451523

American Review of Public Administration

ARPXXX10.1177/0275074012451523Cabaleiro et al.The

Article
American Review of Public Administration

Developing a Method 43(6) 729­–751

© The Author(s) 2012
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DOI: 10.1177/0275074012451523

Financial Health arp.sagepub.com

Roberto Cabaleiro1, Enrique Buch1, and

Antonio Vaamonde1

Abstract
Following the conceptual framework developed by the Canadian Institute of Chartered
Accountants, which is based on three broad dimensions of sustainability, flexibility and vulner-
ability, this paper proposes a method for evaluating the financial health of municipalities. This
methodology could be useful for performance assessment in any country and framework. An
aggregate indicator has been obtained for each municipality that covers all the aspects analyzed.
For this, multivariate statistical techniques of principal component analysis and discriminant
analysis are combined. The proposed method overcomes the problem that we detected in the
literature related to the weighting of variables, optimizing the measurement of the variability
of all indicators that are included in the financial condition. The indicator evaluates and ranks
the degree of financial health of each municipality and serves as a tool to study how different
factors might have an impact on its financial health. The performance of the indicator has been
contrasted with the socioeconomic variables of population size and geographic location. The
proposed method has been applied to 5,165 Spanish municipalities.

Keywords
financial health, local governments, financial condition, public finance

In a time of crisis like the present, knowledge of appropriate diagnostic tools of the financial situ-
ation becomes not only a topic issue, but a necessity.
The aim of this work is to develop a new method for assessing the financial health of munici-
palities. The techniques used in this study try to solve the measurement problems inherent to
different alternatives used in literature to evaluate a concept of a complex nature.
The multidimensional nature of the financial health of public institutions implies that its
assessment is performed through multiple indicators that are related to various aspects that, a
priori, appear to be separated. The frequent existence of relationships between indicators to
assess independent aspects causes important biases when we try to obtain an aggregate valua-
tion of all aspects of financial health (Brown, 1996; Kloha et al., 2005a; Morgan & England,

1
Universidad de Vigo,Vigo, Spain

Corresponding Author:
Roberto Cabaleiro, Universidad de Vigo, Facultad de Ciencias Económicas y Empresariales , Lagoas Marcosende s/n,
Vigo 36310, Spain.
Email: rcab@uvigo.es
730 American Review of Public Administration 43(6)

1983; Wang et al., 2007; Zafra et al, 2009b). The existence of indicators which reflect the same
variability behavior tends to distort the global index because it incorporates certain financial
aspects of a duplicate manner. In other studies, although issues with different variability were
separated, nonoptimal weighting criteria were used for constructing the global indices (Mercer
& Gilbert, 1996).
We intend to solve this problem by developing a new method in this work. The proposed
method is an alternative to weight, in an optimal manner, the multiple indicators used in assess-
ing the financial condition of public institutions.
Consequently, the first part of the paper is a review of the literature regarding the concept of
financial health in local governments, its complex nature and identification of alternatives for
its measurement. Then, using the framework developed by the Canadian Institute of Chartered
Accountants (CICA; 1997, 2009) as a theoretical basis, we developed the proposed method on
a very large sample of Spanish municipalities. We used various statistical techniques of multi-
variate analysis to achieve the objective of the work: obtaining an aggregate index of municipal
financial health that adequately weights all financial indicators, identifying the ones that are
most relevant.
Finally, with the unique purpose of checking the adequate functioning of the method devel-
oped, we contrast the degree of financial health of Spanish municipalities measured by our indi-
cator with two commonly used examples of socioeconomic variables: Population size and
Location.

