identifier Information •• Revenue Section of the Income Statement •• Cost Section of the Income Statement •• Cash Flow Statement •• COVID CAPEX Response Program 2.31 Identifier Information This section is used for indicating the name and contact information of the WSP as well as for setting the opening month of the projection period. The “opening month” is the month just prior to the first projection month for which the WSP has actual data. For example, if January is the first projection ­ month, the opening month would be December or “12” as the calendar number. The opening month can be changed, which then resets the projection period. The input for the opening period should be the number that corresponds to the month. In other words, “1” corresponds to January, “2” for February, “3” for March, and so forth. This section also includes the currency used, keeping in mind that outputs are displayed in millions, whereas units for inputting operating costs are in the currency as described in the Revenue and Cost Build-Up section. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 3 2.32 Revenue Section of the Income Statement The Revenue section of the worksheet includes water and sewerage revenue, connection fees, and other revenue that the WSP may wish to include in its assessments. These amounts are calculated in the Cost and Revenue Build-Up worksheet and will be explained later. The revenue calculations also include amounts that can be entered for transfers to or from the local government. These could be in the form of subsidies provided by the local government or funds distributed back by the WSP. Input Instructions: •• Base Case (actual average). The COVID Financial Impact Assessment calculates the difference between a baseline of actual performance versus a month-by-month projection of likely impacts to the WSP due to the COVID contagion. The simplified model takes the averages of revenue and actual cost data from the month or a combination of months just prior to the projection period. These averages should be based on actual operational results assuming a non-COVID operational environment. Given that some WSPs have seasonal variations in production and consumption, it is best to take a 12-month average to capture such seasonal trends as the base case. •• The Revenue Statement includes the opportunity to directly input the collection ratio as this variable is probably the most impactful to the WSP from the COVID contagion. In such cases the WSP will need to assume how collections will be impacted and input the appropriate collection ratio on this section of the worksheet. The revenues will then be reflected on a cash basis, and no additional adjustments are needed in the cash flow of the statement for this variable. •• Input transfers to or from the local government as appropriate. 4 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 2.33 Cost Section of the Income Statement The cost section of the COVID Financial Impact Statement presents the average base case actuals against the projected month-by-month impacts likely to affect the operations from COVID. As shown most of the inputs to this statement are done from the Revenue and Cost Build-Up worksheet and will be explained later. The only input items required in this section are amounts for interest expense if appli- cable and depreciation expense. While depreciation does not have a cash flow impact, it may affect the taxes payable in the event the WSP is charged income tax on profits. In such cases the WSP would need to estimate the applicable income taxes for each projection month. Input Instructions: •• As for the revenue section, the WSP would need to develop and average monthly expenses as the baseline figure. •• Input the remaining month-by-month projection items where applicable. 2.34 Cash Flow Statement COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 5 The income statement information is converted to cash impact through the cash flow statement. The cash flow statement will include requirements to pay down the principal balance of any outstanding loans where applicable as well as inputting a new CAPEX requirements. The result calculates the month ending and cumulative projected cash flows, which are then reviewed against the baseline ending cash flow, to determine the financial impact of the COVID. In the example shown the financial impact is cal- culated as 12.157 million, where this impact is caused by a reduction of cash revenue of 6.153 and an increase in costs of 5.934. Because there is also a reduction in net profits from the base, the WSP would likely avoid paying income taxes from the base case averages in the amount of 580 thousand. However, the example shown also indicates that additional CAPEX will need to be undertaken in the amount of 550 thousand, which results in the final cash flow impact amount. 2.35 COVID CAPEX Response Program This is the section where additional CAPEX requirements are indicated. The model allows the WSP to change the name of the investment and input the amounts in the appropriate month. This information will flow directly to the financial impact statement and can be revised as needed for simulations. 