How To Analyze Water/Sewer Bonds (Part 2)

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This is the second in a series of posts explaining how I analyze municipal bonds to provide municipal bond investors a guide on what to look for. When I began analyzing municipal bonds, I was lucky enough to have co-workers to show me where to start. For the average investor, reading an official statement for a municipal bond issue can be overwhelming. Here’s part 2 of my series on how to analyze water/sewer bonds. Part one can be found here.

How to analyze water/sewer municipal bonds

As we continue our analysis of water/sewer bonds we will dive deeper into financial statement analysis. For this article, I will be examining a recent water utility bond issue for the city of Madison, Wisconsin. The bonds were issued in December of 2016 and were rated Aa2 by Moody’s.

The Income Statement

The income statement tells us about the financial performance of the municipality. A few questions we want answered from the income statement include:

  • Is the municipality growing revenue?
  • Are expenses rising faster than revenue?
  • Is the municipality operating at a surplus? i.e. Are revenues greater than expenses?
  • Does the municipality rely on transfers from the city or other government entities, such as the Federal government?

Analyze water/sewer bonds

Let’s address the questions I outlined above for Madison’s water utility.

Is the municipality growing revenue?

Revenue peaked in 2012 and is since down slightly to $29.5 million in 2015. We would need to look further to determine the cause of the decline.

We can see from the official statement that the city billed 423 million fewer gallons of water in 2015 compared to 2014.

Madison Water Pumped and Billed

Interestingly while the amount of water billed declined, the number of customers increased by 425. This indicates on a per customer basis, the city is using fewer gallons of water per year.

Madison Water Customers


Further reading of the official statement explains why this is happening. The city implemented a new metering system in 2012 that is helping customers monitor their water usage. This is beneficial for the sustainability of water and the environment, but it is a negative in terms of the decline in revenue for bondholders. Lower water usage will lead to lower revenues unless the rates charged to customers are increased.

Madison Project H20

The city installed these new meters at no additional cost or fee to the citizens.

Madison Project H20

Source: From the City of Madison Website

The differences in revenue from year to year have been relatively minor and are not a concern. Revenue has grown at about a 1.23% compound annual growth rate since 2011 so it is still positive. The key is to look out for sharp revenue declines and determine what the underlying cause is. If people are leaving the city, such as they have in Detroit, then investing in a municipality with a declining population would not be a good idea.

Are expenses rising faster than revenue?

I mentioned above that revenues are growing at about a 1.23% rate. Total operating expenses are growing at a faster pace of about 2.03%.

Another way to look at this is through the operating margins. In 2015, the utility earned $8.49 million of operating income on total revenue of $29.5 million for an operating margin of 28.8%. This is a decline from the 31% operating margins of 2011. Much like the decline in revenue, this appears to be a minor variability and is not going to raise any red flags about the long-term viability of the utility.

Is the municipality operating at a surplus?

We can clearly see that income before capital contributions and transfers have been positive since 2011. This indicates after non-operating expenses such as interest payments on their debt they are still operating at a surplus.

Does the municipality rely on transfers from the city or other government entities, such as the Federal government?

There are no substantial transfers from other municipalities that the utility relies on. The transfers under taxes are what is called payment in lieu of taxes (PILOT) which is an expense based on the value their of capital assets charged at the local and school property tax rates.

These are just a few of the questions that can be answered by reviewing the income statement. Lastly, we can see the the net position, or equity, of the utility has slowly grown over time which leads us to the balance sheet.

The Balance Sheet

The balance sheet provides a snapshot of the financial position of the utility.

Madison WI Balance SheetAssets

For a water utility, we would expect the majority of their assets to be in the plant assets that are used to produce and transport water to their customers. As we can see below, the total assets of the utility were $304 million at the end of 2015. $244 million of those assets were in their net plant assets and construction work in progress.

Their current assets include cash and accounts receivable. It is always important to ensure the utility has enough cash on hand to pay the bills and their interest payments. We can see there was nearly $4 million in unrestricted cash on the balance sheet. From looking at the income statement, we know their annual operating expenses are right at $21 million. This means they have about 19% of their annual operating expenses in cash. I would prefer to see it above 25% which would be about 3 months of expenses in cash. They do receive monthly cash flows from their customers so there is always cash coming in.

On a positive note, we see a net pension asset. This seems to be less common in the municipal world because most municipalities have underfunded pensions. This is important because liabilities for pensioners are going to become more of a problem in the not too distant future as more baby boomers retire.


On the liability side, we can see their current assets are greater than their current liabilities. This shows that they have enough short-term assets to cover their short-term liabilities which is always a basic requirement. The majority of their long-term liabilities are found in their revenue bonds which account for $166 million. This gives the utility a long-term debt to total asset ratio of 54.4% which is higher than I like to see it.

While their pension was fully funded and reported as a net asset, we see that their other post-employment benefit obligations (OPEB) are $555,940. OPEB obligations tend to be unfunded and cover items such as health insurance and other costs promised to workers after they retire. Just like pensions, OPEB should be reviewed for every municipality because they can sometimes be as much as the total debt outstanding.

Finally, we can see their total assets are $112 million greater than their total liabilities which is the value of their net position.


Balance Sheet Opinion

Overall, the balance sheet for Madison looks pretty good. I would like to see a debt to asset ratio below 50% and more cash reserves. The trend is for higher debt is a concern, especially with slightly lower revenues. They have a net pension asset which is impressive. Management should be commended for planning to meet their employees’ post-retirement benefits.

Conclusions on Madison’s Financial Statements

There are no apparent red flags when examining the financial statements of Madison’s water utility. Management is doing a good job managing the operations and financial performance of the utility. I would like to see a rate increase to offset the decline in revenue and rising debt levels. Otherwise, having a net pension asset is a plus. I would agree with Moody’s rating of Aa2 in terms of the quality of their financial statements.

Financial statement analysis is just one piece of the municipal bond investment puzzle. As outlined in the first part of this series, other important items to consider include their debt service coverage and bond covenants.

In part 3 of this series, I will explain how to analyze the economic and demographic trends of water/sewer municipal bonds.

If you would like to review the official statement for the Madison, WI Water Utility, I have attached a PDF below.