Literature Review
The Financial Health of the Municipalities: A Complex Concept

Having adequate financial health is a prerequisite for meeting the objectives of any institution.
The factors affecting the financial health of municipal entities are diverse and of a varied nature
and in a large extent are outside the sphere of influence of local public managers. However, these
factors affect the economy and, therefore, fiscal policies, focusing on the volume and / or qual-
ity of the demand for services (Honadle et al., 2004).
In her study of how to measure the fiscal health of public institutions, Hendrick (2004) shows
that the possible indicators to be used are based on various concepts such as fiscal strain, fiscal
distress, fiscal crisis, financial condition, etc, revealing the existence of alternative names that
correspond to different methodological approaches to the same reality.
Upon revising the literature it is revealed that there is great ambiguity in terminology. In many
cases the various terms shown in the literature have been used interchangeably (Table 1).
Following the systems approach developed by Berne and Schramn (1986) and applying it to
a financial context, Hendrick (2004) establishes three major dimensions that affect local fiscal
health: environmental characteristics, the balance between the social context and tax structure
and the characteristics of the tax structure of institutions.
A term closely related to fiscal health is financial condition (Honadle et al., 2004) and it can
be structured in cash solvency, budgetary solvency, long-run solvency and service-level solvency
(Groves et al., 1981).
Recently, the Canadian Institute of Chartered Accountants, to understand that governments do
not have a common methodology, issued the Statements of Recommended Practice (SORP) 4.
The aim is to establish a common framework of indicators for assessing the financial condition
(CICA, 2009). This statement has taken a Research Report published by the institution previ-
ously as a precedent (CICA, 1997). The CICA (1997, 2009) defines the financial condition of a
public entity as its “financial health.” Financial health is measured by its sustainability,
 Table 1. Definitions and Uses.

Term Author/s Definition Used by other/s author/s

Fiscal health Berry (1994) Extent to which its financial resources exceed its Honadle and Lloyd-Jones (1998); Kleine et al. (2003);
spending obligations. Honadle (2003); Carmeli (2007)
  Ladd and Yinger (1989) The ability of a city to deliver public services to its  
residents.
  Hendrick (2004) The ability of government to meet its financial and  
services obligations
Financial health Zafra et al. (2009a) Ability of the institution of meeting its debts and in turn Groves et al. (1981); Mercer and Gilbert (1996);
providing acceptable levels of services. Honadle and Lloyd-Jones (1997); Petro (1998);
Honadle (2003); Hendrick (2004)
Fiscal condition Ratcliffe et al. (1990) The ability of a district to provide reasonable quality Petersen (1977), Honadle and Lloyd-Jones (1998);
services at a reasonable tax burden on its residents. Kleine et al. (2003); Honadle (2003); Kloha et al.
(2005b); Carmeli (2007)
Financial Berne (1992) It is likely to meet the financial obligations due Lorig (1941); Petersen (1977); Hughes and Laverdiere
condition to creditors, employees, taxpayers and other (1986); Zehms (1991); Brown (1993, 1996); Mercer
stakeholders, and obligations to serve their and Gilbert (1996); Honadle and Lloyd-Jones (1998);
constituents in both the present and the future. Wolff and Hughes (1998); Petro (1998); Carcaba
(2004); Chase and Phillips (2004); Zafra et al. (2006);
Wang et al. (2007); Zafra et al. (2009a, 2009b).
  GASB (1999, 2004), Mead Its government´s ability to adequately provide services  
(2001) to meet current as well as future obligations.
  GASB (1999, 2004); Jones Financial achievement and measured by cumulative  
(1979); Chaney et al. changes in net assets, fund equity or net cash flows.
(2002)
  Wang et al. (2007) Ability of an organization to timely meet its financial  
obligations
  Groves et al. (1981) It has many meanings:  
  Cash solvency: government`s capacity to generate  
enough cash or liquidity to pay its bills.
  Budgetary solvency: city`s ability to generate sufficient  
revenues over its normal budgetary period to meet its
expenditure obligations and not incur deficits.

731
(continued)
 Table 1. (continued)

