United States
      Environmental Protection    Office of Water     EPA 810-R-95-003
      Agency           4601         August 1995


&EPA METHODS FOR ASSESSING THE

      VIABILITY OF SMALL WATER


      SYSTEMS:




       A Review of Current Techniques and


       Approaches

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                            TABLE OF CONTENTS
Chapter 1:         Introduction and Overview


Chapter 2:         PAWATER: A Financial Planning Model for New, Small Community
                  Water Systems


Chapter 3:         A Dozen Questions Diagnostic to Assess Small System Viability


Chapter 4:         Washington State Small Water Utilities Financial Viability Manual


Chapter 5:         Small Utility Ranking Formula (SMURF)


Chapter 6:         Financial Distress Assessment Models

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                                   CHAPTER  1.
                      INTRODUCTION AND OVERVIEW
1.1    Introduction
       This manual has been developed to assist States in understanding and applying presently
available water system viability assessment methodologies.  EPA hopes that the information
presented here will stimulate State creativity and lead to development of additional, alternative
viability  assessment methodologies appropriate to the circumstances of specific States.  Small
systems and technical assistance providers should also  find this document useful as a tool for
water system self assessment.
1.2    What Is Viability?

       At its simplest, the term viability can be defined as follows:

              Viability is the ability to
                     • consistently provide
                     • quality service
                     • at an affordable cost.

An alternative definition is:

              Viability is the
                     • technical
                     • financial, and
                     • managerial capability
              to consistently comply with current and prospective performance requirements.

       While there is no universally  accepted definition of viability, all definitions are fairly
similar and  cover the  same major  points.   Every  one  of these  points has  considerable
significance.

       Technical, financial, and managerial capabilities of small water systems are often limited
by the flow of revenues and the  strength of the institutional arrangements. Weakness in any of
these three areas can affect the reliability of water service.  Over the long-run, inadequate cost
recovery will lead to deterioration of system components.   The lack of a dedicated flow of
revenues sufficient to sustain the system raises a question as to the long-term reliability of water
service.

       The ability to consistently comply with current and prospective performance requirements
incorporates the fact that performance requirements may change as our knowledge of technology

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and health effects advances. The emerging concern regarding Crvptosporidium is an example.
Thus a system must be capable of adjusting to change and meeting new challenges as  they
emerge.   In terms  of all  the above components of viability, the correct context is  forward-
looking, towards the future rather than the past.
1.3    Why Address Small System Viability?

       Why new words and new initiatives to address small system viability?  It could be said
that history has finally caught up with us, or stated otherwise, that we are at a turning point ~
a crossroads - in the history of the  small system segment of the water supply industry.  For
some time, historical forces have been creating and enlarging a gap between the performance
demands placed on small systems and the institutional capabilities of small systems.

       Figures 1.1  and 1.2 illustrate some key institutional characteristics of the  small system
universe.  "Small systems" have typically been considered to be those serving fewer than 3,300
persons. As shown in Figure  1.1, 87 percent of the community water systems in the country
classify as "small systems" by this definition.  Moreover, the largest two slices of the pie chart
in Figure 1.1 illustrate the fact that 62 percent of all community water systems serve fewer than
500 persons. There is a natural tendency to think of small water systems as being small towns
or small utilities.  As these  data make clear,  however, most small systems are actually  small
clusters of homes.

       Other significant characteristics relating  to the ownership profile of small systems are
displayed  in the pie chart in Figure 1.2.   As shown here, about  55 percent of small water
systems are  mobile home parks, home owner's associations, or small private water companies
(shown as investor owned, but actually mom & pop small companies for the most  part).  These
private  ownership forms are highly  concentrated in the very smallest systems,  those serving
fewer than 500 persons.  Of the systems serving fewer than 500 persons, 80 to 90 percent are
in one of these three private ownserhip categories.  While roughly 40 percent of all systems
serving fewer than 3,300 persons are publicly owned by small towns,  districts, or authorities,
these systems are concentrated near the large end of the small system spectrum.

       There are many stories behind such statistics, the recurring theme is one of institutional
weakness. This is illustrated by two predominant stereotypes: the case of rural economic decline
and the case of suburban sprawl.

       Water supply infrastructure in many rural communities was initially sized and put in
place  during the earlier part  of the twentieth century  at a  time when the economics and
demographics of these communitites supported larger populations. With technological advances
in agriculture, and with various changes affecting natural resource and mining industries, many
rural communities are now less prosperous economically and home to much smaller populations.
In addition to the smaller customer base, advances in public health protection have increased the
expense of providing potable water.

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                                   FIGURE 1.1
                    NUMBER OF SYSTEMS BY SIZE
                          (based on size of population served)
          >3,300 persons  13%
1,000-3,300 persons   14%
       501-1,000 persons   11%
                                               .   25-100 persons  30%
                                                  101-500 persons   32%
                      Total number of community water systems = 58,000.

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                                    Figure 12
                      OWNERSHIP OF SMALL CWSs

                                             Publicly Owned  40%
Mobile Home Parks  25%
Other 5%
                                                     Investor Owned  15%
                Home Owners Assoc.   15%
                 Approximately 52,000 CWSs are small (seve <3,300 persons).

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       Over the latter half of the twentieth century, the process of suburbanization has been one
of the dominant demographic and economic trends in the nation. It has resulted in the creation
of thousands of small water systems, initially built by  land developers and then turned over to
cooperative homeowners associations.  Because the developer's interest often extends no further
than the sale of the last lot, the provision for  prudent financial and technical management of
these water  systems within  a sustainable  institutional framework has often been completely
lacking.

       Among the many thousands of small systems, there are many other  stories which may
not adhere exactly to  these two  stereotypes,  but  still share the  same  types of institutional
weaknesses and the same results in terms of performance problems. Because water supply was
not historically an expensive service to provide, institutions devised for service delivery were
not conceived with very strong management and  financial capabilities.  The gap  between
performance expectations and capabilities is likely to grow wider  and cannot be ignored.
The systemic deficiencies in water service delivery mechanisms of small communities  are
an accident of history and must be viewed  in a  much broader context than that of  the
SDWA program.  The institutional changes required to address the performance gap in
service delivery raise much broader issues of public infrastructure policy and the respective
roles of state and local government.

       Thus, there is a need for a new way of thinking about small systems.  The new focus on
the underlying service  delivery mechanism has been captured in the word "viability."  State
primacy agencies originally recognized the need and offered the term "viability" in requesting
assistance from EPA in the development of "viability screening tools" that could be applied to:
1) evaluate  the sustainability of new developer-built  small  water systems; and 2) determine
whether existing small  systems were capable of sustaining themselves.
 1.4    State Programs To Address Viability

       At the most general level, a state viability program consists of a coordinated collection
 of initiatives by state government to address concerns regarding the reliability of water supply
 service delivery mechanisms in small communities.  The issue of viability is rooted in state and
 local institutions that  are, in turn, rooted in state  law and in  the  unique  regulatory and
 intergovernmental culture of each state.

       Viability is a much broader issue than SDWA compliance and affects the full range of
 organizations and individuals involved  in state and local policy towards public infrastructure as
 well as public policy in other areas such as social policy, economic development, and  rural
 poverty. While there are similarities in the nature of the problem across the country, it is very
 clear that  the  development of  solutions will  require  approaches  tailored  to the  unique
 circumstances of each state.
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       The ultimate objective of a state viability program is to help local institutions to become
fully capable and reliable service delivery mechanisms.  In order to be effective, state viability
programs will have to carry out a sequence of two steps: 1) assessing the viability of water
systems, and  2) acting to enhance the viability of water systems.  These two steps are very
broadly conceived. This breadth of interpretation is consistent with the fact that viability touches
on a broad range of issues regarding the role, responsibility, and authority of state government.
This being the case, the approach to be taken will have to evolve  uniquely in each state. The
pace of development will vary.  The form in which different states undertake to assess viability
and  act to address viability concerns will vary.

       A comprehensive state viability program could have  the following four programmatic
elements:

       •      a mechanism for new system viability screening to deter formation of potentially
              non-viable systems;

       •      a mechanism for viability  assessment of existing systems to  assist systems and
              state regulators in identifying and anticipating the needs of the future;

       •      effective coordination within and between agencies of state and local government
              to enhance the viability of troubled systems through restructuring or other means.

       •      a safety net mechanism to  rescue and restructure water  systems  which have
              clearly failed and where economic and social  issues unrelated  to water  supply
              make it impossible to restore adequate service without substantial  government
              assistance.

       To  be fully effective, these types of mechanisms  may require new types of explicit
authority for the agencies of state government involved in their implementation.  However, there
is still a very wide range of interpretation and approaches that can be taken to putting these
elements in place. Also, the type and amount of authority needed could be very different from
one  state to another. Many states may have more existing authority to initiate these efforts than
previously  realized.

       This report provides a review of  methods for viability assessment and therefore bears
primarily on the first  two elements of a viability program.   Viability assessment can  be an
effective means of educating all of the stakeholders regarding  the need for institutional changes
at both the  state and local level.  In addition, viability assessment can provide the understanding
necessary to build consensus on the most appropriate public policy  approaches to implementing
the other viability program elements (i.e.,  inter-agency coordination and safety net mechanisms).
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1.5    The Role Of Viability Assessment

       Viability assessment can be undertaken at two levels.  One approach is to  assess the
viability of individual water systems. Another approach is to perform viability assessment at the
"aggregate" level,  viewing all the systems in the  state to obtain an overall profile.

       •      The results of system-level analysis can go right to work for small systems and
              state regulators, helping them  to  clearly  identify and understand  existing and
              potential small system problems and to appropriately target financial and technical
              assistance.

       •      The  results of aggregate-level analysis can  be  used  to help educate  state
              legislators and other agencies of state government regarding the needs for broad
              state initiatives (e.g., a  safety net) in this  area of public infrastructure.

In many states,  these two types  of viability  assessments can be initiated without any additional
legal authority.
 1.6    Five Examples Of Viability Assessment Methodology

       This  manual  presents summary descriptions of  five  different  examples of  viability
 assessment methodologies that have been developed by states and others.  The intent  is not to
 provide  a detailed "cookbook"  to viability  assessment,  but rather to describe each  of these
 examples in sufficient detail that other suites can gain enough understanding of the approach to
 be able to apply it in their own circumstances.

       The five methodologies covered include one system-level method for new system viability
 screening, two methods for system-level assessment of existing systems, and two methods for
 aggregate-level assessment of existing systems.
 1.7   New System Viability Screening

       The new system viability  screening tool described in Section 2 is a viability planning
 software called PAWATER that was developed as part of joint State-EPA viability research in
 Pennsylvania.1  This user-friendly device has  also been used  by a few other states for new
 system screening.

       The idea behind PAWATER is to encourage developers and local officials responsible
 for development to consider the full costs of running a proper water system before commiting
 to build one. PAWATER requires the user to complete a structured set of input specifications
 to provide a sufficient basis to estimate the costs of all necessary facilities, operation,  and
 management.   The cost curves used  in the costing step  can be  edited by  the user  to  suit

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 individual circumstances.  There is also a treatment module that allows the user to "what-if" the
 cost impact of different SDWA  compliance requirements.  This feature can be made more
 directly relevant in states where source water quality testing is required as part of the permitting
 process.

       Based  on these  input assumptions, the  PAWATER  model computes the  total  capital
 requirement and total annual revenue  requirement  of the  proposed system under different
 assumptions regarding ownership (private water company, municipally owned, or homeowners
 association).  The program provides a summary of the capital cost and annual cost per dwelling
 unit that is meaningful to a developer.
 1.8    System-Level Viability Assessment of Existing Systems

       In the models that have been developed, system-level viability assessment of existing
 systems has been conceived as a two-step process:

              •      Step  1 ~ Figure  out where the  system is, presently, — in terms of the
                     condition of the infrastructure and the quality of service — and where it's
                     going in the future.

              •      Step 2 ~ Develop a comprehensive business management and  financial
                     plan to take the system where it  needs to go.

       Most of the information needed in the first step is  engineering and performance data of
 the type developed in the course of sanitary surveys, comprehensive performance  evaluations,
 and vulnerability assessments.  The development of the  grass-roots level of financial information
 implied in the second step is  an effective means of educating  the owners, managers, and
 customers of small systems to the realities of the future cost environment.

       The methodologies described in sections 3 and 4 of this manual represent approaches to
 the two steps in the process of assessing existing system viability.

       Section 3 presents a summary of "A Dozen Questions To Assess Small System Viability,"
 the product  of an effort by the American Water Works Association's Guidance  Committee to
 Small Water Systems.2  A structured series of questions  is provided as a diagnostic  guide to
 assist small  system owners, managers, and customers hi  performing a self-assessment of the
 extent of potential future liabilities stemming from either existing infrastructure deficiencies or
 anticipated SDWA compliance requirements.  The diagnostic procedure is the first step towards
 development of a comprehensive plan for the water system.

       Section 4  presents a summary  of the Washington State Financial Viability Planning
Manual.3  Washington State has a program of comprehensive water supply planning already in
place that performs the comprehensive  diagnostic analysis.  The next step  after identifying all

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current and future needs is development of a financial plan to meet those needs.  This second
step in viability assessment is the focus of the Financial Viability Planning Manual.  Similar to
the approach used in the PAWATER model, the manual provides a procedure to define the total
capital investment requirements and total annual revenue requirement of the system, projected
six years into  the future.  The ability to meet  these and other needs must be demonstrated in
order to pass specific tests of viability envisioned in the Washington State program.
1.9    Aggregate-Level Viability Assessment of Existing Systems

       Aggregate-level viability assessment can be used to characterize, or profile the condition
of all  small systems within a state,  taken as  a  group.  Such assessment methodologies use
operating and financial data to develop a profile evaluation of the current status of the small
system segment of the water supply industry within a state. This is contingent, therefore, upon
the existence of data with which to characterize the current performance and financial condition
of small water systems.  Institution of an annual reporting process intended to collect operating
and financial data from small water systems would  be needed to  support this approach where
such reporting processes are not already in place.  Such reporting is performed in a number of
states by investor-owned utilities, municipal uilities, and water districts.

       In general,  aggregate viability  assessment consists of analyzing the data  on various
operating and financial parameters from the entire population, or from a large sampling, of the
small water systems within a state.  This aggregate perspective provides a sense of the range of
variability between systems, as well as a general  indication of the correlates of viability.   Such
broad  perceptions can then be validated against the state's first hand  knowledge of the systems.
From this type of analysis of the aggregate profile, states can identify those water systems that
appear to be the ones that could profit the most from available forms of technical and financial
assistance to enhance  viability. Another product of such aggregate profiling is it provides a
picture that can  be presented  to state policy makers  to  document  the extent to which more
serious problems exist in systems that are, by all indicators and comparisons, in truly serious
trouble.

       The methodologies presented in Sections 5 and 6 of this manual offer two examples of
aggregate-level viability assessment.  These examples should be viewed as illustrations rather
than as  fully developed models.  It  is  possible to devise an array  of different approaches to
performing such assessment.  In one state, for example,  there is an effort underway to merge
the two  methods described here into  one.4

       Section 5 describes  a methodology developed by staff of the  Pennsylvania Consumer
Advocate's Office  using data  submitted by private water companies in annual reports to the
Public Utility Commission.5 The intent of this methodology was to develop a relatively simple,
but quantitative assessment approach. The resulting index of viability, the Small Utility Ranking
Formula, is based on 20 indicators; five each in areas of size,  rates,  management, and finance.
The index results in an overall score on a scale of 0 to 100.  While  not based on formal use of

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quantitative analytical techniques, the SMURF ranking formula has a lot of intuitive appeal and
represents the degree of flexibility that is available for analysts to exploit in assessing viability
in a manner that makes sense to those using the information.

       Section 6 describes a more formal quantitative methodology for aggregate viability
assessment utilizing a combination of statistical techniques and predictive models used  in
financial failure analysis in the banking industry.6 The application of these techniques was made
possible through the use of a data base of annual report information supplied by private water
companies to public utility commissions.  Although this method utilizes sophisticated analytical
techniques, the intuition in the approach is very simple.  As described in Section 6, the approach
can be useful as a source of ideas for  specific indicators of financial distress.

REFERENCES:
1.     PAWATER: Financial Planning Model for New Small Water Systems, developed for the
       Pennsylvania Department of Environmental Resources by Gannett Fleming, Inc. and
       Wade Miller Associates, Inc., July 1992.

2.     Cromwell, Albani and  Schmidt, A Dozen Questions to Assess Small System Viability,
       Annual Conference of the American Water Works Association, San Antonio, TX, June
       1993.

3.     State of Washington, Department of Health, Division of Drinking Water, Small  Water
       Utilities Financial Viability Manual, August 1994 draft.

