Balance sheet capacity ... made simple

Some people think housing associations are dangerously close to their borrowing capacity; others believe there are endless reserves available. In reality, it's a little more complicated.

Part of the conundrum relates to the different approaches used to value assets in the balance sheet, which are tricky to decipher despite recent attempts to improve transparency. Perhaps because of this, there has been a tendency to focus on short-term measures to assess financial viability. These measures – including interest cover (the amount of surplus generated compared to the interest paid) and gearing (overall borrowing compared to the value of property) – may not always be appropriate.

The National Housing Federation has proposed a new measure to quantify long-term capacity: the housing association lifetime cover ratio or HALCR.

Whether it is widely adopted remains to be seen but it is no accident that the Housing Corporation is taking a much broader look at the financial capacity of associations when assessing their development bids.

Can you afford it?
The key factor in determining whether an organisation has the capacity to borrow is its ability to pay the interest on the debt from its revenue. The mixed funding grant regime was developed to determine this for any individual scheme. Similarly for stock transfers, the price is calculated to enable the association to repay its loan.

However, the day-to-day running of a social landlord can diverge from the formulae used to determine grant funding or stock transfer valuations. Associations may find themselves in very different positions, depending on the robustness of the original assumptions and their ability to manage the business.

Using the balance sheet
The income and expenditure account and the balance sheet gives users a broad guide of the association's financial position but they are of limited use when trying to assess future financial prospects.

Recent changes to the valuation of assets in the balance sheet have been designed to reflect their use as social housing. However, the balance sheet valuation may not offer a full picture of future repairs liabilities and other risks facing the organisation (such as falling demand or the effect of rent restructuring).

The balance sheet gives users a broad guide to the association’s financial position but is of limited use for trying to assess future prospects

The accounts give only a snapshot of the current loan position and the interest paid over the past couple of years. Generally they do not show the full extent of any long-term fixed-rate commitments. Yet these commitments can be critical to assessing an association's long-term borrowing capacity. As the NHF has indicated, a more appropriate tool for calculating future capacity is a longer-term business plan.

The 30-year plan
The HALCR is a ratio that compares the aggregate of loans outstanding to the amount of loans that the business plan can service. It therefore shows how much more the association can afford to borrow.

The NHF's proposal is to discount the net income and expenditure over 30 years to work out what it is worth now. A "terminal value" is also calculated to reflect its use as social housing beyond that period. This is then divided by the loan debt to give the HALCR. A ratio of greater than 150% is considered acceptable.

Components to consider
There are a number of variables to consider when looking at your association's capacity. These will include:

• rents: what is the impact of restructuring on the association's future rent income? What would be the impact of a reduction to inflation only? Is there likely to be any change in demand? How might changes in housing benefit affect rent income?
  
• service charges and Supporting People: is the association collecting all it should? Could there be a decrease or an increase in Supporting People grant?
  
• management costs: are these reasonable and has sufficient provision been made for cost growth? What changes have been allowed for as the association grows or contracts?
  
• repair costs: how much will it cost to reach and maintain the stock at the decent homes standard? Do stock investment forecasts reflect any additional needs and are these based on a sound condition survey? Has sufficient growth in costs been allowed for? What would happen if VAT rates or rules changed?
  
• sales receipts: are sales assumptions reasonable? Do sales forecasts allow for any recycling of grant or repayment to local authorities as applicable?
  
• corporation tax: if non-charitable, has the potential tax liability been taken into account? What if rates or rules change?

All of these factors and more need to be considered when considering the net value of future income streams and the capacity of the association to sustain or raise its borrowing.

In an ideal world, any new scheme would be self-financing and the net revenue would meet the loan costs but the government is increasingly looking to use existing reserves in the sector to support social housing development, acquisitions and regeneration. This would have the effect of reducing the HALCR.

Other considerations
Although long-term borrowing capacity is important, the lending market still focuses on short-term ratios such as interest cover. In particular, the NHF report that proposed HALCR – Do you have the Capacity? A Guide to Assessing your Future Borrowing Capacity – indicates that these measures disguise the additional capacity of some large-scale voluntary transfer associations compared with traditional associations.