732
Term Author/s Definition Used by other/s author/s
  Long-run solvency: long-run ability of a government  
to pay all the costs of doing business, including
expenditure obligations that normally appear in each
annual budget, as well as those that show up only in
the years in which they must be paid.
  Service level solvency: It refers to whether a  
government can provide the level and quality of
services required for the general health and welfare of
a community.
  Lin and Raman (1998) Probability of being able to sustain the current level of  
services at acceptable levels of taxation.
  CICA (1997; 2009) It is the financial health measured by sustainability,  
flexibility and vulnerability.
Financial Lorig (1941) Ablility to pay debts Hughes and Laverdiere (1986); Mead (2001)
position
Fiscal distress Kloha et al. (2005a, A failure to meet standards in the areas of operating Cabill and James (1992); Kleine et al. (2003); Carmeli
2005b) position, debt, and community needs and resources (2007).
over successive years.
  Jones and Walker (2007) Inability to provide services at preexisting levels.  
Fiscal stress Wolman (1992) It would consist of either poor fiscal health relative to Petersen (1977); Morgan and England (1983); Hughes
other cities or a deterioration of a city`s fiscal health and Laverdiere (1986); Wolman (1992); Clark (1994);
over time Honadle (2003); Kloha et al. (2005a); Skidmore and
Scorsone (2011)
Fiscal crisis Inman (1995) When a city`s potential to raise revenues is insufficient Carmeli (2003, 2007); Honadle (2003); Wolff (2008)
to cover the city`s legally required expenditures.
  Hirsch and Rufolo (1990) When a government reaches a state such that normal  
budgetary flexibility no longer exists.
  Chernick and When there is a negative gap between the revenues  
Reschovsky (2001) raised and expenditures needed
Financial crisis Carmeli (2003) It is when an organization does not repay its current Zafra et al. (2009b)
liabilities on time.
Fiscal strain Clark (1994) A lack of adaption by a government to its private-sector Clark (1977); Morgan and England (1983)
environment
Cabaleiro et al. 733

flexibility and vulnerability. Sustainability means the level at which an institution can maintain
current programs and to comply with the current credit requirements without increasing the level
of indebtedness. Flexibility is the degree to which the entity can increase its financial resources
to respond to rising commitments, either by means of increasing its revenues or increasing its
debt. Finally, vulnerability is the extent to which the entity depends on resources that are beyond
its control or influence.
Another important contribution, extensively applied by local governments of U.S. is the
Financial Trend Monitoring System (FTMS). Released by the International City/County
Management Association (ICMA), it is intended to serve as an internal monitoring system.
Current version of FTMS (ICMA, 2003) is adapted to the reporting requirements of Statement
No. 34 (GASB, 1999) to local governments. It is based on the definition and dimensions reflected
in the concept of financial condition developed by Groves et al. (1981)(cash solvency, long-run
solvency, budgetary solvency and service-level solvency; see Table 1).
The study of financial health is also an object of interest for rating agencies. In order to carry
out this risk assessment rating, these institutions consider diverse factors: quantitative and quali-
tative, financial and environment (Ficth Ibca, 2008; Moody`s, 2008; Standard and Poors, 2010).
The economic literature has examined through research which indicators are most relevant to
provide a specific rating for the assessed entities (Auroles et al., 1996; Benito et al., 2003;
Copeland & Ingram, 1982; Horton, 1970; Johnson & Kenneth, 2005; Michel, 1977; Morton &
McLeavey, 1978; Raman, 1981; Simonsen et al., 2001).

Measuring the Financial Health

Since the concept of financial health is not directly observable it raises the question of what are
the most appropriate instruments for measurement. The administrative structures of each juris-
diction determine the output information, which is indeed a key element in the design of an
instrument applicable and useful for determining the financial health of public institutions
(CICA, 1997, 2009).
The evaluation of this concept requires setting clear objectives. This would allow the con-
struction of a model which organizes the process of analysis and clearly shows the information
to be obtained (Berne & Schramm, 1986).
The methodology differs significantly depending on whether the aim is to analyze the differ-
ent aspects characterizing the financial health of a local government or, to the contrary, the
objective is to obtain a ranking of the various entities in terms of financial health. In the first
case it would be sufficient to analyze the specific aspects that are considered pertinent without
the need to obtain a single quantitative or qualitative indicator (Alter et al., 1984; Groves &
Godsey, 2003; Hendrick, 2004). Obtaining an indicator would be necessary if the objective is to
determine the overall positioning of the institution (Brown, 1993; Kloha et al., 2005a; Wang
et al., 2007). The use of aggregate indicators has advantages and disadvantages compared to the
analysis of individual indicators representing specific aspects (Saisana & Tarantola, 2002).
Existing literature describes a variety of dimensions to consider and what indicators to use.
However, no widespread agreement exists on what categorizations define the concept or which
specific indicators are to be used as definitely representative of the financial situation (Wang et al.
2007) although certain aspects (income, expenses, debt, . . . ) are usually in the studies that
address this issue from different perspectives (Honadle et al., 2004).
Alternatives to measuring the financial health include the use of a limited number of indica-
tors (Wolkoff, 1987) or a cross-validation one, both referring to its intrinsic nature (Ammar et al.,
2001). In some cases the focus is only on financial aspects and in other cases socioeconomic
aspects are also considered. Considering a purely financial view of the concept would exclude
734 American Review of Public Administration 43(6)

