Q: Shouldn't leverage have increased with unfunded pension liabilities on the balance sheet?
A: The definition of leverage can cause a problem. For a commercial business, leverage is, in general, liabilities divided by net worth. Low leverage is desirable since there are more assets to cover the liabilities in the event of default and liquidation.
In this instance, leverage is defined as assets divided by liabilities. The higher the leverage ratio, the greater the asset coverage and the less the risk. If the leverage ratio decreases, it means less assets available to cover every dollar of liabilities. For Calistoga, reporting unfunded pension liabilities dropped the leverage ratio from 2.67 to 1.98, signaling greater risk, i.e., fewer assets to cover each dollar of liabilities.
Q: The last chart statement pointed out lower interest rate environment over the period and reduced principal which shows less need to borrow.
A: A very good observation.
In 2011, the 20-year municipal bond rates varied between 4.75% and 5.50%. In 2015, the rates had dropped to roughly 3.25% at the lower end of the range to 3.85% at the upper end - 150 to 165 basis points difference. This period would obviously translate to lower debt service per dollar of debt.
Course overview: Fund Accounting and Municipality Analysis: Part II of II