2.4 The Revenue and Cost Build-Up Worksheet 2.41 Production & Connection Program for Households and Commercial Customers 6 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide Description: The model includes piped water service programs for households and commercial establishments. Commercial and industrial establishments can be combined into a single service. The above worksheets draw from the opening position for each service, which are inputted for the opening month. These include indicators such as number of house and commercial connections, ­ average usage per connection, NRW levels for the system, and the average tariff for both services. The inputs on this worksheet are few and also include new connections and connection charges for both services and tariff adjustments from month to month. Because most WSPs do not adjust tariffs monthly and sometimes even yearly, the requirement for inputs in these cells are typically minimal. However, the worksheet also provides results information by considering the water production rated capacity of the system, the calculated water volume demand for each service, as well as the production requirement based on the assumed NRW levels. Based on these calculations the water surplus or deficit is calculated, which provides the analyst information on the utilization for the productive capacity. Input Instructions: •• As indicated, this worksheet requires few inputs and instead provides useful data on production, demand, and utilization of water treatment capacity. •• Monthly tariff adjustments should also be minimal unless and perhaps the WSP may also decide to lower tariffs in lieu of not requiring payment. •• The other input items on this sheet are the monthly water production capacity and the connection charges for households and commercial establishments. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 7 2.42 Sewerage Treatment, Connection Program & Other Revenue Description: This worksheet is used for inputting the sewerage operations including new connections, tariff increases, connection charge, and monthly wastewater treatment capacity. The worksheet can also be used for inputting other monthly revenue in the event the WSP has other sources of operating revenue, such as tanker truck kiosk revenue or septage services. The worksheet provides calculated information on monthly sewerage processed, sewerage billings, and sewerage connection revenue based on information inputted. Inputs on the opening sewerage connections and the average sewerage tariff are inputted directly onto the dashboard. Input Instructions: •• Input blue cells for connection charge, new programmed connection, and monthly wastewater treat- ment capacity and tariff increases. •• Similar to water services, new connections and tariff increases should be made if they had been pro- grammed under normal conditions as part of the baseline projection. •• As indicated, a line item has been included to input other operating revenues of the WSPs that are not specifically included in the worksheet. In such cases, the amount should equate to the total other programmed revenue of the WSP that may arise from its other operations such as tanker truck and kiosk sales or septic services. This line item should not include non-operating revenues of any kind. •• In the event the WSP charges a sewerage tariff to sewerage-connected customers as a percentage of the water bill, the average sewerage tariff should be calculated on this basis. For example, if the sew- erage charge is 100% of the water tariff, the average tariff would be same amount as the water tariff where the revenue is still calculated as the average tariff times the amount of wastewater treated. •• If on the other hand, the WSP charges a flat environmental tariff to all water customers based on their monthly bill, the analyst should revise the wastewater treated to equal the amount of water con- sumed (by revising the number of sewerage connections and consumption per connection to equal the number of water connections). In such case the average wastewater tariff should also be the envi- ronmental fee. 8 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 2.43 Water Supply Service Operating Costs Description: The water supply operating cost worksheet allows the WSP to input fixed and variable costs of the water service operation. Several categories have been included based on what are the main oper- ating costs of a typical WSP. These include Extraction, Electricity, Chemical, Maintenance and Repairs, Salaries and Pension, and Administration Expenses. An additional line item is included for inputting other water supply service-related operating costs in the event not all operation costs are captured under the specified categories. Electricity and chemical costs are regarded as variable costs and directly dependent on monthly water production, whereas the other cost categories are considered quasi-fixed based on the given operation. All unit variable cost estimates are in the currency used for the projection run, whereas the total monthly costs that are calculated are in millions of the currency utilized. Salaries are calculated based on the operating labor complement times the average monthly salary. The work- sheet also allows for the calculation of allowances and overtime if needed. The administration costs should include management and back office staff that are not considered operating staff. In addition, administration expenses should include general and overhead items for office supplies, telephone, travel, and so on. The worksheet also includes pension expense items if needed and, as indicated, another line item for other water supply service-related expenses. Input Instructions: •• Input all cost categories where applicable. For example, gravity-fed systems would not include elec- tricity costs. As indicated all unit input costs should be entered in the currency being utilized, whereas the outputs in the white cell are calculated in millions of the currency. It is important to maintain this protocol. Otherwise the analyst will get erroneous amounts. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 9 2.44 Wastewater Service Operating Costs Description: This next worksheet allows the WSP to input the operating costs related to the wastewater operation, and again several cost categories have been included for direct input. These include salaries, electricity maintenance, and administrative expenses. In addition, a separate line item is included for other costs, which may be applicable for the WSP. Input Instructions: •• The input instructions for this worksheet are like the previous worksheet. An important point to note with regard to this schedule is that the input data should be categories according to the revenue and expense categories for maximum compatibility. Should the WSP have additional categories that have been reported separately, they should be consolidated and summarized within the categories shown above. 10 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide Section 3 3.1 Useful Financial Terms for Water and Sanitation Providers1 •• Blended Financing vs. Viability Gap Financing (VGF). Blended finance involves a mix of public grants and concessional loans with commercial loans to derive a financial solution. This solution is deter- mined by deriving a projected cash flow for the consolidated water entity such that all debt obliga- tions are amply satisfied throughout the entire projection period. The importance here is the crowding-in of commercial financial involvement in the financing plan to increase the total pool of finance and reduce information gaps among commercial lenders. Viability gap financing is similar in concept, but its primary objective is to close the financial viability gap irrespective of the mix of loans and grants. It primarily works by financially engineering a mix of grants and concessional loans pri- marily to lengthen maturities and reduce the cost capital to create a financially viable cash flow stream. While the objectives between the two are similar, blended finance involves commercial finance, whereas VGF necessarily does not. •• Capital Contributions vs. Capital Expenditures (CAPEX) Subsidies. Often a source of misunderstanding, capital contributions to a public water entity are not necessarily CAPEX subsidies. Like in all entities, the owners of WSPs have the obligation to properly capitalize their entity with a mix of equity and debt. The appropriate mix should be a matter of policy that incorporates several factors, including mitigating debt leverage risk. Such a policy should not necessarily give rise to the incidence of a sub- sidy. If there is a subsidy component to the capital contribution, it would arise if there are absolutely no expectations for the utility to realize an appropriate return on this capital, which would cover the opportunity cost of the government. Unfortunately, this is not explicitly stated, so it is often difficult to unequivocally state the incidence of CAPEX subsidies on capital contributions as opposed to the interest rate difference on concessional loans or on operating expenditures (OPEX) subsidies where WSPs fall short of their explicit revenue requirement. •• Cost Recovery. In the simplest terms, cost recovery is the ability of the WSP to cover its explicit costs from user tariffs. However, it has been recognized that this basic definition does not fully capture the more complex related issues surrounding WSPs. For example, explicit costs may not capture forgone maintenance or subsidies on capital costs and rate of return requirements. The simple cost recovery formula may also include gross performance problems, which inherently increase costs or lower rev- enues from tariffs. For this reason, it is important to look at cost recovery from different dimensions by assessing the complete situation and correcting specific operational and financing deficiencies. •• Collection Period. Measures whether the utility is getting paid on time. If the utility operates a monthly billing cycle, anything more than 30 days’ receivables outstanding can highlight late or non-­payments. The quality of receivables of a water entity can be further assessed by carrying out an aging analysis of receivables. This would show whether the receivables are stale and non-recoverable. Moreover, it can also provide information for stepping up collection efforts. Utilities with fairly good information systems should be able to develop an accurate aging analysis as well as determine patterns among COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 11 different customer classes. For example, government offices and military are known to be notoriously late in making utility payments. Moreover, utilities may not be able to disconnect these customers, which often exacerbates the situation. Being able to clearly isolate such problems does bring the pro- cess one step closer to resolution, particularly if donor agencies or other key stakeholders are involved. •• Creditworthiness. Measures