A common misconception is that an association’s financial position can be assessed by simply looking at a bank statement or perusing an annual financial statement. While these and other cursory reviews can provide a small snapshot of an association’s financial fitness, they by no means provide the big picture. The need for the board of directors and management to have an understanding of how to assess the financial fitness of an association is imperative. The key to understanding is in monitoring, communication and assessing risks and strengths of the association.
An association’s financial fitness and the best course of action to remedy may not be so easy to assess. While some operational and physical changes are very visible and may not require immediate implementation, there are sure to be items under the surface that can be improved. From a financial standpoint, the board and management should review financial statements as frequently as feasibly possible to determine performance to budget, areas of caution and improvement, and financial trends. This exercise is not only best practice, will help achieve prudent fiduciary responsibility which is an implicit obligation held by all boards and their members. Waiting until the end of the year may allow minor issues to become insurmountable.
The following discussion is designed to provide some suggestions for such a process, indicators to look for, and possible remedies for addressing issues discovered along the way.
One of the simplest financial ratios to use is the current ratio (current assets to current liabilities) which measures an association’s ability to pay current and long-term obligations when they become due. Similarly, there is a quick ratio (liquid current assets to current liabilities), which measures an association’s ability to pay short-termobligations in a timely manner. This is a more strict measure than inventories. Associations should strive for ratios greater than 1:1 under both calculations. In some cases, where the Association has debt obligations, the debt to fund ratio may be relevant. This ratio forecasts the Associations ability to cover long-term debt. Higher results in this ratio may imply the Associationis over-leveraged. Regardless of which ratios are being used, results should be analyzed to determine if a going concern issue exists.
Other Financial Relationships
Outside of common financial ratios, other financial relationships relevant to an association’s board of directors and management include, but are not limited to, the following relationships and/or balances:
- The relationship between cash and prepaid assessments
- The relationship between assessments receivable and the allowance for doubtful accounts
- The relationship of bad debt expense to assessment revenues
- Overall interfundbalances (balances owed between the operating fund and the replacement reserve fund
As a general rule, solid financial footing would dictate that cash on hand at the end of any year equals or exceeds the prepaid assessment balance (funds collected in one year for the subsequent year). If this is not the case, this relationship implies that next year’s assessment has been used for current year operations. Frequently, this situation has a tendency to continue to grow unless it is remedied. Second, an analysis of the percentage of allowance for doubtful accounts to total delinquent assessments receivable. Monitoring this does not only indicate the direction of assessment collections percentages but can also forecast potential future collections for budgeting purposes and assist in proper budgeting. Third, bad debt expense as a percentage of assessment revenue should be monitored. Fluctuations in this percentage show trends in collection rates and if the percentage is increasing, can be an indicator of future financial difficulties. The last item to review relates to interfund borrowings which can denote problems. In many dire situations, the operating fund owes the replacement fund for borrowings used to fund operations in time of insufficient cash flow. As these balances continue to grow, overall sustainability of the association may be in jeopardy.
Reserves for Replacements
One of the more regulated and scrutinized areas of an association’s financial position is the fund for replacement reserves. These funds are intended to be held for major capital-type repairs and replacement of association common areas and components. Some components commonly included under the replacement umbrella include, but are not limited to, unit furnishings, roof, HVAC, pavement resurfacing, pool, elevators, and other exterior building components. To get an idea of the integrity of the existing components, management, and the board should conduct or have conducted a reserve study. From the results of this study, the Board can assess the estimated cost to replace and the remaining estimated lives of each component as well as the adequacy of the current level of savings. At any given time, the reserve fund balance should be sufficient enough to cover the most immediate necessary repairs and replacements as well as a prorated amount for future repairs and replacements based on this schedule. Note, however, that if any underfund balance as described above exists, it should be taken in to account in determining if there is adequate cash available to meet future needs and a plan should be made to remedy the situation.
After analyzing the financial position of the Association, the management and the board will need to evaluate potential options to improve financial standing. There are many options for addressing this issue, a few of which are as follows:
- Increase assessments – Each year, the board reviews/approves the budget and has the ability to increase assessments. This increase may provide more upfront funding and help replenish past shortfalls and is the easiest way to cure financial issues (barring owner displeasure).
- Cut unnecessary spending – During the budgeting process, the board and management should review each cost component closely to determine if there are any unnecessary costs or cost reduction opportunities. Often times, existing vendor contracts are extended without much thought as to whether the contract is reasonably priced. Some savings may surface through simple discussions with the existing vendor and research about current trends and pricing.
- Approve special assessments – Special assessment uses may include funding operations and/or deficits, replenishing the replacement fund, funding renovation, and major replacement projects, or funding insurance deductibles, just to name a few. However, consideration should be given to the potential reaction of the owner base. Although many owners may enjoy the new renovations and upgrades, it is not uncommon to see delinquency rates rise immediately following a special assessment.
- Obtain short- or long-term financing – Bank or other financing is a short-term fix that can be used in the same manner as a special assessment. The terms can be negotiated with the lender and can serve as a temporary cash flow life support for an association. In some cases, the board may follow the financing with a special assessment which is intended to fund the debt service payments over the term of the loan. In order to lessen the burden on homeowners, the board may extend the special assessment payment terms over a period that coincides with the loan principal repayments.
- Monetize delinquent inventory – The tourism market is thriving at the moment and in many places, vacancy is at an all-time low. That is good news for associations with sizable delinquencies because revenue brought in from transient rentals can help mitigate the shortfalls created by owner delinquencies. A healthy, well-maintained resort tends to lead to higher rental revenues, better reviews, and higher occupancy rates. Further, the way people travel is changing and in order to be on the front line for consumers, a resort should have a strong online presence and use online marketing and other tools.
Annually, the board approves and issues a new budget which results in the subsequent year’s annual assessments for operations, replacement reserves, and taxes. As previously mentioned, it is crucial that the board review current assessment levels and expenses for necessary revisions. Although sometimes difficult, it is important to be realistic when establishing the budget regarding collections rates, cost increases, and other individual organizational factors. Understating costs, especially bad debts, will only perpetuate budgeting shortfalls which may eventually become an impossible burden to overcome.
The key in all of this is consistent monitoring and communication about results and a plan to remedy any areas noted for improvement. The only way to affect change is to actually do it. Some possible first steps include:
- Proceeding with liens and foreclosures on delinquent owners and monetize delinquent inventory
- Enforcing rules and regulations to “clean up” the property
- Seeking new quotes from existing or new vendors
- Addressing maintenance of common areas and obtain a reserve study
- Perform a deep dive into the budget and make sure assumptions are realistic
In all cases, if an issue is identified, the board needs to determine the root issue causing it and determine the best course of action to fix, not just repair, the problem. Questions to ask: Is the problem related to an aging owner base? Deteriorating resort amenities? Poor marketing? Inadequate and unrealistic budgeting? Whichever issue is at the forefront, addressing it timely and honestly, as well as being transparent with owners, is the best first step to move your association to a healthy financial fitness level.
Withum provides clients in timeshare, whole and fractional ownership associations and other industries with assurance, accounting, tax compliance, and advisory services. For further information about Withum and the services we provide to the industry, contact Lena Combs, [email protected] or Erik Halluska, [email protected].