4.     Wade Miller Associates, Inc., State Initiatives to Address Non-Viable Water Systems in
       Pennsylvania (1991).

5.     Rubin, et al, "A Quantitative Assessment of the Viability of Small Water Systems in
       Pennsylvania,"  Proceedings  of the Eighth  NARUC Biennial Regulatory Information
       Conference (1992), Vol. IV,  pp. 79-97.

6.     Dreese,  et aL,  "Developing  Models for Assessing the Financial Health of Small and
       Medium-Sized Water Utilities," Journal American Water Works Association (June 1993),
       pp. 54-60.
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                                  CHAPTER 2.
            PAWATER:  A FINANCIAL PLANNING MODEL
         FOR NEW,  SMALL COMMUNITY WATER SYSTEMS1
2.1   Overview of the PAWATER Approach to Viability Assessment

      The PAWATER Financial Planning Model is a microcomputer-based software application
for estimating the total costs of design, construction, finance, and operation of proposed new,
small community water systems.  The model is  intended as a preliminary screening tool to be
used by communities, private developers, and  state  and  local regulators to  assess financial
viability of new water systems prior to beginning system development.

      PAWATER was developed with three primary objectives in mind:

      •     to encourage communities to consider the full capital, operating, and financing
             costs of providing water, and to evaluate the impact of these costs on residents;

      •     to promote an evaluation of alternative operating structures such that planners
             select the water system option best suited to community needs; and

       •     to provide regulators with a tool that can be incorporated in the system permitting
             process so that all system developers are required to complete comparable long-
             range financial plans that make clear the full costs of quality water provision.
             Combined with statutory provisions that enable regulators to tie  system approval
             to acceptable financial planning  results, PAWATER can assist regulators to
             prevent the development of non-viable water systems by identifying potential
             problems prior to construction.

       The  PAWATER model incorporates fundamental financial planning concepts with a
 database of  cost estimates and operating parameters in a "user-friendly"  software package that
 requires no  sophisticated financial expertise.  It is assumed that the user of the PAWATER
 software has an understanding of water system requirements and local conditions, and that, prior
 to using the software, the developer has completed a series of detailed worksheets provided in
 the PAWATER package.  Ideally,  a water system developer's engineer will have completed
 intermediate-level investigations of system requirements, will help complete the worksheets, and
 may assist in exploring alternative scenarios using the PAWATER software. The software may
 be used by  the  developer to explore system options, or by the  regulator and  the developer
 together to assess the viability of a proposed system as part of the permitting process.

       The  PAWATER software prompts the  system planner to enter  data on  water usage,
 source,  treatment, storage, and distribution requirements  for the  proposed system, as well as


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information on anticipated interest rates, inflation, and financing structure. Although the user
has the capability to modify most information in the model, PAWATER calculates default values
for a range of key variables. For instance,  cost estimates of major construction and operating
items, such as pipes and chemicals, are generated from water system cost tables based on user
responses to questions of system size, operating  environment, and treatment needs. These cost
tables can be modified to reflect local economic conditions.

       PAWATER uses information provided by the user and supplied by the system to calculate
the expected annual capital, operating, and financing costs of the system, and the fees  required
per household to cover these costs over a five-year period. The program analyzes costs  and fees
required for three alternative ownership structures: a homeowners association, an investor-owned
utility, and a municipally-owned utility.  In addition, the cost of interconnecting with an existing
system can be  estimated.  PAWATER produces a four-page summary report of total capital
costs, total annual operation and maintenance costs, and a pro-forma cash flow analysis  for each
of the three ownership scenarios.  A detailed 17-page report also can be produced that details
the  user-provided  assumptions  and  the  PAWATER  cost  calculations of  major  system
components.

       The results can be used to assess the practicality of a proposed system based on the
burden to the community and its residents of financing the full cost  of construction, operation,
and financing.  The information used to generate the cost scenarios can then be manipulated by
system planners and regulators to explore the effects on costs of different interest rates, customer
growth rates, system configurations, ownership structures, and other changes in assumptions and
critical water system variables.  In addition, the software allows the user to change treatment
requirements so as to  explore the cost impacts  of future Safe  Drinking Water Act (SDWA)
regulations. Figure 2.1 depicts the major steps in the PAWATER financial planning approach.


2.2    Purpose and Objectives of the PAWATER Model

Financial Planning and Viability Assessment for New Water Systems

       PAWATER is a financial planning tool for new water system developers and regulators.
It provides a systematic and comprehensive methodology for estimating the full costs of quality
water provision based on assumptions about system requirements and financing structure, and
details of the local economy, the geologic and water source environment, and  proposed system
design.  PAWATER is a tool for individual system analysis that provides information for the
assessment of potential viability of a proposed system based on assumptions  and design data,
rather than an assessment of actual viability  for an existing system.

      PAWATER does not address the question of system viability directly.  It simply reports
the full costs of water provision as well as the annual per residence  charges and other  revenue
sources needed to cover these costs over time.  This information can be used by regulators in
conjunction with information on per capita incomes in the service region and  water system

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                                     Figure 2.1
     Major Steps in the P AWATER Financial Planning Methodology
                                  System Developer
                                Completes PAWATER
                                    Worksheets
                                  System Developer
                                  Enters Information
                                in PAWATER Software
                                PAWATER Calculates
                                Five-Year System Costs
                                                                   Developer Examines
                                                                     Alternatives and
                                                                    Modifies Approach
                               Developer Meets with
                                     Regulator
                                Developer and Regulator
                              Perform Sensitivity Analysis of
                            Proposed System Using PAWATER
  Regulator and Developer
Use PAWATER to Determine
      Best Approach
No

Developer and Regulator
Examine Alternatives and
Modify Apporoach
\
i
   Are There
Better Alternatives  >•*
                                  Developer Proceeds
                                  with Next Steps in
                                   Approval Process

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charges in surrounding areas to assess the ability and  willingness of customers to pay these
charges and fees. This information alone, however, is not sufficient to prevent the development
of non-viable systems. Regulators must also have the statutory ability to tie system approval to
the results of PAWATER or similar financial planning studies.   In this way, regulators can
identify systems which appear to be excessively expensive, and therefore potentially non-viable,
prior to system construction.  Ideally, regulators need sufficient authority to be able  to insist on
convincing evidence of viability as a condition of system approval.

       This proactive  approach to  viability assessment has two principal benefits.  First, by
requiring developers to conduct a PAWATER or similar financial planning analysis as part of
the permitting process for system approval, regulators encourage developers to think through the
full costs of water service provision during system planning.  These costs are often not made
explicit by developers who may have  no incentive to minimize operating costs  or  to plan for
O&M  cost  recovery  in  cases  where their responsibility  for system operations ends once  a
housing development is  complete and housing  units are  sold.  In  many cases, homeowners
associations or localities  are  burdened with unanticipated  operating and maintenance costs for
water systems once the system developer has moved  on.  By tying system approval  to full-cost
financial planning, regulators encourage developers to explore alternatives that can lead to less
costly service delivery, like interconnections with surrounding systems. As a result,  developers
may eliminate non-viable approaches from consideration prior to regulatory involvement.

       Second, since the PAWATER tool allows users to save and modify assumptions like the
rate of inflation, growth in demand, and financing structure, as  well as system design variables
such as pumping and treatment requirements, the regulator and the developer can work together
to explore potential system viability based on developer's assumptions as well as other  likely
financial and  operating scenarios.  Notably,  the effect of future SDWA regulations can be
explored by analyzing the cost impacts of additional treatment technology requirements. This
exploration of alternatives can illustrate the sensitivity of system viability to potential increases
in costs and might further suggest modifications to  system design to promote more efficient
operation.  In instances where viability appears questionable over the range of likely scenarios,
the developer and regulator can then evaluate the effects on system costs of other system options.

Users of the PAWATER Software and PAWATER Results

       As described more completely in Section IV, PAWATER requires that the user have
knowledge of water system requirements as well as economic and construction conditions at the
site in order to complete the  planning  analysis.  Although the program is not intended for the
development of detailed,  site-specific cost estimates,  the planning  information requested by the
model still demands a thorough understanding of water system design parameters in general, and
an intermediate-level familiarity with site specific requirements.  It is expected that the developer
will have performed an initial design assessment and  will work with a water system engineer to
complete PAWATER worksheets prior to using the software.
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       The PAWATER analysis can be conducted by the system developer independently and
then replicated together with state or local regulators to calculate the full costs of a proposed
system design. The developer may want to explore a number of alternatives prior to submitting
a proposed design for approval, and the regulator may want to assist the developer to investigate
still  other alternatives  or to critically  examine  the  impacts of changes  in inflation or other
assumptions.  It is expected that both the developer  and the regulator may want to examine a
number of design and operating structures in order to identify the most suitable and cost-efficient
system,  and that a range of realistic assumptions will be tested to analyze the cost impacts of
likely future scenarios.

       PAWATER results  can be used  by developers,  potential water system customers,
governments, and regulators to evaluate the full costs and associated fees and subsidies required
to meet the financial obligations  of the proposed water system.   These costs and fees can be
compared with national  and regional averages and can be assessed  with respect to customer
household incomes and  residents'  willingness to pay to make a  determination of the likely
financial viability of the proposed system. In instances where the costs appear to be excessive,
the developer can use  PAWATER to reevaluate plans and  explore alternative water provision
options.

       If the proposed system design seems reasonable, the PAWATER information can be used
as the basis for more detailed engineering studies prior to system development.  Regulators can
file  the results of the  PAWATER analysis with other system approval documents to  provide
background information in the event  of future system viability problems.  In addition, the
information can be used by local governments and homeowners associations to inform potential
home buyers of the expected costs of water provision in the area. This information may help
justify needed rate increases and may improve system financial viability by providing customers
with information needed to budget household expenses.


2.3     PAWATER Technical Approach:  Financial Planning and Full Cost Recovery

        The general financial planning approach used by the PAWATER software is straight-
forward. The methodology used is commonly applied during planning for any capital-intensive,
long-lived investment for public service provision.  It requires an estimation of the full-costs of
water provision during the life of the system and a determination of the revenue sources, such
as user fees, supplemental charges, and subsidies required  to recover these costs.

 Costs of Water System Provision

        Financial planning for full cost recovery  is based on the premise that the costs of service
provision include more than just the annual costs  of labor, supplies, equipment, and other routine
 expenses needed to operate a facility once it is operational.  The capital outlays needed for the
 initial design and  construction of water system assets, such as payments for pumps, pipes,
 treatment facilities, and engineering services, and the funds needed to expand and upgrade the

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system  over time are often the largest financial burdens  associated with water provision.
Sources of funds for these capital costs must be accounted for by system developers.  Typically,
capital costs for construction are financed,  in part, through the issuance of debt on  public
markets.  The annual interest payments on these loans represent another cost of the system. In
addition,  in cases where  developers  invest private funds in water system development,  they
expect to see a financial return on that investment in the  form of profits.  The fee that private
water providers charge to ensure a  reasonable profit represents an additional cost of water
service provision.  The total of these  capital, operating, and financing costs over the life of the
water system assets represents the full costs of the system.

Water System Revenue Sources,  Subsidies, and Forfeited Revenues

       Since quality water provision  has value,  water system owners, both public and private,
typically charge users directly or indirectly for some or all of the costs of providing the service.
Direct charges  include monthly  fees to each residence, perhaps based on the  amount of water
used, and one-time connection fees for residences that are added to the system.  Indirect charges
may include additions to the purchase price of a home or commercial property, or special
property tax surcharges used to pay water system costs.

       Full-cost recovery implies that the residents who benefit from water provision will pay
the full costs for the service through some combination of user-fees, taxes,  and special charges.
Often, however, a system is built to  service a number of housing units that are sold and
inhabited over  a period of years.  In many  cases, it is  considered unfair to  charge the early
purchasers of residences for the full-cost of service provision during this  "build-up period" when
these costs are  based on a operating a system intended to serve  a larger population.  To avoid
this  situation, private developer or government subsidies may be required to reduce costs to
users before all residences in the service area are purchased and/or  connected to the system.
These subsidies are used to lower user fees below full-cost  recovery  levels for customers who
connect to the water system in early years of development and are set such that customers only
pay  the  portion of  system costs  that  they  would pay under  the fully-developed operating
environment.  Public utility commissions often require that private owner/operators implement
these equitable user fee charges during system  customer base development.   Under private
ownership, these subisidies are  considered a required cost  of business and are referred to as
"forfeited revenues" in the PAWATER model.

Matching Costs with Revenues:  Promoting Rational Decision-Making and Accountability

      A  financial plan for full-cost  recovery makes explicit the expected costs of providing
service over a given planning horizon (typically five to twenty years), as well as the revenues
and  subsidies that will  be used to cover these  costs.  It provides sufficient information for
developers, community  residents, local government officials, citizens, and regulators to  assess
the practicality  of the proposed approach and to evaluate  the expected financial impacts  of the
system on community residents and  other taxpayers.  In this  way, financial plans promote
rational decision-making on the part of developers and local governments,  reduce uncertainties

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over future resource needs, and foster accountability among those responsible for water system
decisions.

       Unfortunately,  the financial  planning  process  is  often  ignored or  implemented
incompletely by system developers and governments, potentially resulting in system costs that
can not be recovered through user fees. In cases where realistic full-cost financial plans are not
prepared, system quality often deteriorates, and customers must pay excessive fees or taxpayers
must provide unexpected subsidies to keep systems operational.  PAWATER is one financial
planning approach  to  limit these non-viable system outcomes.   As  described  below, the
PAWATER software  automates many fundamental  financial planning tasks,  incorporates
historical information on water system costs, and allows system developers to easily explore the
costs of alternative system designs.
2.4  PAWATER Methods and Data Requirements

       PAWATER provides an efficient and consistent method of estimating system costs and
associated revenue requirements for a few common system ownership/operating structures.  The
PAWATER viability screening process requires  the prospective water  system developer (or
engineer) to complete a  seven-page  Data Collection Worksheet describing  relevant system
parameters and economic and financial assumptions.  The developer, alone or in conjunction
with the regulator, then enters  this information into the PAWATER program, which uses this
data and an internal cost database to calculate system costs.  Users can then examine the
PAWATER output to assess system  financial impacts, can adjust input parameters to  explore
system sensitivity to alternative assumptions, and can make a determination on proposed system
viability. The primary steps in the PAWATER methodology are illustrated in detail in figure
2.2.

The PAWATER Data Entry Program and User-Defined System Requirements

       The PAWATER data entry program consists of multiple screens that prompt the user to
enter data  and make decisions  regarding design parameters and physical characteristics of the
proposed system.  The program follows a logical system planning path,  which begins with the
entry of general economic data, such as interest rates and construction conditions, followed by
detail on water  consumption and demand levels, and information on physical system design.
PAWATER customizes its data input requests based on previous information provided by the
user.  For example, a user's choice  of a water source (e.g. wellfield supply) will define  what
 additional  information on system design will be  required  (i.e., if wellfields are specified, no
 information on spring-supplied or surface water-supplied systems will be requested). Throughout
 the  data entry process, PAWATER  checks  the reasonableness and consistency of user input,
 provides recommended default values, and presents immediate output of interim calculations.

       PAWATER initially prompts  the user to supply a number of financial control parameters
 and general utility criteria that will affect cost calculations throughout the PAWATER analysis.

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                                           Figure 2.2
                  PAWATER Data Entry and Analysis Steps
                     Define Financial Control and Cost Adjustment Factors, including:
                       Base Year
                       Price Index
                       Inflation Rate
                       Facility Life
                    Cost of Equity Capital
                    Cost of Debt Capital
                    Financing Structure (% Debt % Equity)
                    Depreciation Rate
                            Define Water Consumption Requirements, including:

                              • Number of Residential Units and Water Use / Unit
                              • Non-Residential Consumption
                              • Unaccounted-For Percentage
                              • Peaking Factors
                              • Fire Service Demand
                                      Define Water Source Parameters
                                               (select one)
Well Supplied
  Average Yield per Well
  Safe Yield per Well
 • Bedrock or Overburden
Spring Supplied
•  Lowest Flow
•  Minimum Row Release
  Construction Requirements
River Supplied
 • Lowest Flow
  Minimum Flow
Interconnection
•  Purchase Cost
•  Base Rate
•  Up-Front Capital
                                       Define Treatment Requirements
                                         (Surface or Non-Surface)
                                                            Softening
                                                            Mineralization
                                                            Nitrates
                                                            Fluondation
                                   Define System Requirements

                           Primary Pumping Facilities Details
                           Distribution Storage
                           Pipes, Wet Taps, Dry Taps
                           Air Release Valve Manholes
                           Blow off Connections
                           Fire Hydrants
                           Residential, Non-Residential, Fire Service Connections
                           Operations Related Capital Costs
                           Other Facility and Project Cost Revenues
                                 Calculate Five-Year Full Cost of System for

                                • Homeowners Association
                                 Investor-Owned Utility
                                 Municipally-Owned Utility
                                 Evaluate System Costs and System Viability,
                                        Perform Sensitivity Analysis
                                         Modify System Design or
                                           Operating Structure.