the capacity of a borrower to fulfill all its debt repayment obligations. Creditworthiness is a valuation performed by lenders and independent credit agencies to determine the possibility a borrower may default on his debt obligations. A creditworthy borrower is one that can demonstrate long-term financial strength and ability to pay its financial obligations in full and on time. The best assessment of creditworthiness is through a consolidated financial projection that demonstrates the capacity of the utility to honor financial obligations throughout the projected period. A creditworthiness assessment based on historical performance has its limitations because it does not consider forward obligations. •• Credit Rating. A credit rating measures the creditworthiness of a potential borrower, and it is pre- sented in the form of a symbol or investment grading. Credit ratings are generally assigned to poten- tial borrowers by independent credit rating agencies and are an important step for promoting WSPs to borrow from commercial financial institutions. A high credit rating indicates a high possibility of pay- ing back the loan in its entirety without any issues; a poor credit rating suggests that the borrower has had trouble paying back loans in the past and might follow the same pattern in the future. Shadow credit ratings have been utilized by governments and WSPs to estimate the rating that would be arrived at by a formal credit agency. A high credit rating not only improves the chances of the WSP qualifying for a loan but also may improve the terms the lender offers. •• Credit Enhancements. A credit enhancement is a way the WSP can improve its credit rating with the lender. Through credit enhancements, the commercial lender is provided with additional assurances that the WSP will meet its debt obligation. The WSP can offer additional collateral such as pledging revenues, increasing cash reserves that help countervailing deposits, obtaining a letter of credit from another financial institution, or obtaining a third-party guarantee. Credit enhancements reduce credit/default risk of a debt and can also lower interest rates. •• Cross-Subsidies. Are commonly utilized by WSPs to lower the cost of service of one class of consumer by commensurately taxing another. In most cases, tariff structures involving cross-subsidies are designed to tax the commercial and industrial customers most and benefit poorer communities. This is typically rationalized on the “ability to pay principle.” While such structures of cross-subsidies can be regarded to have some merit, particularly if they do benefit lower-income communities, many go counter to their intended objectives and may create more economic-related problems. It has also been criticized that subsidies for the poorest communities should be direct rather than implicit subsidies. However, administratively, this is more difficult to achieve. Therefore cross-subsidies are ­ popular in the WSS sector. ­ •• Debt Service Coverage Ratio (DSCR). This ratio measures the ability of the WSP to meet its debt service obligations in terms of current interest charges and any repayment due on the principal portion of the loan. It is calculated by taking the debt service amount (principal and interest due) over the operating 12 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide cash flow (see definition of operating cash flow). This ratio is key because it implicitly incorporates both operating and financial performance of the entity. Hence a review of the DSCR will provide a good quick assessment of whether the utility is meeting its external debt obligations and possibly spot performance problems. A DSCR of 1.2 means that operating cash flow is 20% greater than debt service requirements. This has often been regarded as a reasonable value for a WSP to achieve. However, the ratio must be closely reviewed, considering the changing parameters of the entity, its capitalization structure, and expectations for a reasonable return on the investment. For example, if the utility has practically little or no debt, a 1.2 value may not be enough if it wishes to increase bor- rowing to expand coverage. This ratio is best analyzed under projected assumptions. •• Depositary Agencies. A form of credit enhancement whereby the lender requires the borrower have deposit accounts with the lender, which can also facilitate the creation of a collection account. Collection accounts are used to secure revenue receipts of the WSP for debt servicing the loan. •• Development Finance Institutions (DFI). DFIs are specialized financing agencies established specially to fulfill developmental objectives in each country. In developing countries, these are primarily public special law lending institutions that act as intermediaries for donor and international financial ­ institution programs and may not necessarily accept customer deposits. •• Favorable Financial Leverage. Financial leverage is the ability of the WSP to use borrowed financing to increase the overall returns of the enterprise. Favorable financial leverage occurs if the cost of bor- rowed funds is less than the overall return on assets of the entity, creating the incentive to increase the debt to equity ratio of the enterprise, particularly in times when the cost of borrowed funds is low. However, as with any enterprise, a highly leveraged capital structure can increase risk