The importance of cash reserves in municipal financial stability

Cash reserves are a critical assessment by rating agencies, as they indicate a municipality’s financial stability, liquidity and capacity to manage economic uncertainties. Adequate cash reserves demonstrate a municipality’s ability to handle unexpected expenses, cost increases, revenue shortfalls or economic downturns. Rating agencies view municipalities with healthy reserves as better equipped to respond to revenue declines or expenditure increases without resorting to tax increases or cuts in operational services.

Across rating agencies such as Fitch Ratings (Fitch), Moody’s Investor Services (Moody’s), and S&P Global Ratings (S&P), the assessment of cash reserves constitutes between 20%-35% of the rating criteria. However, significant depletion of reserves can also adversely affect the rating agencies’ evaluation of financial and management performance. Many municipalities have adopted reserve and liquidity policies that specify a minimum cash reserve target. Rating agencies evaluate a municipality’s management performance by its ability to adhere to policy targets. Failure to meet reserve policy targets can result in a negative management assessment by rating agencies. Significant and continuous depletion of cash reserves will likely negatively impact rating agencies’ assessments of a municipality’s overall financial performance as it indicates deficit spending and structural imbalance.

While cash reserve levels vary among municipalities, it is particularly important for municipalities with smaller budgets to maintain higher reserves due to their greater susceptibility to economic cyclicality, unexpected capital needs, and adverse litigation outcome. Moody’s applies a negative adjustment to its rating scorecard for municipalities with available reserves below $8 million. Within S&P’s criteria, municipalities with available cash reserves below $2 million are negatively impacted and considered at risk of liquidity issues. Additionally, municipalities using cash accounting with reserves below 30% are negatively impacted on S&P’s rating criteria, as cash accounting can obscure short-term liabilities.

The tables below show the cash reserve assessments for Moody’s and S&P.