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These variables include construction, electricity, and general cost levels and inflation rates for
the study period, percent debt financing and interest rate on debt, percent equity financing and
rate of return on equity, expected facility life, and depreciation rate for the facility.  The system
also  prompts  the  user for  five  General  Utility Criteria  variables that are used to  adjust
construction costs  for  pipes and other facilities based on nature of the workforce (in-house,
contract, or union) and geographic conditions (type of terrain, percentage rocks, etc.).

       Once these general variables are defined, PAWATER requests more detailed information
on water system  requirements.   Water  system demand  requirements are calculated  from
information provided by the user on numbers  of residential units, commercial consumption,
unaccounted-for water, "peaking factors", and fire service requirements. PAWATER provides
a number of  methods  for calculating residential, commercial, and peak demand  and uses the
results of user input and internal calculations  to determine system costs.   The PAWATER
approach to estimating system costs based on user-input demand and treatment requirement
parameters are discussed in more detail below.

PAWATER Cost Estimates

       The PAWATER software includes a database of cost estimates for all system capital and
O&M  components drawn from historical data on water supply facilities. The database includes
cost tables for system  components based on facilities of various size and design.   As the user
provides information on  physical system requirements, the PAWATER software  matches user
inputs  with appropriate default costs, adjusted for  inflation and  operating environment factors
entered by the user.  In all cases, these system-provided cost estimates can be modified by the
user to reflect unique individual operating conditions. Cost categories covered in the PAWATER
analysis include:

       Capital Costs

       Capital costs are  estimated by  one of  several methods  linked to  the program's cost
database. Methods used  include fixed cost per item, and unit costs tied to item size or capacity.
Capacity requirements are linked to projected demands, based on such user-provided data such
as numbers of residences, commercial "equivalent dwelling units (EDUs)" served, and applicable
"peaking factors". For example, costs for installed water mains, fire hydrants, and meters are
estimated using a fixed cost per unit multiplied by units required for system demands. Costs for
water  treatment facilities are  based on user-defined treatment  requirements,  which  allow
PAWATER to select needed water treatment technologies (e.g. package-type gravity filtration,
or reverse osmosis  plants).  Once treatment  requirements  and water demands  are  defined,
PAWATER  uses  a  construction  cost  versus capacity (maximum daily demand) relationship
tabulated in the cost database to derive  expected construction costs for treatment.   PAWATER
tables  also contain information on construction cost versus  storage capacity and are  used  to
estimate the cost of  storage facilities, such as elevated tanks, clearwells, and standpipes, from
user-supplied data on fire and other emergency needs. Construction costs for pumping facilities
are  estimated based  on a  complex  set of  user-supplied data  and PAWATER  database

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relationships for pump stations, pressure relief valves, and telemetry control requirements.  The
user also can enter the costs of up to three additional capital components not included in the
PAWATER database.

       O&M Costs

       Operation and Maintenance (O&M) cost estimates represent anticipated annual costs for
comprehensive system operation consistent with industry standards.  O&M cost estimates are
included for water supply, treatment, transmission, and distribution.  All energy costs, customer
costs, and general administrative costs are also included. Customer costs include meter reading,
billing and collection,  and miscellaneous customer service expenses. O&M cost estimates are
drawn from PAWATER's cost tables, using historical relationships between system O&M costs
and numbers of EDUs served.
2.5  Results

       PAWATER reports system costs and a projected cash flow analysis for the first five years
of water system operations under  three water utility ownership  structures:  a  homeowners
association, an investor-owned utility,  and a municipally-owned utility.

       For all three ownership options, capital costs for the water source, treatment facilities,
pumping facilities, storage structures, operations  capital,  and other facilities are financed
assuming  that  these  facilities are constructed  in the base  year.   The remaining  capital
expenditures,  which  include mains, taps,  hydrants,  meters and  meter pits, manholes,  and
blowoffs are assumed to be constructed in proportion to the EDUs served annually.  All annual
operating expenses are also computed in proportion  to the total EDUs served hi  each year.
PAWATER then presents the annual  charges per  EDU,  additional costs per residence,  and
subsidies or forfeited returns required by system owners under each ownership structure.  These
calculations are unique to each ownership option and are discussed in detail below.

Homeowners Association

       For systems owned by a homeowners associations and for mobile home parks, it  is
assumed that the capital costs for system construction will  be included in the purchase price of
the units served by the water system.   PAWATER  calculates the contribution to water system
capital costs required per EDU by dividing the total capital  cost of the system by the number
of EDUs expected once the system is fully developed. This  methodology implies that  developers
must sell all of the planned units in a development in order  to recoup water system capital costs,
and that early purchasers will not be required to pay the capital cost share of unsold units.  Since
this capital cost contribution is hidden  in the purchase price  of the unit, it is not included as a
financial outlay for the water system and is reported separately on the PAWATER report.
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       PAWATER then calculates the annual charge per EDU for the homeowners association
owned system by dividing the gross revenue required once the system is fully developed by the
total number of EDU's.  Gross revenue requirements include the O&M costs calculated from
user-supplied information and PAWATER cost tables as well as contributions to a fund for
capital renewal and replacement.   The annual renewal and replacement fund contributions are
assumed to be  equal to the loss in value  of the system's cumulative capital  assets each year
(calculated from the user-defined depreciation rate times the cumulative capital cost of the
system). PAWATER assumes that this annual charge per EDU, calculated to cover costs once
all EDUs are connected to the system, will be the annual charge per EDU in the early years of
system  operation  as well.  In cases  where this  annual charge results in system  revenues
insufficient to cover gross revenue requirements prior to full system development, PAWATER
calculates the annual subsidy required  each year.  The present value of all subsidies required
throughout the  study period is presented in the  PAWATER report.

Investor-Owned Utility

       For systems owned and operated by the private  sector, PAWATER assumes that the
construction cost of the facility is  recovered from users in water rates charged over the life of
the system.  In addition, the private entity will charge users a price that allows the firm to earn
sufficient returns to pay off debt used to finance the facility and compensate equity investors for
their financial investment.  PAWATER uses user-supplied information on the debt-equity mix
used to finance the facility, interest rate on debt, and  required return on equity to calculate the
overall return required on the depreciated value of the system each year.  In estimating system
costs and project cash flows, PAWATER must  also account for income and other taxes paid by
the private owner/operator.

       PAWATER calculates  the total capital and operating costs incurred in each of the first
five years of system operations.   The report also includes the yearly depreciation expense
incurred on  capital assets.   PAWATER then calculates private sector taxes and the  return
required on the fully-developed system based on user-supplied information on tax rates,  debt-
equity mix, and the cost of debt and equity. Once the costs, taxes, and returns are determined,
PAWATER calculates the revenue required for the fully-developed system and establishes the
annual  charge per EDU.  This annual  charge is assumed to remain constant in the early years
of system operations and PAWATER calculates the return available to the private investors in
these years by subtracting total O&M costs, depreciation, and taxes from revenues generated by
the annual EDU charge.  PAWATER  then calculates the  required return in these years (based
on the weighted return on debt  and equity for cumulative system assets) and  presents any
shortfall between actual and required return as a "return forfeited" by the private investor.  The
present value of these  forfeited returns,  or  private sector subsidies, is also presented  in the
PAWATER report.
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Municipally-Owned Utility

       For municipally-owned utilities, PA WATER assume that construction costs of the water
system  will be  recovered  through  a one-time tapping fee and annual  water fees  charged
throughout the life of the facility.  All construction costs not recouped through tapping fees are
assumed to be financed through a bond  issue, with  interest payments recovered through user
charges. PA WATER assumes a $3000 tapping fee, but this default value can be changed by the
user.

       PA WATER estimates  the capital and operating costs required under the first five years
of system operations. As with the Homeowners Association option, PAWATER also  assumes
that contributions  to a  replacement reserve  are  funded annually at  a  level equal to annual
depreciation of accumulated capital assets. PAWATER also calculates the annual debt service
required each year based on the total amount of debt required for the system (total capital costs
minus total tapping fee revenue), the cumulative capital costs expended, and the interest rate and
maturity of debt information supplied by the user.

       Once  yearly  costs have been determined,  PAWATER  calculates the  gross  revenue
required to cover  these costs once the system is fully developed. PAWATER divides gross
revenue by total EDUs served to establish an  annual charge per EDU.  As with the other two
options, PAWATER assumes this user charge for the fully developed system will apply to users
in earlier years of system development as well. It is assumed that the municipality will provide
a subsidy to meet  any additional revenue needs of the system. The PAWATER report details
the annual subsidy required as well as the present value of total system subsidies throughout the
study period.
2.6    Summary and Extensions

       PAWATER provides an easy-to-use tool for developers and regulators to assess the full
costs of providing water service for proposed community  water  systems.   The PAWATER
approach minimizes the complexity of the financial planning process by both automating the
planning steps and providing ready access to a database of historical information on design,
construction, and operating costs.  PAWATER also provides for a great deal of flexibility in
analyzing numerous ownership/operating structures, alternative economic assumptions, and what-
if scenarios regarding the impacts of future SDWA regulations on system costs and viability.

       Nevertheless, users may want to adapt and build on the tools provided in the PAWATER
package. Some modifications can be made from within the PAWATER software.  For instance,
the cost database can be updated to  reflect recent changes in prices of materials or regional cost
variations.   Other changes may require more substantive efforts. For instance, system owners
or regulators may wish to develop financial plans for more than a five-year period, or may wish
to analyze  the impacts of other ownership structures not included in the PAWATER reports.
Although the financial planning methodology used by PAWATER is straight-forward and can

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be implemented with any  spreadsheet program, the  inclusion of historical cost data and
automation of the cost estimating process can involve some substantial development time.

       In addition, PAWATER is just one piece of the viability assessment process.  PAWATER
can be most effectively used as part of a broader policy and regulatory framework for viability
assessment.  Such a framework would need to be defined so as to meet the needs of individual
states and regions but will likely include statutory provisions to tie system approval to the results
of a PAWATER or similar system financial plan. In addition, some states  may wish to explore
mechanisms to  ensure that  developers build  the system they have defined in their proposal.
Policy tools, such as financial guarantee requirements, might be used to encourage developers
to implement the system as  approved.

REFERENCES:

1.     PAWATER:  Financial Planning Model for New Small Water Systems, developed for
       the Pennsylvania Department of Environmental Resources by Gannett Fleming, Inc. and
       Wade Miller Associates, Inc.,  July 1992.
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                                   CHAPTER 3.
                   A DOZEN QUESTIONS DIAGNOSTIC
                 TO ASSESS  SMALL SYSTEM VIABILITY1

3.1          Overview of the Dozen Questions Approach

       The "Dozen Questions" approach to assessing small system viability was produced for
the AWWA Guidance  Committee to Small  Systems.  It provides a  diagnostic procedure for
probing an existing drinking water system's ability  to meet current  and future operating and
financial requirements.  The objective  of the method is to promote comprehensive strategic
planning among small system owners, managers, customers, and regulators so that near- and
long-term operating and financial challenges are understood and effective cost-efficient responses
can be planned.

       The method simply consists of a series of  detailed  questions that cover  the critical
parameters defining small system viability.  The twelve categories of questions form a five-tiered
"diagnostic pyramid"  as depicted  in Figure 3.1.  The five tiers of the pyramid are traversed
sequentially, beginning with questions on water system capacity and demand, continuing through
questions on water quality and infrastructure conditions, to arrive at  questions of management
capabilities and financial stability.  Finally, questions on customer awareness assess the degree
to which customers understand the operating and  financial challenges faced by small water
system providers. The implication of this pyramid structure is that the problems and challenges
identified in upper tiers  will  require a broader,  sturdier underpinning of management and
financial support to  ensure system viability  in  the future.   At  its foundation, customer
understanding of what is required to operate and maintain a water system is integral to assuring
cooperation for new capital investment and higher water rates, and, therefore, system viability.

       The focus of the dozen  questions method is on encouraging small system owners to ask
themselves the  necessary questions to uncover system risks and liabilities and to confront the
costs of meeting these challenges.  The method deliberately raises questions without providing
too much structure for exploring  solutions.  Its intent  is to  provide insight into existing and
potential problems such that owners are stimulated to take logical next steps to address system
limitations revealed in the diagnostic process.  In addition, the procedure focusses on collecting
and organizing  information so that owners, managers, governments, and customers can evaluate
the extent to which the water  system is meeting, and will continue  to meet, its financial and
regulatory  obligations.   This information provides a basis  for  action and can improve
understanding  and cooperation among key stakeholder groups.
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         Figure 3.1
 The Dozen Questions "Diagnostic Pyramid"
       Quantity
        Quality
      Infrastructure
Management & Finance
 Customer Awareness

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3.2          Purpose and Objectives of the Dozen Questions Approach

       The dozen questions methodology is intended to alert small system owners, managers,
and customers of the challenges they must meet and the decisions they must make hi order to
remain viable throughout the  next decade as  new, more stringent  Safe Drinking Water Act
(SDWA) regulations are introduced.  The method has three basic objectives:

       •     to encourage a  "big picture" evaluation  of existing system demands and future
             system requirements implied by Safe Drinking Water Act (SDWA) regulations (to
             be phased  in over the next ten years) so  as to promote efficient operational and
             investment decisions over the long-term;

       •     to combine  knowledge of water demand and  quality issues with an equally
             comprehensive  understanding  of the full costs  of meeting  these  operating
             requirements; and

       •     to encourage systematic collection and  dissemination of information on these
             critical water systems issues so as to promote dialogue and cooperative planning
              among owners,  managers, regulators, and customers.

       The approach does  not result in a definitive determination of system viability. Instead,
the goal is to encourage key  stakeholders associated with small systems to ask themselves a
series of questions that will lead them to  recognize the risks of being unprepared and to discover
then- most viable options  for the future.  In this way, systems all  along the "viability  spectrum"
will benefit from the dozen questions diagnostic.  Systems that have the technical, managerial,
and financial capability to meet all customer demands and regulatory requirements without major
modifications to operations will be able  to use the diagnostic to prepare detailed operating and
financial plans in order  to communicate  their stability to customers, regulators,  and credit
providers.  Owners of systems that appear viable today, but that may face serious challenges as
new SDWA regulations are imposed, can identify major required changes to current  operations
needed to meet requirements for the foreseeable future.  These systems can institute one-time
cost-effective modifications or seek outside assistance, rather than make a series of incremental
expenditures that may be costly in the long-run. Finally, systems that are not currently meeting
obligations or that will be unable to meet future customer demands and regulatory requirements
can begin seeking assistance before  problems become severe.   In these cases, restructuring
alternatives or other options can be evaluated and implemented with a full understanding of area
needs and system costs.

3.3          Dozen Questions Technical Approach:  A Forward-Looking Assessment of
              Operating Requirements and Full Costs

       The "dozen  questions"  diagnostic actually consists of many more than twelve questions.
These questions, which  can  be divided into twelve  general  categories,  cover both current
conditions and  future  requirements  and  contingencies.   Many  require  specific,  detailed

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information about the chemical, geological, financial, and physical characteristics of the water
supply, treatment, and  distribution system.  Others require a more open-ended assessment of
future conditions and an ability to predict the ways in which demographic, agricultural, and
industrial changes to  the region surrounding the system will impact water provision operations
and costs.  It is likely that system owners, managers, and engineers will need to participate in
the diagnostic process so that technical, operational, managerial, financial, and strategic concerns
can be addressed.

       The questions systematically probe system quantity, quality,  infrastructure conditions,
managerial competence,  financial  stability,  and  customer awareness, in  that order.   This
progression leads the system "diagnosticians" to fully explore the technical challenges faced by
system owners and managers in order to meet current and future customer demands as well as
satisfy existing and soon to be  introduced  SDWA regulations.   Once these challenges  are
identified,  the diagnostician must then critically evaluate the managerial and financial capabilities
of the system to achieve these objectives. Finally, the extent to which water system customers
are aware of the technical challenges and financial requirements for providing water is assessed,
to evaluate the potential for customer support for needed  rate  increases in the future.

       The twelve categories of questions, grouped by the five tiers of the diagnostic pyramid,
are summarized in figure 3.2.  Additional detail on the nature of the questions in each category
is provided in section 3.4.