considerably and may be considered negatively by a commercial lender. •• Guarantees. Guarantees are a specialized form of insurance related to financial transactions in which the risk of noncompliance by one of the two sides in a transaction is taken up by a third-party external to the original transaction. They are essentially a transfer of risk related to a portion of a specific finan- cial transaction. Guarantees can work in several ways to transform opportunities into effective invest- ments. First, they can mitigate risks that lie outside the inherent project fundamentals (that is, political, regulatory, and policy and sovereign risks). Second, they can enhance the creditworthiness of the borrower to extend maturities and lower the effective cost of debt. •• Implicit Subsidies. A subsidy is a form of financial aid provided by the government in which the recipient does not have to bear the full economic cost of a given product or service, but something typically lower. Implicit subsidies arise through financial support for performance-related issues and are a form of operational subsidies. Operational subsidies can also be explicit when a specific policy decision is made to shore up revenue to subsidize the tariff of a certain class of consumer. If the government covers the operational deficit due to additional cost of performance-related issues, they would be considered operational subsidies. If customers instead are charged a higher tariff to cover the performance problems, they are in fact being overcharged for the services being provided by the utility. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 13 •• Internal Rate of Return (IRR) vs. Net Present Value (NPV). The NPV is the value of the sum of a proj- ect’s projected cash flows discounted at the cost of capital. Any value over zero indicates adequate return, but the higher positive value indicates a higher return. The NPV calculation does not give an exact rate of return in percentage terms. It just indicates that you are either above or below your threshold level. A project’s IRR is the rate of return that it yields, expressed as a percentage for the same projected cash flows. The formula for NPV and IRR are the same for the economic analysis as they are for the financial analysis. In such cases, they are usually referred to as the economic net present value or the economic internal rate of return (EIRR) instead of the financial net present value and the financial internal rate of return. The difference between the two is how you define the costs and benefits. The financial analysis includes cost and benefits that accrued to the project only, not externalities that accrue outside the project to the wider economy. It is important to underscore that these indicators should be applied to project analysis and are particularly important for the economic justification of the project. The financial assessment must consider the consolidated financial projection of the WSP to ascertain positive cash flows throughout the projected period and the ability to meet all financial obligations during the period. •• Municipal Water Departments. These include WSPs that are part of the municipal organizational structure and as such are not regarded as separate legal entities. Municipal water departments are a direct contrast to water utilities, which have been chartered as separate legal entities either as public corporations or special law companies. The key difference from a financing point of view is that municipal governments would be the legal borrowers for municipal water departments. Nonetheless, for lenders it is important that water providers that are part of the municipal or pro- vincial organization retain complete operational and financial information for credit analysis; and lenders would also need to evaluate the creditworthiness of the municipal government for approving credit. •• National Transfer Intercept. A form of third-party loan security available to WSPs that are owned by municipal or provincial governments. Under a decentralized framework, local government units receive an annual transfer from the national government for redistributing tax revenues. The transfer payment received by the local government is pledged as additional security through an automatic intercept mechanism in the event the WSP delays or defaults on its debt service payments. •• Negative Pledge. A negative pledge is a clause in the loan agreement stating that the borrower will not pledge any of its assets to another lender if doing so gives the lender less security for its loan. The borrower is limited to financial transactions in which the original lender maintains priority to seize assets in case of a default. It also limits the likelihood that an asset is pledged more than once, creating an issue of which institution has rights to the asset. The negative pledge clause can be utilized in the loan agreement of the senior lender to ensure that other lenders are subordinated. •• Net Profit Ratio. The net profit ratio is a common profitability ratio that assesses the net return from revenues. As such, it is calculated as net income after taxes to total revenues. A more precise calcula- tion should focus on operational revenue to obtain a better understanding of operational effective- ness. Like many other financial indicators, the net profit ratio can vary widely between one WSP and 14 