socioeconomic factors from the core concept although they are accepted as conditioning fac-
tors (Wang et al. 2007), or contrarily these socioeconomic factors are considered part of the
essence of the concept, so, its exclusion would be a major weakness of the assessment (Kloha
et al., 2005a).
The literature shows a variety of instrumental alternatives to measure financial health. The
analysis of the values of specific ratios and their evolution has been the choice made by Alter et al.
(1984), ICMA (2003), Chase and Phillips (2004), Genito (2005), or Jones and Walker (2007).
The construction of aggregate indices is very common. Several alternative techniques have
been employed in the construction of these indices.
Some authors calculated aggregate indicators to measure certain aspects of financial condi-
tion (Clark, 1977; Zafra et al, 2009a), while others have developed a unique aggregate index to
measure the overall financial condition of the institution (Brown, 1993, 1996; Cohen et al., 2012;
Kleine et al. 2003; Kloha et al, 2005a; Mercer & Gilbert, 1996; Morgan & England, 1983; U.S.
Department of Treasury, 1978; Wang et al. 2007; Zafra et al. 2006, 2009b).
Brown (1993), Kloha et al. (2005a), and Zafra et al. (2009b) used statistical techniques to
assign cutoff values and build an index using an additive process. Wang et al. (2007) used the
standardized values of indicators to obtain an aggregate index calculated by the arithmetic mean.
Using the sum of standardized values was the option chosen by the U.S. Department of Treasury
(1978) and Morgan and England (1983). Other authors use the technique of principal compo-
nents for the extraction of different dimensions. The explained variance represented the weight-
ing of the dimensions of the overall index developed by Mercer and Gilbert (1996). This statistical
technique was also used by Zafra et al. (2006), who considered the score of the first component
as the index of the global financial condition. Cohen et al. (2012) developed an operational
model for assessing financial distress of municipalities in Greece by combining a simulation
analysis approach with a disaggregation technique.
Consequently, the literature highlights the lack of agreement on making a single indicator
measure the overall financial health. Some previous studies do not consider the existence of
similar behavior and similar information in the indicators, whereas others weight the aspects
that have different variability in a nonoptimal manner. This could be causing duplications and,
therefore, to distortions, in the value of the overall index. As noted by Jones and Walker (2007)
and Hendrick (2004), the subjective assignment of values to the ratios according to selected
parameters or using arbitrary weights are the current problems in building global indicators of
financial health.

The Assessment of the Financial Health

of the Spanish Municipalities
The aim of our work is to find an indicator that can rate the degree of overall financial health of
municipalities, avoiding the problems of its construction seen in the literature cited above.
Accordingly, we design a methodology that identifies those municipalities that initially,
using any aggregate index, no doubt, are those which are in situations of extreme (best or worst)
financial health in a specific geographical area. This allows us to build, through discriminant
analysis, a financial health index that represents the optimal linear combination of all the indica-
tors used. This combination produces the maximum possible ratio of between and within the
groups sum-of-squares that optimally discriminates the municipalities having the best and worst
financial health. In addition, we identify the indicators that have greater weight in the measure-
ment of the financial health of institutions.
This study was structured with the support of the framework developed by the CICA to ana-
lyze financial health.The decision to use the CICA approach is partially dictated by the type of
Cabaleiro et al. 735

information that is available. The accounting system for Spanish municipalities and the informa-
tion available in databases allow a reasonable analysis of the sustainability, flexibility and vul-
nerability. The absence of certain data precludes the calculation of indicators of underlying
dimensions in other approaches, such as cash solvency dimension used by the ICMA. Both
approaches use series of indicators covering various aspects and they propose the use of bench-
marking techniques. In any case, the developed methodology is neutral and it is susceptible to be
applied to any general framework for analyzing institutional financial health.
Then, taking into account that factors affecting the financial health of municipal entities are
diverse and varied (Honadle, 2003), we have proceeded to contrast how the indicator obtained is
subject to change based on socioeconomic factors. We have taken as examples the population
size and the geographic location. These two contrasts are only intended to check the extent to
which the indicator reflects the impact that different social and economic variables may have on
the financial health of municipalities. We intend to test the usefulness of the indicator obtained
for research purposes.