3.4           Dozen Questions Diagnostic Methods and Data Requirements

       The questions that comprise the twelve diagnostic categories require assessments  of
existing water  quantity and quality parameters, operational and  engineering  detail  on water
source,  storage, distribution, and treatment, capital  and operating financial  requirements, and
managerial and personnel capacity.  In addition, questions  probe likely changes in many of these
critical factors  and therefore require estimates of future needs and costs.  For many questions,
the implications of some answers are briefly explored.  In order to complete the diagnostic, it
is likely that a  number  of technical studies, water quality monitoring, and financial plans will
need  to be prepared so that  accurate answers  and  reliable  projections can be made.   A
description of the twelve questions categories and types of questions included in the diagnostic
is summarized  below.
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                    Figure 3.2  Twelve Categories of Questions in the
                                Dozen  Questions Diagnostic

          Quantity

          1.       Is the water source safe, adequate, and reliable?

          Quality

          2.       Is microbiological contamination a current or a potential future problem?
          3.       Are disinfection by-products likely to be a problem under new SDWA regulations?
          4.       Are corrosion by-products an existing or potential future problem?
          5.       Are natural geologic contaminants an existing or potential future problem?
          6.       Are agricultural chemicals an existing or potential future problem?
          7.       Are industrial/commercial chemical contamination an existing or potential future problem?

          Infrastructure

          8.       Is water system infrastructure, including pumping, storage,  and distribution systems, in
                  good condition?

          Management and Finance

          9.       Can existing and future operator requirements be met?
          10.     Are management systems and controls adequate to meet existing and future requirements?
          11.     Has the system completed comprehensive financial plans and is the system capable of
                  meeting all existing and future financial obligations?

          Customer Awareness

          12.     Do water system customers understand the challenges and costs of providing high-quality
                  water on demand?
1. Is the Water Source Safe, Adequate, and Reliable

       Small systems differ in their ability to maintain an adequate quantity of supply on a
reliable basis to meet existing and future water needs.  The twenty-six questions in this section
of the diagnostic focus on adequacy of existing supplies to meet existing demand (e.g.  What are
average and peak daily requirements?, and Have shortages been experienced?} and existing or
new supplies to meet future demand (e.g.  Does the system have a demand forecast?, Are the
long-term plans of commercial customers known?, What alternative water sources are available,
and what are their characteristics and costs?, and How much influence does the system have over
activities taking place in the watershed  or well head area  that may be potential sources  of
contamination ?).

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2.  Is Microbiological Contamination a Current or Potential Future Problem

       Recent major outbreaks of waterborne disease  have emphasized the  need for strong
discipline in protecting water  supplies from microbiological  contamination.   This discipline
requires  vigilant efforts in source  protection, treatment, storage, and distribution.  Also, new
SDWA regulations  will increase  the  treatment  requirements  for protection from microbial
contamination in both surface waters and groundwater.  The thirty-one questions in this section
explore microbiological considerations for both surface water and groundwater,  as well as in
water distribution systems.  Questions  include:

       For  Surface  Water Systems.   Will you have to filter?, Is  your record free of any
       waterborne disease outbreaks or  "boil water" notices from the state?  Has the state or
       your own engineer performed a  "sanitary survey" or "performance evaluation" of your
       plant recently with satisfactory results?

       For Ground Water Systems:  Are you sure it's really ground water?  Does your water
       become cloudy  or turbid and undergo changes in temperature in the period after storm
       events? Do you regularly inspect and maintain your chlorine dosing equipment?  Can
       you detect a chlorine  residual at taps  throughout the distribution system ?

       For Distribution Systems: Are you just delivering water or are you growing anything else
       in there? Have you encountered compliance problems with the Coliform Standard?  Do
       you regularly receive  complaints regarding the taste and odor of chlorine?

3.  Are Disinfection By-Products an Existing  or Potential Future Problem

       Although the public health benefits of disinfection are universally accepted, recently there
have been questions raised about the potential health effects of various chemical by-products
formed by popular disinfectants such as chlorine.  As  a result, new SDWA regulations will
require small water systems to begin controlling  for disinfection by-products in the latter part
of the  1990s, with further controls possible during the first decade of the next century.  This
diagnostic section explores the likelihood that  small water systems will need to address the issue
of disinfection by-products in the future.  Questions include: Do surface water systems have raw
water with Total Organic Compound (TOC) levels > 4mgl? (TOC >  0.7mg/lfor ground water
systems)  and/or bromide levels >  40 ug/l (bromide  > 60 ug/l for ground water systems)  Do
surface water systems  have a filtration process that includes  both chemical coagulation and
settling prior to filtration ?

4.  Are Corrosion By-Products an  Existing or Potential Future Problem ?

       Lead and copper occur in trace amounts in tap water, in part as by products of corrosion
from pipe materials  and plumbing fixtures.  Recent SDWA regulations, known  as "the  Lead
Rule" govern monitoring and control requirements for small systems to address corrosion by-
product issues. The three questions in this section of the diagnostic are designed as a guide to

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assessing  water system  liabilities in this area.  These questions  are:  Has your first draw
monitoring produced results for lead above the 15 ug/l level? Does your treated water have a
pH less than 8 and an alkalinity less than 50 mg/l? Do you have lead service lines, goosenecks,
or service connections in you distribution system ?

5.  Are Natural Geologic Contaminants an Existing or Potential Future Problem ?

       A number of naturally occurring inorganic chemicals present contamination problems in
ground and surface waters as a result of gradual weathering of soils and geologic materials and
as a result of other releases from these sources during mining and processing operations.  This
section of the diagnostic explores the extent to which radon, radium and uranium, arsenic, and
sulfate represent existing or potential contamination sources that may require treatment under
future SOW A regulations.

6.  Are Agricultural Chemicals an Existing or Potential Future Problem?

       Agricultural chemicals  such as nitrate (from fertilizer),  pesticides, and  herbicides can
contaminate water sources. Removal of these chemicals can be expensive, although only a small
percentage  of  water  systems  are expected to have  levels of contamination that exceed the
standards  for these contaminants.   This section of the  diagnostic begins to assess  a water
system's potential compliance challenges as regulations governing agricultural contaminants are
phased in over the next decade.  Questions are primarily general assessments such as:  Do you
know your local  geology and geography?,  Within  your watershed area or your  "zone of
contribution,"  are there any facilities engaged in  the production, storage, or handling of
agricultural chemicals such as  manufacturing plants, warehouses, or farm supply stores?

7.  Is Industrial/Commercial Contamination an Existing or Potential Future Problem

       Organic and inorganic contaminants often associated with hazardous waste sites or other
industrial/commercial  disposal areas represent potential threats to  water quality that will be
regulated  under various phases of the SDWA implemented throughout the coming decade.
Although  most wells and surface intakes are not expected to exhibit this sort of contamination
at above regulated levels, the questions in this section of the diagnostic begin to assess potential
liabilities  in this area.   The principal question in this section  is:  Have  you had any water
samples with VOCs?

8.  Is Water System Infrastructure in Good Condition ?

       The questions in this section of the diagnostic provide an evaluation of the condition of
water system infrastructure, including pumping, storage, and distribution.  Questions include:

       Pumping:  Do you hire a qualified pump contractor to perform an inspection of all
       pumping equipment, identify potential problems, and perform maintenance on an annual
       basis?  Does the system have sufficient gravity-flow distribution storage to provide safe

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       and adequate service for  up  to  24  hours  without power?    Is  an  existing
       standby/emergency power equipment, controls, and switches tested or exercised routinely
       under load conditions for at least 30 minutes at a time ?

       Storage: Is there only one storage tank? Is there a contingency plan for storage if the
       tank collapses?  Is there a high and low  water level electrode signal to control the
       pumps?  Do  all  interior piping, fittings,  and accessories  conform to  the minimum
       plumbing requirements of the National Plumbing Code?

       Distribution:  Does the operator routinely flush,  test, and maintain the hydrants in the
       system ?  Is  unaccounted-for water in the system monitored and analyzed each month ?
       Is there a program to gradually replace sub-standard sized mains?

9.  Can Existing and Future  Operating Requirements Be Met?

       For many  small  systems,  the combination of  a 'backlog of  deferred  infrastructure
rehabilitation needs and new SDWA performance requirements imply that operational demands
are rising at unprecedented levels.  This section of the diagnostic explores whether existing and
future operational needs can  be met.  Questions include:  Has your water system experienced
recent episodes of:  violations of any SDWA standards including contaminant levels, monitoring
and reporting requirements,  shutdowns or outages, or  customer complaints?   Is the present
quality of staff adequate to do the job ?  Based on the answers to previous questions regarding
the extent of your potential water quantity,  water quality, and infrastructure liabilities, what is
the forecast for operational requirements and how does this match up against your current level
of operational capability ?

10. Are Management Systems and Control Adequate to Meet Existing and Future Requirements?

       The management systems needed to oversee the water system grow more complex as the
quantity, quality, and infrastructure needs increase.  This section of the diagnostic highlights the
general types of management systems required. The thirty-six questions include: Is there a
clear plan of organization and control  among the people responsible for management and
operation of the system?  Do you  have  explicit rules and standards for system modifications?
Do you have a deliberately organized regulatory compliance program?  Is there a contingency
plan for making interconnections to neighboring systems and how do you know they will work
when  needed?   Do you have  adequate legal  counsel,   insurance,  engineering  advice,
technical/operations assistance, rate case preparation, and financial advice?

11.  Has the System Completed Comprehensive Financial Plans and
    Is the System Capable of Meeting All Existing and Future Financial Obligations?

       The answers to all of the previous questions in the diagnostic typically result in higher
levels of both capital and operating costs.  The dozen questions diagnostic addresses the small
system's  ability to meet these  costs by asking questions that assess the financial planning process

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as well as pricing, budgeting, and accounting systems.  The questions that make up this generic
financial viability test are illustrated in figure 3.3.
                            Figure 3.3  Dozen Questions Diagnostic:
                                  Financial Viability Assessment

        Does your water system presently operate on a break-even basis, or does it generate surpluses or
    losses?  Is your water system an independent financial entity?  Are there any other sources of revenue
    besides the water rate? Does the water system keep all the water revenues, or are they also used for other
    purposes? If your system is not an independent financial entity, what  would it take to convert it to such
    independent status, wherein the water rate is the sole source of revenue and water expenses are the sole use
    of water revenues, resulting in pay-as-you-go break-even cash flows?

            Do you have a budget? Does your budget process provide for annual depreciation of existing plant,
    the annual cost of servicing your debts, and the annual cost of operations and maintenance?  Do you use
    the budgeting process to  determine your annual revenue requirement via either the cash needs approach or
    the utility approach, as described in the AWWA Revenue Requirements Manual (M35)? Do you provide
    for a reserve fund for capital replacement? Do you use a cost-of service method to develop rates sufficient
    to meet your revenue requirements, as described in the  AWWA Water Rates Manual (Ml)?  Do  you
    regularly review your rates?

            Do you have a capital budget, or capital improvement plan that projects future capital investment
    needs some distance (at least five years) into the future? How are forecasts made? How are they translated
    into construction projects? How are projects scheduled and approved? Does your planning process take
    account of all the potential capital needs suggested by all of the preceding questions in this paper? Does
    your long-term planning incorporate analysis of alternative  strategies that might offer cost  savings to
    customers, such as  consolidation with other nearby systems or sharing of operations and  management
    expenses with  other nearby systems?

            Do you employ  standardized accounting and tracking  systems?  What accounting conventions and
    standards do you follow? How do you track budget performance?  How do you track tax liabilities and
    assure compliance?   How  is billing  and  collection  handled?   Where are the records to substantiate
    depreciation of fixed assets?  How are financial management  record-keeping systems organized?  Who's
    in charge of the cash drawer?  What controls are exercised over expenditures? How  do you  keep from
    exceeding your budget?  What are the  purchasing procedures?  What are your procedures for selection of
    outside contractors and suppliers?
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12.  Do Water System Customers Understand the Challenges and Costs of Providing
    High-Quality Water on Demand?

       Customer awareness is a critical factor in the long-term viability of small water systems.
When customers fully appreciate all of what it takes to operate and maintain a water system,
they are more likely to support rate increases needed to meet new treatment standards or to fund
adequate infrastructure maintenance.   In addition, when customers are provided information
about system needs and challenges, they can understand and assist in evaluations of alternative
strategies for providing water service, conceivably at lower cost.  Since customers will bear part
of the burden of a small system's  failure to  meet  SDWA compliance liabilities through a
reduction in property values, they have a strong incentive to see that the system can successfully
achieve its objectives, or that alternatives are identified before there are severe problems. These
incentives can be used to build support for a viability planning process that takes account of all
the issues identified in the diagnostic.  In addition,  in cases where small systems appear well
suited to meet existing and future challenges,  public awareness of this fact can help system
owners  secure low-cost capital or attract neighboring communities  who may wish to purchase
excess water.  The penultimate questions in the dozen questions diagnostic is therefore:  How
much of all this is known  and understood by customers;  and how would this change  their
attitudes about the future?

3.5           Results

       In may respects, the dozen questions diagnostic is an interactive process. It is expected
that  as questions are  posed, and information is gathered to respond, many problems will  be
identified  and solutions designed before the diagnostician moves on to  subsequent questions.
The  process is unstructured,  however, and, as designed, there is  no standardized "product"
produced as a  result. Nevertheless, it is expected that the operating and financial plans prepared
as part of the diagnostic process will be available  to those within and outside the system who
have a  direct stake in water  system operations.  In addition,  the diagnostic should not  be
considered a one-time test of long-term viability.   Conditions change,  often rapidly, and the
answers to the diagnostic questions may be quite different in a year.  Therefore,  the results of
the diagnostic should not be considered static,  the questions lend themselves to periodic
reassessment as condintions, needs, and regulations change.

3.6           Summary and  Extensions

       The dozen questions diagnostic provides a free-form question-and-answer approach to
viability assessment. It does not produce a discrete "viable/non-viable" determination for small
systems, but instead encourages  system owners and other  interested stakeholders to ask the
questions necessary to uncover potential problems and reach their own conclusions regarding the
ability of the system to meet current and future operating and financial obligations. The answers
generated   during  the course  of the diagnsotic  are intended  to encourage  small  system
stakeholders to take action, in some cases to resolve operating problems before they become

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severe, in other cases to seek assistance or evaluate restructuring options if problems appear
overwhelming.

       The diagnostic can be expanded or streamlined to meet priority needs of systems in a
particular state or region. It can be incorporated into a broader program for viability assessment
that includes more formal procedures for information reporting or a regulatory framework that
ties operating  permit approval to the results of some or all of the results of the diagnostic
questions. Since one of  its primary objective  is to encourage small system owners to being
answering questions and taking action prior to  regulatory involvement, states may wish to
consider  the diagnostic as an  informal initial step in the viability assessment process.
REFERENCES
1.     Cromwell,  Albani and Schmidt, A Dozen  Questions to Assess Small System Viability,
       Annual Conference of the American Water Works Association, San Antonio, TX, June
       1993.
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                                   CHAPTER 4.
                    WASHINGTON STATE FINANCIAL
                      VIABILITY PLANNING MANUAL1
4.1    Overview of the Washington State Water Systems Planning and Financial Viability
       Program

       Washington State has implemented a comprehensive package of programs and regulations
to promote viability of new and existing community drinking water systems and to provide
information to the public on the operating and financial health of these systems. The programs,
aimed  at non-investor  owned  systems  serving  less  than  1000  residences,  incorporate
comprehensive water system planning steps with a multi-stage "financial viability test".  In
addition, the state has established a number of regulatory  provisions that allow the Washington
State Department of Health (DOH) to tie permit approval to successful completion, certification,
and submission of system planning documents and the financial viability screening test. Major
steps in the  Washington State program are illustrated  in Figure 4.1.  The steps  required to
prepare for and take the financial viability test  are described hi the Washington State Small
Water Utilities Financial Viability Manual and are summarized in this section.

       The Washington State DOH  requires that water systems  regulated by the department
complete and submit a comprehensive planning document  known as the Water System Plan
(WSP). The WSP provides a detailed description of the existing  system, presents twenty-year
Capital Improvement Planning (CIP) information for system expansion and improvements, and
details  historical  sources of revenues and anticipated future sources of financing for capital and
non-capital expenses. Water system owners also must complete the Financial Viability Program
(FVP), which requires facilities to prepare a detailed six-year budget of revenues and expenses
and pass a financial viability test (FVT).  The FVT consists of four basic financial calculations
aimed at assessing the internal financial stability of the water system as well as determining the
affordability of water system customer charges.  In the event that systems do not pass the FVT,
Washington State has the statutory authority to deny construction or operating permits or begin
receivership  action.  New regulations governing the FVT program will take effect in 1995. If
a facility fails to pass FVT's affordability test, Washington State authorities can encourage
owners to investigate  restructuring options and can promote public disclosure of the  rates
required to operate the system in the future.