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide another depending on technical and financial factors. But generally, a range between 10% and 30% would be acceptable. For infant WSPs with sizable investment requirements, this ratio should be on the higher side of this range. •• Non-Revenue Water (NRW). NRW is probably the most important indicator because it not only ­ measures the technical efficiency of the operation but also the commercial efficiency of theft control and of the billing and collection process. NRW has several components: (i) unbilled authorized consumption—reflecting problems with the billing system that is not capturing authorized consump- ­ tion; (ii) commercial losses—reflecting losses related to unauthorized consumption either through theft, faulty meters, or the inability of the utility to measure actual usage; and (iii) physical losses— reflects problems with the actual system through leaks that are not detected. •• Operating Cash Flow. Its importance is often overlooked, but it is just as important as net income from operations because it reflects the internal cash generation produced by the utility to pay down its debt service obligations and what remains for leveraging additional financing. Every analyst must look at the financial results of the utility from two very important perspectives: (i) profits from operations and (ii) cash flow since both are needed for different reasons and often a WSP can achieve one but not the other. Operating cash flow is calculated by adding back to net income, interest charges, and depre- ciation expense and including net changes in working capital (a net increase of working capital would reduce operating cash flow). This amount is then compared against the total debt service requirement to determine the DSCR. Any residual is then “free cash flow” available for new investment expendi- tures or to pay down debt. •• OPEX Subsidies. Provide financial support for the explicit purpose of reducing the cost to consumers for the water service if there is a deliberate policy to keep tariffs below cost recovery levels. The government also bears the burden of operational losses of the WSP, which also need to be funded. For ­ the most part, operational subsidies are handled as cash infusions to the cash flow statement to com- pensate for operational losses of the WSP. Rarely they are included as an added revenue item on the income statement of the WSP as this would be improper from an accounting perspective because they would distort operational performance of the WSP. At times, operational subsidies are made on an “off-balance sheet” basis such as the payment of civil servants by a government ministry instead of the WSP. However, this is administratively more difficult to achieve. •• Operating Cost Coverage Ratio (OCCR). The OCCR measures operational efficiency of a water entity and is calculated by operating costs divided by operating revenues. It does not include other non-­ operating charges to the income statement, such as depreciation, interest expense, and income taxes. Generally, an OCCR of 1.5 has been regarded as adequate for developing countries. However, this value should always be reviewed against the need for additional financing and particularly the current size of the fixed asset base in relation to its new investment requirements. ­ •• Partial Credit Guarantees (PCG). Credit risk instruments are more important for domestic lenders and bondholders and are designed to cover the portion of the debt service that falls due beyond the nor- mal tenor of commercial loans available from commercial lenders. As such, they are typically used to extend maturities beyond what is available through commercial lenders or bondholders in a partial COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 15 domestic market. PCGs cover non-payment of the guaranteed portion of the debt obligations. In that sense, they are considered a comprehensive guarantee for both principal and interest for maturities beyond what can be obtained by commercial lenders without enhancements. Credit risk can be offered on only a portion of the debt obligation (typically the periods where maturities have been extended) or a portion of the loan throughout the life of the loan. Credit risk guarantees have also been known to lower the cost of financing overall. •• Partial Risk Guarantees (PRG). Cover commercial lenders against the risk of a government government-owned entity) failing to perform its contractual obligations or changing policies, (or ­ which would impact the financial results of the utilities. PRGs can cover several risks, including changes of laws and regulations; non-allowance for agreed tariff adjustment formula or regime; ­ government (or government entity) contractual payment obligations (e.g., periodic or termination payments, agreed subsidy payments, minimum revenue guarantees, etc.). ­ •• Project vs. Entity Analysis. The assessment of the project versus the entity is largely a consequence of the perspective of the stakeholder. While it is always important to analyze the specific project as part of any feasibility analysis, it is most critical to analyze the financial capacity of the entity to fulfill all its financial obligations, not just those of the project being considered. As such, the financial informa- tion of the project must be consolidated with all other financial parameters of the entity into