Method
We selected a set of ratios to construct an indicator of financial health for the municipalities in
Spain. This selection was made following the approach of the CICA (1997, 2009) for an assess-
ment of sustainability, flexibility and vulnerability in reference to the actual budgetary and
accounting system of Spanish municipalities. We have aimed that this selection of ratios is
close to the indicators that make up the core of analysis proposed by the CICA (1997, 2009),
with the limitations arising from the information available in Spain. In some cases it was neces-
sary to develop indicators that have a reading similar to those proposed by the CICA although
their components are not exactly the same. According to the CICA (1997, 2009), each of the
20 ratios used has been associated with a particular aspect of the financial health concept. The
resulting set of indicators that we have used to measure the three aspects mentioned above, is
shown in Table 2.
In order to analyze whether a public institution has a good or bad financial condition is neces-
sary to have information which would be the appropriate values for the benchmarks. However,
as the CICA (1997, p. 15) notes “there are no guidelines or benchmarks to guide users on what
are the reasonable levels for such indicators.” Therefore, we consider that using a transverse
approach is appropriate. This procedure across jurisdictions is considered useful by the CICA
(1997, p. 18), because it represents a good basis for making judgments. That is, we proceeded to
compare the different municipalities between them.
Once we have calculated the 20 ratios of reference for all municipalities in the sample, we
applied the principal component analysis in order to reduce as much as possible the number of
explanatory variables for each of the three main dimensions of financial health. The new vari-
ables are configured as components of sustainability, flexibility and vulnerability and are charac-
terized because they are a linear combination of the starting set of indicators. These new variables
have shown different intrinsic aspects. We need to seek the smallest number of components that
explain the most of the variability of the data.
Once we identified the components that explain each of the three aspects that make up finan-
cial health from the specific perspective of the municipalities, we proceeded to calculate a gross
indicator of financial health. For the construction of this indicator we have considered the
weights obtained for the components (OECD, 2008), acting similarly to Mercer and Gilbert
(1996). This gross indicator of financial health is a first attempt to identify situations of finan-
cial health. Extreme and central values of this indicator will be used as a reference to identify
the municipalities that are “beyond doubt” in very poor, intermediate and very good financial
736
Table 2. Indicators of Financial Health.

Indicator Explanation
Sustainability S1 Long-term debt / Long-term debt in relation to the total net budgetary revenues (TNBR)
TNBR
  S2 Long-term debt / NBR Long-term debt divided by net budgetary revenues (NBR) from nonfinancial operations
Ch.a 1 to 8
  S3 Long-term debt / NBR Ratio between the long-term debt and net budgetary revenues from current operations
Ch. 1 to 5
  S4 Long-term debt / Pop. Long-term debt per inhabitant (Pop)
Flexibility F1 NBR Ch. 1 to 5 / Net current budgetary revenues divided by net budget obligations (NBO) from current
NBO Ch. 1 to 4 expenditures
  F2 DRN Ch. 1 a 5 / NBO Net current budgetary revenues divided by budget obligations from nonfinancial current
Ch. 1 to 4 and 9 expenditures, minus debt service
  F3 Net savings / NBR Ch. Difference between the receivables from current budget resources and the budget obligations
1 to 5 from net nonfinancial current expenditures, minus debt service, divided by net current
budgetary revenues
  F4 Net savings / Pop. Difference between the receivables from current budget resources and the budget obligations
from nonfinancial current expenditures, minus debt service per inhabitant
  F5 NBO Ch. 3 and 9 / Debt service (interest and principal) divided by net current budgetary revenues
NBR Ch. 1 to 5
  F6 NBO Ch. 3 and 9 / Debt service per inhabitant.
Pop.
  F7 NBO Ch. 3 / Pop. Debt interest per inhabitant
Vulnerability V1 NBR Ch. 1 to 5 / NBR Ratio between net current budgetary revenues and current grants received
Ch. 4
  V2 NBR Ch. 1 to 3 / NBR Direct and indirect taxes and fees divided by net budgetary revenues from current operations
Ch. 1 to 5