       The Washington State approach  combines forward-looking requirements  for system
planning with an easy to apply mechanism for identifying water systems likely to have financial
viability problems.  It incorporates this planning  and screening methodology with regulatory
mechanisms  in order to promote compliance, identify and restructure non-viable systems, and
improve information dissemination to the public.
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                                     Figure 4.1
                    Major Steps in the Washington State
                        Viability Assessment Program
                                         Stepl:
                                System owner has a preplan
                                  conference with DOH
                                   to discuss WSP and
                              financial viability requirements
                                        Step 2:
                                   Owner prepares the
                                         WSP
                                         StepS:
                          Owner prepares detailed six-year operating
                          budget and supporting capital improvement
                             and financial viability information
 Owner makes required
 changes to system plans
or considers restructuring
       options
                                 Owner establishes system
                                        reserves
                                       P.E. submits
                                    WSP and FVT for
                                   review and approval
    DOH notifies of
  unacceptable results

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4.2    Purpose and Objectives of the Washington State Financial Viability Program

Promoting Financial Viability and Improving Information Disclosure

       The Washington State Financial Viability Program (FVP) is a central  part of DOH's
broader policy for water systems planning and regulation.  It is aimed at assisting new or
existing small community drinking water systems to plan for and demonstrate financial viability.
The primary  objectives of the FVP are to:

       •      Highlight the importance of maintaining a financially sound water utility;

       •      Provide managers of small water utilities (under 1000 connections)
              with an easy to use framework for preparing a  budget used to
              measure rate impacts of projected water system needs and to assess
              system financial viability;  and

       •      Establish a consistent mechanism for regulators to assess financial viability
              and to collect information on a water system's compliance  with  DOH
              viability  criteria.     In  conjunction   with Washington's  regulatory
              framework, this information can be used to restrict operations of systems
              deemed to be non-viable.

       In addition, the program is a vehicle for improving public disclosure of water system
financial information for existing  or potential  water system customers.  The  tools of the
Washington State program also can be used in situations where restructuring is being considered
to determine  the cost and viability impacts of alternative water service  provision options.

Users of WSP and FVT Results

       Utility owners can use WSP and FVT results to evaluate the current and  future financial
and operating health of community water systems.  This information can be used by owners to
adjust capital investment plans and other  planning assumptions so as to  ensure compliance  with
current and impending water regulations or to improve the efficiency and affordability of the
system.  The comprehensive planning data prepared by the owner can also be used to justify
future  rate increases  needed  to finance  investments  intended  to  meet new water quality
regulations.  Regulators can use the information provided by owners to ensure that water quality
standards will be  met and to evaluate the financial soundness  of the utility  and the cost of
service.  Since the regulator has the statutory authority to tie system approval to the results of
the planning documents and the FVT,  the regulator can identify potentially non-viable systems
and can work  with system owners to improve financial stability through restructuring.  In
addition, water system customers and surrounding residents can evaluate future  operating plans
of the water utility and can  use  information on  current  and estimated future rates to  plan
household expenses.
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       Since information collected  for the FVP is available  to  owners,  regulators,  and
customers, the Washington State approach promotes cooperative dialogue among  important
stakeholders.  Owners are encouraged to explore alternative service provisions options prior to
regulatory involvement, customers are provided with information so that they can understand the
need for rate increases, and regulators have a consistent set of data from which to pursue policy
objectives equitably among water systems in the region.


4.3    The Financial Viability Program Technical Approach: Full-Cost Financial Planning
       Combined with Tests of Financial Stability and Affordability

       The FVP is based on the following definition  of financial viability:

              Financial viability is  the ability  to  obtain sufficient funds to
              develop, construct, operate, maintain, and manage a public water.
              system  in full  compliance  with federal,  state,  and   local
              requirements.

This definition implies that in order to be considered viable, water systems must have sufficient
financial stability to meet their current and future financial obligations even when revenues fall
below expectations or when emergencies occur.  Therefore, the Washington State FVP requires
owners to prepare budgets  detailing  the full  costs of water supply  provision as well as the
revenues  expected to be available to meet these costs over a six-year planning horizon.  In
addition,  owners  must demonstrate that the system  has established and funded  contingency
reserves sufficient to meet unforseen operating and emergency needs.

       Full cost estimates include routine operating, general, and administrative expenses as well
as  capital outlays needed to maintain  existing  facilities,  expand  capacity, and/or upgrade
treatment  technologies to  meet six-year customer  demands and  regulatory requirements.
Expenses also include the  cost  of  repaying  new or existing loans used to  finance  system
construction.  In addition, expenses may include contributions to establish or enlarge contingency
reserves.   Revenue  sources include monthly fees collected from water customers, one-time
charges for connection, penalties for late payment, and interest earned on water system investing
activity expected over  the planning period.

       Contingency  reserves are financial accounts  created by the utility  that hold funds
designated for a  specific purpose.   These reserve  funds may include  reserves  used  to pay
operating  costs in the event of revenue  shortfalls  (operating reserves), or  funds used for
replacement and repair of critical system components in the event of an emergency (emergency
reserves}. Some  systems also may wish to fund a reserve for the long-term replacement of
capital assets in order to spread the burden of financing capital replacement over the life of the
system (replacement reserves).
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       The FVT component of the Washington State FVP requires owners to use the revenue
and expense budgets and reserve fund  information to address the following four financial
viability questions:

       1.      Do projected revenues exceed projected expenses?

       2.      Are operating reserves sufficient to cover operating needs in the
              event of a revenue shortfall?

       3.      Are capital reserves sufficient to finance repairs and keep the system operational
              in the event of an emergency? and

       4.      Can customers afford to pay system rates?

       The first three questions probe the internal financial stability of the water utility.  They
assess  the water utility's ability  to meet routine operating  expenses with anticipated system
revenues (question 1), and the ability of the utility to meet obligations under adverse conditions
(questions 2 and 3).  The fourth question assesses whether  customers will be able to pay the
rates projected in the utility's budget.  The affordability question has an important impact on
financial viability since  high rates may result in a higher percentage of uncollectible bills or a
lower than anticipated demand for services.  These factors  will result in lower than expected
utility revenues and, therefore, decreased financial stability.

       The Washington State FVT uses the results of a simple financial calculation to answer
each of the four viability questions. Although no set of four calculations can fully determine a
utility's financial viability, the test questions used in the FVT are aimed at identifying systems
that do not meet minimum criteria expected of a viable system. Section 4.4 provides detail on
the budget information required for the FVP and the FVT calculations used to answer the four
viability questions.
4.4    Washington State Financial Viability Program Methods and Data Requirements

       The Washington State Financial Viability Program builds on information contained in the
Water System Plan (WSP), a comprehensive twenty-year planning document supplied by system
owners to the Washington State DOH.  Figure 4.2 summarizes the information contained in the
WSP.  Using information  from the  WSP, owners then prepare a detailed six-year budget of
revenue sources and  expenses.   Owners must  also prepare detailed  information on system
contingency reserves,  annual system charges per residence, and median household income in the
service area.  The budget, contingency reserve, annual charges, and income information will be
used as input to the FVT.
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                                              Figure 4.2
               Content of Washington State Water System Plans (WSPs)

         The outline below summarizes the key elements addressed  in WSPs.  Information must be supplied for a
twenty-year  planning period and the plan  must be approved in writing by a certified professional water systems
engineer.

         1.        Description of the System

                  Maps  and descriptions  of the service  area, existing facilities,  and pressure
                  zones, information on system owners and managers,  policies, history, and
                  agreements with surrounding facilities.

         2.        Basic Planning Data

                  Existing and future  projections of population served and number of service
                  connections, historical and future projections of water usage by customer class
                  and  per   connection  (including  average  and  peak  flows,  fire  service
                  requirements, and unaccounted for water),  and planned water conservation
                  programs and their impact on water demand.

         3.        System Analysis (Adequacy of Facilities and Activities)

                  Identification of  water  system minimum design criteria and  evaluation  of
                  existing systems (capacity, remaining life expectancy, instantaneous demand),
                  information on source requirements, treatment,  storage, distribution, and fire
                  flow,  water quality  analysis (history of monitoring, required changes under
                  SDWA and WSDOH drinking water regulations), and summary of deficiencies
                  identified in the evaluation of existing systems related to growth, replacement,
                  existing and proposed requirements.

         4.        Improvement Program

                  Identification of capital and non-capital improvements for a twenty-year period,
                  with a six-year implementation program.

         5.        Financial Program

                  Itemized three year summary of system revenues and expenses, detail on past
                  system improvement finance (surcharges, debt,  reserves);

         6.        Relationship with  Other Plans

                  Compatibility with adjacent system and regional  plans, county response and
                  compatibility with land use plans; and consistency with previous water system
                  plans.

         7.        Operation and Maintenance Program

                  Description of  personnel  and personnel responsibilities for  water system
                  operations, description of water quality sampling procedures and responses to
                  samples that exceed state standards, and identification of most vulnerable system
                  facilities and description of cross connection control program.	
                                                   4-6

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Operating Budget

       Revenue Sources

       The first category in the operating budget is revenues. Major revenue categories include:

       Water Rates  All money received for supplying water service.  Information from the
       WSP  on the  forecasted number of  service connections and projected water  sales
       combined with current rate structures and assumptions on rate  increases are used to
       calculate  total utility revenue from rates.  This information is also used to calculate
       annual charges per service connection.

       Fees and Services All other miscellaneous fees and charges  for service provided other
       than for water service.  This includes bad check fees, reconnect fees, and meter testing
       fees.  These  revenues are  estimated for the six-year planning horizon by using a
       historical growth rate,  if available,  or assuming  revenues for  these categories will
       increase at the anticipated rate of inflation.

       Other Revenues  All other revenues not included in the two categories above.  Expected
       interest income on invested funds is reported here.

       Expenses

       The second  major sub-section of the operating budget is the identification of utility
expenses. Expenses include all those activities or purchases that incur cost for the utility during
the same periods as revenues.  Expenses can be estimated in various ways.  One  method bases
the projections on historical experience  and assumes past growth trends will continue in the
future.  In other  cases, it is known that expenses will increase at a different rate than in the past
and this information can be included in budget projections.  The two principal expense categories
are Operation and  Maintenance (O&M) expenses  and  General  and Administrative (G&A)
expenses.

       O&M Expenses  O&M expenses include all expenses incurred by  the utility that are
       directly related to the production and delivery of water to the customer.  They include
       salaries and benefits of employees directly involved in water provisions activities, electric
       power, telephone, and  other utility costs,  chemical used in the treatment of water, and
       parts, supplies, and repairs needed for the routine production and delivery of water.  In
       addition,  all water monitoring and outside analysis costs incurred by the  utility are
       considered O&M expenses.   Recent changes to SDWA regulations imply that owners
       should estimate these costs carefully, using information from the WSP on new treatment
       and monitoring requirements.
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       G&A Expenses These expenses are not directly related to water production and delivery.
       They are considered system overhead. All expenses related to the administration of the
       utility are included here.  Major G&A categories  include salaries and benefits for
       officers, directors, secretarial, and meter-reading employees,  insurance policies, legal,
       accounting,  and  other  professional  staff,   contracted  engineering   services,  and
       administrative  office supplies.

       Other Expense Categories

       In addition to O&M and G&A expenses, the FVP requires owners to report other major
expense items in their  operating budget.  These include depreciation expenses, taxes, and annual
debt payments (interest and principal). The FVP also requires a full accounting of anticipated
capital improvement program expenditures and loans sources over the coming six-year period.
This information is taken directly from the CIP and includes  information on capital outlays for:
new capital improvement facilities, renewals or replacements to existing facilities, and facilities
built to conform to  SDWA regulations.

Contingency Reserves

       In addition to  the operating budget, owners must also submit information on operating
cash reserves, emergency reserves, and replacement reserves.  For each reserve account, the
owner must supply information on annual installments and running balances.  This information
will be compared against the minimum  required balance in the FVT  for the  operating  cash
reserve and the emergency reserve.  A replacement reserve is not required to pass the FVT, but
is recommended. A replacement reserve will spread the economic burden of future capital  costs
over a longer period and will lessen future rate shocks to the customers of the system.

The Financial Viability Test

       Once information on  system revenues  and  expenses  and contingency  reserves are
prepared, the owner can take the FVT. Figure 4.3  details the four calculations that make up the
FVT.  Test  1  is straight-forward,  no utility can  remain viable if revenues are not meeting
operating expenses. Tests 2 and 3 imply that viable systems must have established and funded
operating reserves  and emergency reserves to cover contingencies at levels  acceptable to
Washington State.  Test 4 is based on national averages that suggest that water rates begin to
be unaffordable when they exceed 1.5%  of the median household income of residents served.
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                                      Figure 4.3
                       Washington State Financial Viability Test
   TEST 1:            Are Revenues -  Expense > 0

   TEST 2:            Is the Operating Cash Reserve > Va x (Annual O&M Expenses +
                       G&A Expenses)

   TEST 3:            Is the Emergency Reserve  > The Cost of the Most Vulnerable
                       System Component

   TEST 4:            Are Annual User Rates <  1.5% of Customer Median Household
                       Income
4.5    Results

       Based on the results of the FVT, the owner can adjust plans in the WSP and the
operating budget to improve the financial stability of the system, change annual contributions
to contingency  funds to achieve FVT target levels, or modify rates to generate additional
revenues.  If the FVT is completed to the satisfaction of the owner, the owner then establishes
the operating, emergency, and voluntary replacement reserve accounts as specified in the WSP
and FVT. The completed WSP and FVT are then reviewed, certified, and submitted to DOH
by a registered professional engineer.  DOH then reviews the WSP and the FVT and informs
the owner in a  WSP review letter whether the system met DOH requirements for approval.
DOH may raise questions about the owner's plans that require amendments to the WSP. In this
case, the owner must modify the WSP, retake the FVT, and resubmit the WSP and the results
of the FVT for approval.

Financial Viability  Test - Pass/Fail Consequences

       It is assumed that a water system has direct control over the outcome of the first three
components of the FVT and can take appropriate planning action (e.g. system redesign or rate
increases) to  meet  FVT requirements.  The fourth test,  however, is used as a  measure of
affordabiliry only.  While  it is expected that the owner will critically examine water system
designs to develop  the most cost-efficient system, it is understood that it might not always be
in the power of the water system to assure a  rate that is less than the FVT value.
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       By passing the first three parts of the FVT, a water system  demonstrates  sufficient
financial viability to suggest it can be  managed and operated successfully even under adverse
conditions.  Successful completion of the first three components of the FVT will facilitate the
water system remaining in compliance  with DOH requirements and may also assist the system
in securing funds from commercial lending and financial assistance institutions.

       Conversely, failure to pass any of the first three tests will prevent approval of the utility's
FVP and WSP.  As specified in a number of State of Washington regulations, this may lead  to
denial of construction permits or a DOH determination that the water system is inadequate. An
inadequacy determination by DOH could then result in denial of building permits,  denial  of
home mortgages by lending institutions, or receivership action by  DOH.  Alternatively, DOH
may work with the system to identify  and implement an  acceptable institutional  restructuring
option.  Alternatives include merging with an adjacent system, formation of a water district,  or
contracting for management and/or O&M with an outside agency. The  regulator and the owner
can use the tools of the FVP to explore the financial impacts of alternative  ownership/operating
structures.

       Passing the fourth component of the FVT demonstrates that water system rates are within
the national average  range and, therefore,  assumed to be affordable for  system  users.
Conversely, if rates exceed the FVT parameter,  owners must recognize  that users may have
difficulty  paying water system charges.  In addition,  the owner may have difficulty  obtaining
loans or financial assistance for the system.  DOH  will encourage the owner to investigate
restructuring options and  require the owner to provide public  disclosure of the  projected rates
and findings of restructuring option studies.

       In all cases, the results of the FVP provide the utility,  DOH, and current or prospective
customers with a detailed assessment  of six-year financial and operating health of  the water
system. If the system passes all components of the FVT, the owner has  a documented statement
of financial health that will facilitate  system approval and will expedite  attempts to secure loans
or financial assistance for  needed capital upgrades or expansions. If the system fails parts of the
FVT, the information collected as part of the FVP process will assist owners and regulators  to
evaluate alternative system designs and restructuring options.   In cases  where internal financial
stability is unacceptable,  DOH has  the statutory authority to prevent system  operations and
encourage the owner to explore restructuring options.  In instances where system affordability
is in question, the owner  can be encouraged to explore alternative options before experiencing
financial distress.
4.6    Summary and Extensions

       The Washington State FVP approach combines a detailed information-gathering phase
with a simple set of viability screening calculations.  This approach is implemented within a
broader regulatory context that gives the regulator the ability to make system approval decisions
based  on the results  of  the screening  process.   In addition, the  program  recognizes  the

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importance of information dissemination and provides for public distribution of the information
submitted.  These general attributes of a viability assessment approach for existing systems have
wide applicability to the viability question.  They are also easily modified or expanded to meet
the needs of individual states or communities. It is likely that states may want to add additional
viability criteria or modify the details of the FVT to stress other important aspects of financial
health. Likewise, the WSP and operating budget details may be simplified or otherwise altered
to conform with local requirements. The regulatory mechanism can also be adapted to conform
with existing statutes or to strengthen compliance through alternative means.  This approach may
also be combine with aggregate assessment methods in order to target existing facilities that may
be especially prone to viability problems.