a pro- jected cash flow to ascertain financial capacity throughout the projected period. The project analysis is most critical for the economic valuation to ensure that the project is economically justified and that it surpasses the opportunity cost of capital of the government. •• Return on Investment (ROI). Measures the overall profitability of the utility and whether the utility is generating an adequate rate of return on capital invested. WSS providers that have received substan- tial external donor assistance grants may be financially healthy with ROI ratios well below what may be generally accepted. However, the cost of grant contributions from national or local government should be benchmarked at the opportunity cost of capital of those entities. •• Security Instruments. Loans can be secured and unsecured. Secured loans carry less risk because they are backed up by a real asset such as property and equipment that can be held as collateral for the loan. Unsecured loans are riskier to lenders because they are based solely on the borrower’s credit- worthiness (i.e., its ability to cover all the debt service obligations). Typically, WSPs have few assets that can be collateralized for loans given that most of their fixed assets are in the form of civil works or pipes underground. However, there are some techniques that can be utilized to collateralize loans by: (i) pledging the WSP’s revenues through a collection account; (ii) creating an intercept mechanism from national transfers to the local municipality where the utility operates; or (iii) by the local govern- ment itself pledging its tax revenues. Third-party guarantees can also minimize the risk of unsecured loans by commercial banks. •• Self-Financing Ratio (SFR). Measures the ability of the WSP to fund new investments from internally generated funds. Lenders review this indicator closely to determine not only the available free cash flow of the utility but also its capacity to contribute to the financing plan for a proposed investment program. This is a prospective ratio that would allow the analyst to determine whether 16 COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide the entity has the capacity to contribute a portion of their planned CAPEX program from internally generated financing, typically at least 20% to 30% of the total new investment requirement. •• Senior vs. Subordinated Debt. Senior debt has first claims on repayment in the event of default and as such it is less risky than subordinated debt. Senior debt is usually collateralized but can also be secured against the earnings of the WSP. Subordinated debt ranks below senior debt with regard to claims on a WSP’s assets or earnings and is more risky than senior debt. •• Subsidiary Loan Agreement. This is generally separate and additional to the main loan agreement between international financial institutions or donors and the government, which specifies different terms and conditions to be offered to the beneficiary. The mix of loans and grants, tenors, grace peri- ods, and interest rates offered to the beneficiary could be changed considerably to suit the objectives of a given investment project. •• Tariff Adequacy Analysis. The analysis of whether the tariff is truly cost reflective needs to determine whether consumers are substantially overcharged for performance-related issues of the WSP. The tariff adequacy analysis attempts to do this by recasting the operation results under more acceptable performance standards, including adding back forgone maintenance that should have taken place. The analysis is important because it then determines what are justifiable tariff levels versus other items that should be corrected through capital infusions for performance improvements. •• Underutilized System. Refers to an entire network or just part of the network running at less than desired capacity. During the investment planning process, it is important to size new investments such that the related debt service can be handled effectively. If the system is significantly underuti- lized or the investment has been oversized, the revenue to cost ratio will be low and hence the utility may have difficulty in servicing the related debt it assumes to finance the CAPEX program. From an economic perspective, an underutilized system would also be considered inefficient. •• Viable vs. Bankable. Financial viability addresses the ability of the WSP to fully meet its financial obli- gations, or in other words, it can pay its debts and earn an acceptable rate of return on its assets. Bankability on the other hand deals with the WSP being able to source a commercial loan or another form of commercial finance. The two are not the same as it is very possible that a viable utility con- templating a capital investment may not be able to qualify for a loan either because: (i) the payback period is greater than the maximum tenor of the loan that can be offered; (ii) the utility cannot meet the lending requirements for collateral and other loan security; or (iii) the commercial lender is not familiar with lending to the sector and considers involvement to be too risky. Note 1. Source: World Bank. 2017. “Crowding-In Private Finance in World Bank Water and Sanitation Operations - A How-To-Guide for World Bank TTLs.” World Bank, Washington, DC. COVID Financial Impact Assessment Tool for Water and Sanitation Providers User Guide 17 SKU W20019