REFERENCES

1.     State of Washington, Department of Health, Division of Drinking Water,  Small Water
       Utilities Financial  Viability Manual, August 1994 draft.
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                                   CHAPTERS.
            SMALL UTILITY RANKING FORMULA (SMURF)1


5.1    Overview of the SMURF Method of Viability Assessment

       The Small Utility Ranking Formula (SMURF) is a relatively simple, quantitative
method to assess the viability of a group of small water systems.  SMURF can screen a large
number of water systems quickly while still accounting for the multi-faceted nature of the
"small water system problem."  The SMURF analysis  results in a profile that illustrates and
quantifies the problems facing small water systems and provides some indication of possible
solutions. The profile can be used to support efforts to remove state barriers to, and provide
incentives for, obtaining new regulatory authorities to address the small water system
problem and implementing program changes.  The results can also help identify the factors
that are most important to viability and show how individual water systems rank against
sample averages.

       The general approach used by SMURF involves: identifying suitable indicators based
on their perceived relationship to viability; assigning points for  different values of the
indicators; and aggregating the points for  individual indicators into one viability score for
each water system. By examining the resulting distribution of viability scores, groups of
systems can be identified based  on common characteristics such as capability to  borrow, size,
and level of management expertise.

       The SMURF viability score comprises 20 indicators of system size, rates,
management, and finances.   Data inputs are obtained from annual reports and company
tariffs and rate review information on file with state Public Utility Commissions.  For states
without access to  such data,  SMURF illustrates the type of data that could be included hi new
reporting requirements and the way  that data can be used to profile small water  system
viability.

       If SMURF indicators and scores are appropriate to an individual users' needs, a
simple,  spreadsheet-based software program is available that stores the raw data and
automatically computes viability scores.  If SMURF indicators and scores are deemed
inappropriate,  the approach is easily modified to incorporate: indicators and scores reflecting
different views on factors affecting small water system viability; and/or alternative indicators
for which data are available.  Users  can also define their own classification scheme that may
or may not involve viability  determinations.
5.2    Purpose and Objectives of the SMURF Method

       The purpose of SMURF is to screen a large number of existing systems using a
simple and quantitative approach  that still addresses the multi-faceted nature of the "small

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system viability problem."

       Methods to assess viability at an aggregate level necessarily focus on a subset of the
variables that are  examined during detailed assessments of individual water  systems.
Nonetheless, viability is a function of financial, technical and managerial capabilities that
cannot be measured by just one or two variables.  SMURF balances the need to limit the
number of variables examined during aggregate level assessments with the need to explore
enough variables to accurately assess viability.  Four different aspects of viability are
examined: system size, rates, management, and finance.  SMURF incorporates five
indicators of each.  Each system receives a score in each of the four areas,  as well  as an
overall viability score.

       Although SMURF addresses many aspects of the viability problem, SMURF remains
simple. Where data are available, SMURF viability scores can be generated very quickly for
a large number of systems.  Where  data are unavailable,  SMURF illustrates the variables that
could be incorporated into new reporting requirements -- a first step in  developing a full
viability program ~ and the types of analysis  that could be performed with the variables.

       The result of applying SMURF is a profile illustrating and quantifying the spectrum
of small water systems (from viable to "basket cases"), as well as some indication of where
the problems lie (size, rates, management and/or finance). Such a profile can help place the
"small water system problem" on the state policy agenda by providing educational support
for efforts to:

       •     remove state barriers  to and provide incentives for small  water system
             viability;

       •     obtain new regulatory authorities to address the "small water  system  problem;"
             and

       •     implement new programs,  such as "safety net"  programs for basket cases.

       SMURF may also assist in identifying the indicators that are most reliable in
determining the viability  of water systems. SMURF's aggregate assessment can potentially
show which indicators vary most over a sample of water systems.  Sample averages can be
calculated from the SMURF results  to form the basis for comparing and ranking individual
systems.
5.3    Technical Approach

       Several principles and assumptions underlie SMURF and other aggregate-level
assessment methods.
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       •      Despite the diversity of small water systems, a fairly small number of
              variables (in SMURF's case, 20) provides sufficient information to portray the
              viability of small water systems at an aggregate level.

       •      Although relationships between viability and individual variables have not been
              formally validated, reasonable indicators of  viability can be selected based on
              limited evidence or common sense.

       •      Viability indicators are a relatively objective means to measure small  water
              system viability.

       •      The indicators,  even though measured using historical data, reveal the extent
              to which small water systems can reliably meet performance requirements on a
              long-term basis.

       SMURF's 20 indicators were chosen for two reasons.  First, the  indicators were able
to be quantified from information on file with the Pennsylvania Public Utilities Commission.
Information sources included annual reports, company tariffs and rate case data.  For states
without such data, SMURF indicators suggest what variables could be required under a
reporting requirement to support a viability assessment program. Second, the indicators
measure one of four important factors related to the ability of a water system to operate:
size, rates, management, and finance.

       The rationale behind each of the four factors is as follows.

       Size:  The raw size is believed to be an important determinant of a system's  ability to
respond to system emergencies, hire professional personnel, and spread the costs of
improvements among customers without causing large rate increases.  Size indicators
include: number of customers, gallons delivered, and revenues.

       Rates: Rates set at levels sufficient to recover the long-term costs of delivering water
services are essential to ensure viability. Without adequate cost recovery, systems will not
be able to finance ongoing maintenance, expansions or restructuring, upgrades to comply
with SDWA requirements and other planned investments.  Rates indicators include:  level of
current rates, types of rates used, and frequency of rate reviews.

       Management:  Poor management is frequently the underlying cause of financial or
technical performance problems.  Simple factors are used as indicators of whether "the
system is being operated as one would expect a public utility to operate." The quality of
management is measured with indicators such as: frequency of rate review cases, quality of
annual reports, and average age of plant.

       Finance:  In viability assessment, the finance variables are designed as much to
measure the ability of systems to finance their activities as they are designed to measure the

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systems' ability to generate a profit to their owners.  Therefore, a company with small
profits but no debt might score better than a highly indebted system with greater profits.  The
variables should measure water systems' access to all three major sources of funds to finance
investments:  retained earnings; equity issues; and debt (loans or bonds).  Financial indicators
include: cash flow, shareholders' equity, and equity  as a percent of total capital.

       Overall viability of a system is the combined status in the areas of size, rates,
management  and finance.  One score ~ the SMURF viability index — measures a system's
rating in all four areas. Individual indicators and the calculations for the viability scores are
described in  detail below.
5.4    Methods and Data

       Straight forward, spreadsheet-based software is available to aid analysts in using
SMURF.  The SMURF software prompts the user to enter the variables shown below.  The
SMURF software uses the data inputs to calculate 20 indicators and assign a ranking from 1
to 5 for each indicator.2  More points are assigned when indicators suggest greater viability.
A single viability score is then calculated by simply adding up the points assigned to each of
the 20 indicators.
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                                        Figure 5.1
                                   SMURF Data Inputs
                Name of Utility
                Number of Customers:
                       Total Number of Customers
                       Number of Residential Customers
                Gross Utility Plant In Service ($)
                Depreciation Reserve ($)
                Capitalization:
                       Shareholders' Equity ($)
                       Total Debt ($)
                       Other (preferred stock, CAC, CIAC) ($)
                Gross Operating Revenue ($)
                Depreciation Expense ($)
                Net Income ($)
                Millions of Gallons Delivered
                Rate Type (Fixed/Fixture/Metered)
                Rate Charges
                Is a Stand-By Fee Charged for Vacant Lots? (Yes or No)
                Has the PUC Examined the Rates  in Last 5 Years? (Yes or No)
                Quality of Annual Report on a Scale of 1 (poor) to 5 (good)
                Number of Rate Cases in Last 10 Years
                Number of Years Since Last Rate Case (rounded to nearest year)
                Number of Utilities with Same Owner
Size Variables

       Number of Customers.  Other things being equal, systems with fewer customers have
fewer resources with which to maintain viability. A customer count of 1,000 is roughly
equivalent to EPA's small system cut-off point (serving a population of 3,300).  Therefore,
systems with 1,000 customers or more are scored 5.  Systems with fewer than 200 customers
are scored 0.  This is a somewhat arbitrary lower bound, reflecting  opinions that with fewer
than 200 customers a system could likely not afford to hire a professional operator, deal with
emergencies or finance system improvements.  Between  200 and 1,000 customers, one
additional point is scored for each additional 200 customers or part thereof.

       Gross Utility Plant In  Service.  Data from the National Association of Water
Companies indicate that investor-owned utilities with  annual revenues above $1 million have
invested approximately $1,600 per customer.  A good sized system  (serving 1,000 customers
or more) would, therefore, have gross plant investment of $1  million or more.  Five points
are assigned to such systems.   Systems with a gross plant investment of less than $100,000
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are likely to be very small systems or larger systems which are undercapitalized.  These
systems are assigned a score of 0.  Between these extremes, one score is assigned for each
additional $225,000 of plant investment or fraction thereof.

       Gross Utility  Operating Revenues.  A good size system would generate $375,000 or
more in annual revenue.  This corresponds to an average of $375 or more in revenue per
customer. While this is high for residential  customers, a viable system is likely to have a
base of commercial customers and, therefore, higher average revenues.  Total  revenues less
than $75,000 indicate that a system has very low rates, a small number of customers, or
both. Since such systems are less likely to be viable, they are assigned a score of 0. An
additional point is awarded for each additional $75,000 in revenue or fraction thereof.

       Millions of Gallons Delivered.  A score of 5 is given to systems that deliver more
than 70 million gallons of water.  This is based on an average of 1,000 residential customers
using on average 15,000 gallons per  quarter, as well as a 20% allowance for lost or
unaccounted for water.  Below  10 million gallons per year, systems were scored 0.   Systems
that do not report gallons sold or delivered are also scored zero since this indicates a lack  of
adequate knowledge about system operations or possibly an absence of metering.  Between
10 million gallons and 70 million gallons, an additional 1 point is scored for each 15 million
gallons or fraction thereof.

       Percent Non-Residential Customers.  A diverse customer base generally provides a
more stable revenue base and higher average revenue per customer. As the number of
customers declines, the percentage of non-residential customers should increase.  Therefore,
twenty percent was selected as a good ratio  of non-residential to total customers.  No points
are assigned to companies with no non-residential customers.  Between 0% and 20%, one
point is awarded for each 5 % or fraction thereof.
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                           Figure 5.2 Summary of Size Variables
                    SMURF Variable
           Score Awarded
        Number of Customers
0 if < 200
1 if 200 to 400
2 if 400 to 600
3 if 600 to 800
4 if 800 to 1,000
5 if > 1,000
        Gross Utility Plant in Service
0 if < $100,000
1 if $100,000 to $325,000
2 if $325,000 to $550,000
3 if $550,000 to $775,000
4 if $775,000 to $1,000,000
5 if > $1,000,000
        Gross Utility Operating Revenues
0 if < $75,000
1 if $75,000 to $150,000
2 if $150,000 to $225,000
3 if $225,000 to $300,000
4 if $300,000 to $375,000
5 if > $375,000
        Millions of Gallons Delivered
0 if <  10
1 if 10  to 25
2 if 25  to 40
3 if 40  to 55
4 if 55  to 70
5 if >  70
        Percent Non-Residential Customers
0 if 0%
1 if > 0% to 5%
2 if 5% to 10%
3 if 10% to 15%
4 if 15% to 20%
5 if > 20%
Rates Variables

       Typical Annual Residential Rate.  Rates that are too low can jeopardize a system's
viability.  However, rates that are too high sometimes indicate that the system is: close to
collapsing (spreading costs over fewer customers); poorly managed (e.g., not refinancing
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high-cost debt); and/or more likely to be by-passed by the drilling of private wells.  The
"typical" annual residential rate is used to indicate rate levels, where typical annual resident
is defined as:

       •      a resident consuming 15,000 gallons per quarter (for systems with metered
              rates); or

       •      a resident with a kitchen sink, outside spigot/hose, first bathtub, first water
              closet, extra water closet,  first sink,  extra sink, and automatic clothes washer
              (for systems with rates based on fixtures).

Systems with rate levels between $300 and $450 per year for a typical residential customer
receive 5 points.  Systems with rates below $100 or above $650 receive no points.  In
between, each $50 or part thereof away from the 5-point range results hi one less point being
awarded.

       Type of Rate.  Three types of water rates are common:  flat rates; fixture rates; and
metered rates.  Flat rates  do not necessarily reflect the cost of the services provided to
individual customers. Therefore, systems with flat rates  are awarded no points.  Metered
rates are preferred since they provide accurate price signals base on the quantity  of water
consumed by individual customers.  Systems with metered rates receive 5 points. Two
points are given to systems  with fixture rates.

       Presence of Stand-By Charges for Vacant Lots.  The Pennsylvania State PUC allows
systems serving vacation home developments to charge a stand-by fee for as-yet undeveloped
lots.  This allows the systems to recover the fixed costs  of having installed a water system to
serve future developments.   In practice,  many lot owners do not pay the charge. Only when
they are ready to build, do  owners pay the arrearage.  Since it cannot terminate service to a
vacant lot, systems have little power to enforce payment.  Therefore, the presence  of stand-
by charges can result in cash flow problems.  It could also  indicate  an inadequately sized
system — either too large because the expected number of homes were not built, or too small
because building takes place more rapidly than anticipated.  Therefore, 5 points are awarded
to systems without stand-by charges and 0 points for systems with stand-by charges.

       Minimum Bill as Percent of Typical Annual Rate. Stable revenue streams are more
conducive to system viability.3  Therefore, a system receives 5 points if the minimum bill is
at least 60% of the typical annual residential bill (defined above).  At the other extreme, a
system receives 0 points if the minimum bill is  less than 20% of the typical bill. One extra
point is awarded for every  10% increment or part thereof.4

        PUC Examination in Past  5 Years.   Public utility commissions usually examine a
system's quality of service, financial management and other operating features during a rate
case review.  Such reviews can encourage restructuring  to increase  viability.  Therefore, 5
points are awarded if the system has gone through a detailed rate review within the past 5

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years and 0 if it has not.  A detailed rate review is defined as one where the PUC suspends
the proposed rate increase for a full investigation.  If the rate increase is granted without an
investigation, the system receives 0 points.
Figure 5.3 Summary of Rates Variables
SMURF Variable
Typical Annual Residential Rate
Type of Rate
Stand-By Charge for Vacant Lots
Minimum Bill as % of Typical Annual Rate
PUC Examination in Past 5 Years
Score Awarded
0 if < $100 or > $650
1 if $100 to $150 or $600 to
2 if $150 to $200 or $550 to
3 if $200 to $250 or $500 to
4 if $250 to $300 or $450 to
5 if > $300 and < $450
$650
$600
$550
$500
0 if FLAT
2 if FIXTURE
5 if METER
0 if YES
5 if NO
0 if < 20%
1 if 20% to 30%
2 if 30% to 40%
3 if 40% to 50%
4 if 50% to 60%
5 if > 60%
Oif NO
5 if YES
Management Variables

       Quality of Annual Report.  A  "better" annual report is an indicator that a system is
well managed. Criteria distinguishing annual reports include: whether all entries are made in
the proper location; whether the arithmetic is correct; and whether all appropriate
information is provided.  Reports are graded with 5 points given to systems with good
reports and  1 point given to systems with poor reports.  Since the grading is somewhat
subjective, it is important that only a small number of people perform the grading and that
explicit grading criteria are established.
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       Number of Rate Cases in Past 10 Years.  The number of rate cases in the previous
decade is an indicator of system managers' attentiveness to finances.  The SMURF
developers expect most well managed systems to have requested a rate increase every two
years.  Some evidence suggests that water consumption falls with a large rate increase.
Therefore, regular, moderate rate increases can contribute to system viability.  One point is
awarded for each rate case in the last 10 years, up to a maximum of 5 points.

       Years Since Rates Changed.  The number of years since the last rate change also
reveals how closely managers are watching system finances.  If rates are less than 2 years
old, 5 points are  awarded.  One point is subtracted for each additional 2  years or fraction
thereof since the  last rate change.

       Average Age of a Plant.  Newer plants are  likely to be more viable than older plants.
The developers of SMURF, however, did not have access to direct data on the age of the
plant.  Therefore, plant age was approximated with the depreciation reserve expressed as a
percent of gross plant in service. Five points are given if the  reserve is less than 10% of the
gross plant in service.  For each additional 10% one point less is given.  No points are given
to systems if the  depreciation reserve is 50% or more of the gross plant in service.

       Number of Affiliated Companies.  This variable measures the likely expertise of the
utility's management.  Specifically, it is assumed that a system affiliated with several other
systems is more likely to have professional management, sound financial practices, etc.   One
point is given for every two affiliated companies to a maximum of 5 points for more than 8
affiliated systems.
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                  Figure 5.4  Summary of Management Variables
                SMURF Variable
           Score Awarded
  Quality of Annual Report
Subjective Rating Between
1 (if POOR) and
5 (if GOOD)
  Number of Rate Review Cases in Past 10 Years
OifO
1 if 1
2 if 2
3 if 3
4 if 4
5 if > 5
  Years Since Rates Changed
0 if > 10
1 if 8 to  10
2 if 6 to  8
3 if 4 to  6
4 if 2 to  4
5 if < 2
  Depreciation Reserve as % of Gross Plant
  (Average Age of a Plant)
0 if > 50%
1 if 40% to 50%
2 if 30% to 40%
3 if 20% to 30%
4 if 10% to 20%
5 if < 10%
  Number of Affiliated Companies
OifO
1 if 1 or 2
2 if 3 or 4
3 if 5 or 6
4 if 7 or 8
5 if > 8
Finance Variables

       Net Operating Income.  Net operating income, defined as revenues less expenses,
measures the profitability of a system.  Other things being equal, higher profits improve
access to capital from all three financing sources (retained earnings, equity and debt).  One
point is awarded for the first $10,000 of net operating income.  An additional point is given
for each additional $15,000 or part thereof, to a maximum of 5  points.
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       Shareholders' Equity.  Shareholders' equity represents the owners' interest in the
utility, as defined by retained earnings plus paid-in capital.  The variable measures the
internal financial resources of the water system.  One point is scored for each $100,000 (or
part thereof) of shareholders'  equity, to a maximum of 5 points.

       Equity Ratio.  The equity ratio measures equity  as a percent of total capital (equity
plus debt).  The equity ratio describes the capitalization structure of a water system or, more
specifically, the degree to which the water system is  capitalized through equity.  The higher
the ratio, the less indebted is the water system.  Systems with equity ratios greater than 40%
receive 5 points. For  each drop of 10 percentage points, the system receives 1 less point.

       Net Cash Flow. Net cash flow is defined as net income plus depreciation.  Cash flow
represents the funds generated annually and available to meet the water system's financial
commitments.  Points  are awarded for net cash flow  in the  same manner as points for net
operating income:  1 point for the first $10,000 and an additional point for each additional
$15,000, to a maximum of 5  points.

       Debt as a Percent of Net Plant Investment.  This ratio is calculated as:

                               	Debt	
                            Gross Plant - Depreciation Reserve

As the ratio increases, the system's ability to finance new investments declines.  Higher
ratios indicate that the system has greater debt obligations relative to the remaining revenue-
producing life of the system assets.  No points are awarded if the ratio is 70% or more. For
each drop of 10 percentage points (or part thereof), an additional point is awarded, to a
maximum of 5 points.
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                      Figure 5.5  Summary of Finance Variables
                 SMURF Variable
           Score Awarded
  Net Operating Income

          =  Revenues - Expenses
0 if < $10,000
1 if $10,000 to $25,000
2 if $25,000 to $40,000
3 if $40,000 to $55,000
4 if $55,000 to $70,000
5 if > $70,000
   Shareholders' Equity
          =  Retained Earnings + Paid-in
          Cash
1 if $0 to $100,000
2 if $100,000 to $200,000
3 if $200,000 to $300,000
4 if $300,000 to $400,000
5 if > $400,000
  Equity Ratio
                 Equity
              Equity + Debt
0 if < 0%
1 ifO% to 10%
2 if 10% to 20%
3 if 20% to 30%
4 if 30% to 40%
5 if > 40%
  Net Cash Flow

          =  Net Income + Depreciation
0 if < $10,000
1 if $10,000 to $25,000
2 if $25,000 to $40,000
3 if $40,000 to $55,000
4 if $55,000 to $70,000
5 if > $70,000
  Debt as % of Net Plant
                      Debt
           Gross Plant - Depreciation Reserve
0 if > 70%
1 if 60% to 70%
2 if 50% to 60%
3 if 40% to 50%
4 if 30% to 40%
5 if < 30%
       It is important to remember that the above indicators and scoring were derived from
data available in Pennsylvania.  There are several reasons why analysts may wish to deviate
from the SMURF indicators and scoring.

       •      Some indicators may not be suitable for some states.  In Pennsylvania, stand-
              by charges are allowed and, based on a perceived relationship to viability, are
              incorporated into  the SMURF viability index. Other states may not allow
              stand-by charges,  thereby making the  variable meaningless.
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       •     As mentioned above, the indicators were selected, in part, because they could
             be measured from data on-file with the Pennsylvania State PUC.  States that
             lack individual data can simply use a smaller set of indicators or define
             alternative variables.  In these cases, the SMURF software cannot be used.
             However, these and similar financial ratio calculations are straight forward and
             can be easily performed in any spreadsheet software program.

       •     Some analysts may disagree with the hypothesized relationships between the
             indicators and viability.  In addition, analysts may believe that the indicators
             are not the best measures of system  viability.

       The general approach adopted by SMURF is, however, flexible enough to
accommodate different indicators and rankings.  The general approach involves:  identifying
appropriate and available indicators of small water system viability; attaching ranking scores
to ranges of each indicator so  that the rankings reflect the  relationships of the indicators to
viability; computing a viability score for each  small water system.

       Regardless of whether  or not the specific SMURF indicators and rankings are used,
the results should be verified.  For example, if detailed assessments are  available for a small
number of small water systems, the conclusions of the detailed assessments should be
compared to the SMURF results. If the SMURF results are found to misrepresent the
viability of the systems, indicators and/or rankings should be adjusted to reduce the errors.
5.5    Results

       As described above, for each small water system examined, SMURF produces a total
viability score out of 100, as well as a score out of 25 for each of the four indicator groups:
size; rates; management; and finance.
The SMURF results can be used to:

       •      identify groups of small water systems with similar characteristics;

       •      identify the extent to which certain problems — such as poor management —
              are present  hi a sample of small water systems;

       •      develop a profile illustrating the diverse problems and opportunities facing
              small water systems; and

       •      begin to identify the need for programs and restructuring to promote viability.
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       There is no fixed way to analyze the results from SMURF.  Instead, the analysis
involves examining the distribution of system scores and developing a classification system
that suits the results and the needs of the users. In some instances, for example, viability
determinations based on SMURF  scores may be desirable.  In other cases, viability
determinations may not be appropriate.

       To illustrate the results analysis, consider the classification scheme that emerged from
the 139 privately-owned small water systems in Pennsylvania. Six distinct groups of systems
were identified from the results.  The descriptions and score ranges for each group are listed
below.

       Group 1 - Viable Systems:  small water systems that have the financial and managerial
capability to provide reliable water service on a long-term basis.

       Group 2 - Well-Managed,  Too Small, Capacity to Borrow,  small water systems with
strong management (as indicated by their management and rates indicators) and sufficient
financial strength to raise expansion capital. However, their small size indicates that growth,
perhaps through acquiring other nearby small systems, may improve  their viability and the
viability of neighboring systems.

       Group 3 - Well-Managed,  Too Small, Little Capacity to Borrow:  small water systems
that would fit into group 2 if their financial situation provided them greater access to
financing  sources.  Specifically, low equity ratios and debt/net plant ratios reveal that a lack
of borrowing capacity to facilitate expansion.  These companies are not yet good candidates
for growth but, through regional support programs, could  raise  additional revenue by
providing management and operational support to other water systems.

       Group 4 - Fair Size, Poor Management:  small water systems that are large enough to
qualify as viable but for lack of management expertise (revealed by low scores in the
management and  rates indicator groups). If systems in this group fail to  improve
management, they could be taken over by a water system  in Group 1 or Group 2.
Alternatively, a Group 3 company could be enlisted to help improve  management.

       Group 5 - Non-Viable Systems:   small water systems characterized by low or
mediocre  scores in all four indicator groups.  This category, however, contains a broad
spectrum of systems.  Some may  require immediate attention, while others' needs may be
less acute. Participation in shared management programs  or acquisition by other systems
may make some of these water systems viable, others may require  active management and/or
financial assistance.

       Group 6 - Basket Cases: small water systems that, due to very low total scores,  are
likely to be  unable to meet current regulatory requirements, provide adequate service or
otherwise meet current obligations.
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Figure 5.6 SMURF Index Categories
System Categories
1. Viable
2. Well-Managed, Too Small, Capacity to Borrow
3. Well-Managed, Too Small, Little Capacity to Borrow
4. Fair Size, Poor Management
5. Non-Viable Systems
6. Basket Cases
Index Ranges
Total Score > 65
31 < Total Score < 65
Management + Rates > 31
Size < 8
Equity Ratio + Debt > 6
31 < Total Score < 65
Management + Rates > 3 1
Size < 8
Equity Ratio + Debt < 6
31 < Total Score < 65
Size > 8
Management + Rates < 27
31 < Total Score < 65
Do Not Meet Criteria for 2, 3 or 4
Total Score < 31
       The general approach taken by SMURF in developing the classification scheme is
flexible.  Different classification schemes can be defined depending on the results obtained
and the users' needs. Caution should be exercised when developing classification schemes
based on a small number of indicators. Systems can be ranked using the total viability
scores, scores for indicator groups, or scores for individual indicators.  However, errors are
more likely if the classification schemes rely on fewer indicators.
5.6    Summary and Extensions

       SMURF illustrates an approach used by aggregate-level viability assessment methods.
Aggregate-level assessments derive conclusions from a necessarily small number of
indicators.  Given that the relationships of specific indicators with viability have not been
formally validated, anecdotal evidence and common sense remain the basic tools for selecting
viability indicators.  SMURF shows the type of rationale that can be used to identify and
rank viability indicators for system-level viability assessment as well as other aggregate-level
assessment methods.  The details of the SMURF rationale can be transplanted to other states
as is or, more likely, amended to suit other data constraints, state characteristics and
perspectives on viability.
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       SMURF also shows one approach to analyzing the viability scores that result from
aggregate-level assessments.  In this approach, a classification scheme is allowed to emerge
from the distribution of viability scores for a sample of small water systems.  The
classification scheme for any particular application of the approach will vary with the sample
and the needs of individual analysts.

       Regardless of the specific indicators, scoring and classification scheme developed,
SMURF produces the basic product of all aggregate-level assessment methods: a profile of
the "small water system problem" that quantifies and describes the diversity of small systems
along the viability spectrum.  The value of such a profile lies in its use as an educational tool
to help place the small water systems on the agenda of state legislators.  SMURF does  not
prescribe changes, either at the state program level or at the system level.  But it can offer
preliminary indications of what viability problems might be present.  Regulators and owners
can use this information to identify possible solutions.

       SMURF also illustrates some of the drawbacks and dangers to aggregate-level
viability assessment.  First, SMURF includes a fairly small number of indicators for
assessing such a complex and multi-faceted issue as small system viability.  Therefore,  the
method may not always result  in correct classifications of individual systems. Second,  the
heavy reliance of aggregate-level viability assessment on the data available is clear from
SMURF.  Data for the SMURF model were  available for about half of Pennsylvania's  260
small water systems.  Choices  of viability indicators are currently limited by data that are
readily available.  For some states, SMURF and other aggregate-level assessment methods
can suggest data that could be  included in new or expanded reporting requirements. Third,
SMURF provides only a snapshot of small water systems based on current data.  While
useful for mobilizing  support to address the "small water system problem," interpreting the
SMURF results must consider  that viability refers to the ability  to meet long-term
performance requirements.
REFERENCES AND ENDNOTES
1.     Scott J. Rubin et al., "A Quantitative Assessment of Viability of Small Water Systems in
       Pennsylvania," Proceedings of the Eighth NARUC Biennial Regulatory Information Conference
       (1992), Vol. IV, pp. 79-97

2.     There are some inconsistencies between the ranking ranges contained in the software and
       those contained in the report describing SMURF. For the purposes of this manual,  the
       ranking ranges from the report are used.

3.     Rubin and O'Neal point out that, even though stable revenues may enhance viability, other
       goals such as water  conservation may be better served by less stable rates.
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4.      This variable is obviously related to the rate type variable described above.  A flat rate will
        receive a total of 5 points (0 points for being a flat rate and 5 points for being very stable).
        A metered rate will receive total points between 5 and 10 (5 for being metered and between 0
        and 5 for stability).
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                                   CHAPTER 6.
             FINANCIAL DISTRESS ASSESSMENT MODELS1
6.1    Overview

       Financial Distress Assessment Models (FDAMs) are a method for assessing the
financial health of small water systems based on the simplest and most common financial
analysis technique ~ analysis of financial performance ratios.  Just as private investors use
financial ratios to make investment decisions, utility regulators can use financial ratios to
help identify water systems that are financially distressed.  Although financial capability is
not equivalent to small water system viability, it is an essential component of viability.

       The mechanics of using FDAMs are straight forward and flexible.  Financial ratios
measuring liquidity, leverage and other financial characteristics are used to calculate a
"Distress Score" for each system.  By defining a classification scheme,  the Distress Score
can identify systems that are financially strong, weak or marginal, or distressed.  Depending
on the user's needs and data constraints, the FDAM can be modified to accommodate: a wide
variety of financial ratios; alternative definitions of the Distress Score; and state-specific
system classification schemes.

       Financial Distress Assessment Models are most suitable for aggregate assessments of
privately-owned water systems.  Given the small number of variables employed, the models
provide an overview assessment of financial health.  Systems classified  as "distressed"
deserve immediate and detailed analysis beyond what the models can provide to determine
the root causes of the distress and  corrective actions.   FDAMs cannot be applied where
financial reporting is not practiced.  However, FDAMs illustrate the data that could be built
into new reporting requirements, a possible first step towards  a comprehensive state viability
program.  Such reporting is practiced  in some states, extending even to small systems and
the availability of such data has proved extremely valuable in educating legislatures and
others involved in water supply issues.
6.2    Purpose & Objectives

       Financial Distress Assessment Models are a method of measuring the financial
capability of small water systems.  The method was developed for three potential uses:

       •     as an early warning system to identify potentially bankrupt or financially
             distressed water systems;

       •     as a screening device to measure the financial capability of systems seeking
             certification; and
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       •      as a viability test to help evaluate the impacts of possible structural changes
              among existing systems.

       By focusing on financial capability, however, FDAMs do not consider all aspects of
small water system viability.   A viable water system is one which is self-sustaining and has
the commitment and financial, managerial and technical capability to reliably meet
performance requirements on a long-term basis. Financial capability is only one aspect of
small water system viability,  albeit one that is necessary.

       Given the small number of financial  ratios used as inputs (seven in the model
described below), FDAMs can quickly assess the financial capability of a large sample of
small water systems.  The  small number of  ratios also means that the financial capabilities  of
individual systems may not always  be correctly identified.  Therefore,  FDAMs are  a method
for aggregate-level assessments.  They do not provide prescriptions for improving financial
capability.   Further research  is needed to determine corrective actions at either the system or
policy level.

       FDAMs generate profiles  of groups of small water systems.  Profiles can quantify the
financial capability of the systems,  identify the  variations among the sample and show the
extent to which  "basket cases"  exist.  For example, FDAMs can quantify the number of
small water systems that:

       •      are financially  capable of meeting current and future service demands,
              including compliance with SDWA;

       •      have sufficient financial capabilities to meet current service demands  but could
              face difficulties hi  meeting future demands;

       •      do not  have  the financial capabilities to meet current demands but could if they
              were restructured;  and

       •      are financially  incapable of meeting current demands and have little hope of
              turnaround.

       Policy analysts can use such profiles  to help educate state legislators about the "small
water system problem" and generate support for initiatives to promote small water system
viability.  Profiles can also provide average  financial performance of small water systems
which can be useful as benchmarks for comparing individual systems.

       In addition to providing profiles, FDAMs can help identify some of the factors that
should be examined during system-level assessments.  System  variables that are most
strongly correlated with viability can emerge from an  analysis  of the models' results.
Caution must be exercised when using FDAMs for this purpose since the situations  of
individual systems are often unique.

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       A key constraint to applying FDAMs is data availability.  The financial data used as
inputs to FDAMs are generally not available for publicly-owned  systems.  Ratios for
privately-owned systems are also frequently not available.  Therefore, the current
applicability of FDAMs may be limited in many areas. However,  FDAMs show the types of
variables that useful for aggregate-level viability assessment and how the variables can be
analyzed.  Where data are not available, these variables could be incorporated into expanded
reporting requirements,  a possible  first step  in developing a comprehensive viability program
for small water systems.
6.3    Technical Approach

       The basic concepts used in bank failure models are the foundation of FDAMs for
small water systems.  Although non-viable water systems do not necessarily declare
bankruptcy or fail in the same way that banks do, financial ratios can identify systems that
are in financial distress and may not be able to deliver the water services needed by their
customers.

       Four important components of financial health are included  in the FDAM described
below: liquidity; leverage; profitability; and efficiency.  Each component is defined and
illustrated with relevant financial ratios.
       Liquidity:  the ability to meet short-term financial obligations.  A system with low
liquidity may be unable to make required payments to creditors.  A system with high
liquidity will have more cash available than required to meet obligations in the near future.
Liquidity ratios generally compare cash and assets that can be quickly converted to cash to
short-term or "current" liabilities.  Examples of liquidity ratios include:

       •      current assets/current liabilities (where  "current assets" are cash, marketable
              securities, accounts receivable and inventories); and

       •      quick assets/current liabilities (where "quick assets" are cash, marketable
              securities and accounts receivable).

Higher values of these ratios indicate better liquidity and, in general,  stronger financial
health.

       An alternative measure of liquidity is fixed assets/total assets,  where fixed assets are
assets that cannot be quickly converted to cash.  This  ratio is inversely related to liquidity.
Higher fixed assets/total assets implies  less liquidity.
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       Leverage:  the extent to which system investments are financed with owners' funds
(equity) as opposed to loans (debt).  The more the system is financed with debt, the higher is
the system's leverage.  Since debt-holders must be paid a constant amount regardless of the
performance of the system, highly leveraged systems are more financially risky than systems
funded with relatively more equity.  The following examples illustrate leverage ratios:

       •      book common equity/total assets:  if the value of equity is high relative to the
              assets of the system, the system is less financially risky;

       •      total debt/total assets:  lower debt relative to assets means that a system can
              more easily meet obligations to debt-holders from the revenue-producing
              capability  of its assets; and

       •      market value equity/book value debt: high equity relative to debt implies that a
              system can meet obligations to debt-holders even when performance is not
              strong.
       Efficiency:  the ability of the system to generate revenues from inputs.  For example,
sales/total assets reflects the system's ability to generate revenues from its assets.  Higher
sales per dollar of assets implies greater efficiency. Alternatively, operating
revenues/operating expenses measures the efficiency with which non-capital inputs  are used.
Higher revenues per dollar of labor, chemicals, energy, etc. indicate greater efficiency.
       Profitability:  the degree to which revenues exceed costs.  The most direct approach
to measuring profitability is expressing profits (earnings or income) as a percentage of other
financial variables, as in net income/sales and net income/shareholders' equity.  A related
ratio is cash flow over sales, where cash flow is equal to net income plus depreciation.
Alternatively, profitability ratios could compare revenues and costs using ratios such as
operating revenues/operating expenses.  Higher revenues relative to expenses indicate higher
profits.

       Measures of profit trends are related to profitability ratios in that they measure
profitability over a number of years.  Successive years of profit are generally reflected in
retained earnings.  Therefore, profit trends are measured by ratios such as retained
earnings/common stock  equity.

       There are numerous financial ratios that could be used to measure these four
components of financial health.   Over 100 financial ratios have been incorporated into
business bankruptcy and bank failure models.  The accuracy  and predictive power of these
models depends on which financial  ratios are included.  The  choice of variables will also
determine the accuracy and predictive power of FDAMs for  small water systems.
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       Extensive research has attempted to identify the most reliable indicators of bank
failures and business bankruptcies.  This research has reached consensus on several points.
              Models should include financial ratios that describe various components of
              financial performance.

              Models should include ratios measuring all four components (liquidity,
              leverage, profitability and efficiency). Looking at one or two components in
              isolation  does not provide a comprehensive snapshot of financial health and
              may result in a misdiagnosis of financial health.  In the context of FDAMs for
              small water systems, models that examine all the components of financial
              health are less likely to identify a healthy system as distressed or a distressed
              system as healthy.
              Ratios describing the same component of financial health are substitutable.

              The predictive power of ratios describing the same components (liquidity,
              leverage, etc.) are similar.  One indicator of liquidity, for example, is
              generally as highly correlated with business failure as other indicators of
              liquidity.  This implies that there is much flexibility in choosing the financial
              ratios to include in an FDAM for  small water systems.  Lack of data on a
              specific indicator does not prevent use of this assessment methodology.
              Rather, the model can be built around the financial data  that are available.
              Only a small number of ratios are needed to assess financial health.

              It is possible to generate accurate results using only a small number of
              financial ratios.  One researcher, for example, achieved 87 percent accuracy in
              predicting business bankruptcy using only one variable ~  cash flow to total
              debt.  A reason for this finding is that many financial ratios are calculated
              from the same variables taken from financial statements.
       The literature also indicates that there are risks in determining financial health with a
small set of financial ratios.  First, bank regulators have not adopted ratio-based bank failure
models because such models lack a high degree of accuracy in predicting bank failure more
the one year in advance of the failure.  This is of concern with viability assessment since
viability relates to long-term performance.  Second, when bank failures do occur, they are
usually the result of poor management. Financial performance ratios in isolation do not
necessarily reflect the management capabilities of a small water system. Comparing small
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water systems on the basis of their financial ratios neglects other factors that determine
viability.
6.4    Methods and Data

       Financial Distress Assessment Models involve four basic steps:

       (i)     select and calculate the financial performance ratios;

       (ii)    calculate a Distress Score for each system;

       (iii)    develop a scheme that classifies systems according to their Distress Score; and

       (iv)    verify the accuracy of the classification scheme.

       Since the calculations and subsequent data manipulations are quite simple,
spreadsheets are suitable for compiling the data.


Step 1        Select and Calculate the Financial Ratios

       Over 100 financial ratios have been used  to help predict business failures.  Yet, as
described above, only  a small number of ratios are needed to build an assessment model that
can generate accurate results.  The key rule in selecting ratios for inclusion in the model is to
cover the various components of financial health: liquidity; leverage;  profitability; and
efficiency.  Data availability may play a significant role in selecting ratios,  particularly if the
model is applied to publicly-owned data.

       Ideally, data for systems with known financial health will be available to guide the
selection of financial ratios.  If the financial health of a sample of firms is known, there are
diagnostic exercises that can help verify the selection of ratios.   For example, the developers
of the FDAM method  had access to data on 30 small systems already divided into strong and
weak systems.  The ratios were calculated,  along with averages for each of the two  groups of
systems.  Based on these  figures, two simple tests are possible.

       (i)     The sample averages are consistent with a priori expectations regarding the
              relationship of the ratios to financial distress.  The first seven ratios should be
              lower for distressed systems and, in fact, they are.  The last three  ratios
              should be higher for distressed systems.  This holds for two of the three ratios.

       (ii)    The magnitudes of the averages are considerably different for the two groups
              of systems.  For example, cash flow/sales for the strong firms is nearly three

-------
              times larger than the weak systems.  The size of these differences suggest that
              the ratios are useful in classifying systems according to financial health.
Figure 6.1 Testing the Selection of Financial Ratios
Financial Ratio
Cash Flow/Sales
Current Assets/Current Liabilities
Book Common Equity/Total Assets
Retained Earnings/Common Equity
Sales/Total Assets
Operating Revenues/Operating Expenses
Net Income/Sales
Total Debt/Total Assets
Net Fixed Assets/Total Assets
Current Liabilities/Total Debt
Expected
Relationship to
Financial Distress
_
-
-
-
+
+
+
Average
for Strong
Systems
(1)
0.258
1.702
0.294
0.500
0.275
1.321
0.175
0.699
0.823
0.100
Average
for Weak
Systems
(2)
0.095
1.157
0.226
0.318
0.236
1.121
-0.029
0.754
0.734
0.181
(D/(2)
2.71
1.47
1.30
1.57
1.17
1.18
-6.03
0.93
1.12
0.55
Step 2
Calculate the Distress Score
       Once the financial ratios are selected and compiled, a Distress Score is calculated for
each system.  This one statistic then becomes the basis for classifying the financial health of
a system.

       If all the financial ratios are inversely related to financial distress, calculating the
Distress  Score can be as  simple as  adding up the financial ratios.  The table below illustrates
this approach.   All seven financial  ratios selected are inversely related to financial distress.
As each  ratio increases in value, the likelihood of financial distress is reduced.  When the
ratios are summed, a system with a higher Distress Score is deemed more financially healthy
than a system with a lower Distress Score.
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Figure 6.2 Distress Classification Model with Illustrative Data
Viable System Distressed System
Profitability
Net Income + Depreciation
Annual Operating Revenues
Liquidity
Current Assets
Current Liabilities
Leverage
Common Stock Equity
Total Assets
Profit Trend
Retained Earnings
Common Stock Equity
Growth and Efficiency
Annual Operating Revenues
Total Assets
Efficiency and Profitability
Annual Operating Revenues
Annual Operating Expenses
Profitability
Net Income
Annual Operating Expenses
Distress Score (sum of the ratios)
$3.3 + 1.3 -0.200 $.240 + 1.6 -0.129
22.9 14.3
5.8 -1.570 3.1 -0.607
3.7 5.1
16.9 =0.326 11.1 -0.170
51.8 65.3
11.1 =0.657 5.0 -0.450
16.9 11.1
22.9 =0.442 14.3 -0.219
51.8 65.3
22.9 =1.220 14.3 -1.190
18.7 12.0
3.3 =0.144 .240 =0.017
22.9 14.3
= 4.56 =2.78
Note: Dollar values are in millions.
       Simply summing ratios to determine the Distress Score is not appropriate if the ratios
selected for inclusion in the Distress Score are not all related to financial distress in the same
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way.  Ratios that are positively related to financial distress (higher ratios mean increased
chance of financial distress) must be adjusted.

       If desired,  more complicated approaches can be used to calculate the Distress Score.
For example, prior to adding,  each ratio can be weighted according to its relative importance
in determining financial distress.
Step 3        Develop the Classification Scheme

       Distress Scores can be used to rank systems according to their financial health.
However, ranking does not reveal which systems are in financial trouble and which are
stable.  To interpret individual Distress Scores, a classification scheme is needed.

       There is no one classification scheme that must or should be used.  In fact, the
appropriate classification schemes will differ depending on:

       •      the number of financial ratios included in the Distress Score;

       •      the relationship of the financial ratios to financial health; and, perhaps,

       •      state-specific factors that determine how high financial ratios must be to ensure
              system viability.

       Classification schemes may vary  in the number of categories of systems, the ranges of
Distress Scores corresponding to each category and the names of the categories.  For
example, some users may wish to use the terms  "viable" and "non-viable"  in the category
names.  Other users may decide it is inappropriate to make viability  determinations using a
methodology that focuses on only one aspect of viability, namely financial  capability.

       A three-tier classification scheme was defined for Distress Scores encompassing the
seven ratios shown above:

       If the Distress Score is:      The system is classified as:

       4.0 or more                 Good to Excellent
       3.0 to 3.99                 Weak to Marginal
       3.0 or less                  Distressed

In addition,  a separate category  was created for "bankrupt" water systems,  defined as
systems with liabilities exceeding assets.  This definition, derived from the private sector,
was assumed to apply to water systems.
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       The scheme was derived from a sample of 15 small water systems that were known to
be financially weak and 15 small water systems that were known to be financially strong.
The averages and standard deviations of the Distress Scores were calculated for each of the
two groups of systems (strong and weak).  For the fifteen strong systems, the average was
4.50 with a standard deviation of 0.99. For the fifteen weak systems, the average was 3.10.
It was assumed that the Distress Scores for the systems were distributed along a normal
curve with an average of 4.5 and a standard  deviation of 1.5.  Systems with Distress Scores
below 3.0, a figure close to the average Distress Score for the  weak systems, were
considered distressed.

       Assuming a particular probability distribution is a somewhat limited approach to
defining the classification scheme.  Nonetheless,  it may be preferred to a purely subjective
approach.  Users' of FDAMs can define their own classification schemes using whatever
approach their needs and data constraints.
Step 4        Verify the Model Results

       After the Distress Scores have been calculated and systems have been classified, the
model results should be verified, This involves checking a subset of the systems to ensure
that the model has classified them correctly.  There are many approaches that could be used
for the verification, including the following:

       •      if the financial health of a sample of systems is known (systems other than
              those used to develop the classification scheme), compare the model's
              classification to the existing classification;

       •      ask independent analysts familiar with individual systems to verify the
              classification; and

       •      send results to system mangers for feedback.

       Verification could reveal that healthy systems are classified as distressed or that
distressed systems are classified as healthy.  The model user  will have to decide whether to
accept errors or to adjust the model to reduce the number of errors.  Three types of
adjustments to the model may be necessary.
       •     Adjustments to the Ratios

       Incorrect classification may result from one or more of the financial ratios included in
       the Distress Score.  For example, verify ing the seven-ratio Distress Score described
       above revealed that the model gave high ratings to two weak systems.  Detailed
       analysis of these systems revealed that both had unusually high liquidity ratios due to

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       high levels of accounts receivable.  The accounts receivable in fact reflected
       uncollectible accounts remaining on the books.  Adjustments could have been made
       either to the values of the ratio for these individual systems or to the selection of
       liquidity ratios.

       •      Adjustments to the Definition of the Distress Score

       The verifications could reveal that some financial ratios are more powerful indicators
       of financial health than others.  In this case, weighting the more powerful indicators
       more heavily may improve the accuracy of the model.
       •      Adjustments to the Classification Scheme

       Consistently classifying healthy systems as distressed would suggest that the range of
       Distress Scores defining heathy systems should be lowered.  Conversely, frequent
       classification of distressed systems as healthy would suggest that the range of Distress
       Scores defining distressed systems should be raised.
6.5    Results

       For each small water system,  FDAMs produce spreadsheets or databases containing
underlying financial data, calculated financial ratios and a Distress Score.  The output can
show the distribution of systems across the different classifications of financial health.
However, a more elaborate picture of "the small system problem" can be derived from the
model's results.  Depending on the data collected, the results could answer questions such as:

       •      are small water systems serving particular areas (urban vs. suburban vs.  rural)
              more likely to be in financial distress?

       •      are small systems serving less than 500 customers more likely to be in
              financial distress than small systems  serving larger markets?

       •      is the financial health of small systems improving or declining over time?

       •      how  closely related to the general economic climate is the financial health of
              small systems?

Answering such questions can help illustrate for state policy makers the need for new
initiatives to help restructure small water systems.

       Two caveats are relevant when interpreting the results of FDAMs.
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       •      Caution must be exercised when interpreting the Distress Scores of individual
              systems.  Given the diversity of small water systems, a model based on a
              fairly small number of financial ratios is bound to produce some classification
              errors.  Some systems that are distressed may escape being classified as
              distressed, while other healthy systems may be classified as distressed.  The
              tests and model verification procedures described above will likely not
              eliminate all inaccuracies.

       •      The model does not prescribe solutions for restructuring distressed or marginal
              systems.  Restructuring systems to increase  viability is a complex task that
              must consider many more factors than those included in FDAMs.

Taken together these two caveats imply that the model is best viewed as an aggregate
assessment model that provides a first screening of small water systems.  If classified as
distressed or marginal, individual water systems are worthy of further research to verify the
classification and identify corrective actions.
6.6    Summary and Extensions

       Financial Distress Assessment Models (FDAMs) measure one aspect of small water
system viability, namely financial capability.  When data are available, FDAMs provide a
quick method for screening the financial capabilities of a large sample of small water
systems.  FDAMs are easily modified to include different selections of financial ratios,
methods of calculating Distress Scores and classification schemes.  They are straight forward
to use and data can be stored and manipulated in basic  spreadsheets.

       Results provide an aggregate profile of the financial state of small water systems that
can be used to educate policy makers, quantify the "small water system problem" and
identify potentially weak systems for further attention.  There are,  however, limitations to
what FDAMs can provide.  They do not prescribe solutions for the "small water system
problem" either at the system or  policy level.  The results are based on data which may have
only limited power to measure long-term financial capabilities.  Finally, financial capability
is only one aspect of system viability. Managerial and technical capabilities are not always
revealed in current financial ratios.

       For many states, data availability will constrain their ability to apply FDAMs. In
these  cases, FDAMs illustrate the information that added to reporting requirements to
facilitate viability assessments.
                                          6-12

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REFERENCES
1.      Dreese, et al.,  "Developing Models for Assessing the Financial Health of Small and
       Medium-Sized Water Utilities," Journal of the American Water Works Association (June
       1993), pp. 54-60.
                                          6-13

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