(continued)
 Table 2. (continued)

Indicator Explanation
  V3 NBR Ch. 1 to 3 / Direct and indirect taxes and fees divided by obligations from net expenditures of personal,
NBO Ch. 1 to 3 services and debt interest
  V4 NBR Ch. 1 to 3 / Direct and indirect taxes and fees divided by net budget obligations from current expenditures
NBO Ch. 1 to 4
  V5 NBR Ch. 1 to 3 / Pop. Direct and indirect taxes and fees divided per inhabitant
  V6 NBR Ch. 1 a 3 to 5 / Net current budgetary revenues less current grants received, divided by net budget obligations
NBO Ch. 1 to 4 (NBO) from current expenditures
  V7 Total NBR - NBR Ch. Difference between the total net budgetary revenues and budgetary current and capital transfers
4 to 7 / TNBO received divided by total net budget obligations (TNBO)
  V8 NBR Ch. 7 / NBO Ch. Ratio between net budgetary capital transfers received and budgetary revenues and budget
6 and 7 obligations from budget investments and capital transfers out
  V9 NBR Ch. 7 / Pop. Capital transfers received per inhabitant

a. Ch: Chapter of the economic classification of the Budgets in Spain.

737
738 American Review of Public Administration 43(6)

health. The statistical procedure that we have chosen ensures that the process of identification
is valid regardless of the specific mechanisms used in the construction of the final index.
Therefore, once we have identified these municipalities, they serve as a benchmark for the
performance of a classification by applying discriminant analysis and for which we use again the
entire 20 ratios. This technique aims to produce a classification rule that maximizes the separa-
tion between groups of identification. Then we study the adequacy of the discriminant process.
The aim is to get some scores from the discriminate functions obtained, which will be subse-
quently transformed into a base with an appropriate scale for the easy reading of results. The
latter result represents an index of financial health for the corresponding municipality.
Then we shall carry out a cross-validation process. A small group of municipalities have
clearly a bad financial condition and another small group of entities have a good one. The pro-
posed index is validated if it is able to correctly classify these cases with a high efficiency (i.e.,
more than 90%).
Once the index value of financial health for all municipalities in the sample is calculated, we
statistically analyze the usefulness of the index. To do this we have chosen two examples of
socioeconomic variables. We will contrast the dependence or association between the level of the
financial health of the municipality and the population. We will also analyze how membership of
the municipality to a particular autonomous community interacts on the corresponding index
value of the entity. We will carry out these tests through an analysis of variance (ANOVA).

Data Extraction
In Spain, the Public Administration is composed of three subsectors: General State Administration,
Autonomous Communities and Local Governments. In accordance with Articles 134 and 141.4
of the Spanish Constitution, the Local Government Subsector is composed of Municipalities,
Cities with a Statute of Autonomy, Common Provinces, Foral Provinces and Islands. In the year
2008, the Local Government Subsector managed 13.5% of the total public expenditure (see
Table 3) and the number of entities of this Subsector was 8,164. The number of municipalities
was 8,110 and they managed 70.18% of the total subsector spending (Ministerio de Economía
y Hacienda [MEH], 2010a).
In order to develop the financial health index of municipalities in Spain, information for all
entities must be uniform. Data for the completion of this analysis has been obtained from various
institutional sources. Budgets of the municipalities and their settlement for the year 2008 have
been obtained from the Ministry of Economy and Finance (MEH, 2010b). Also, debt data
extracted for that year has been obtained from the same source (MEH, 2010c). Population data
from municipalities for 2008 taken from the National Statistics Institute (Instituto Nacional de
Estadística, 2010) were used.
In the data base for budgetary settlement from the previous municipal budgets for 2008, com-
piled annually by the MEH, we have found information about 5,210 municipalities. After a puri-
fying process that involved the elimination of those municipalities whose data was not completely
available or lacking, we were left with a sample of 5,165 municipalities. Thus, we have rejected
less than 0.9% of all available data. This means that the sample used represents 63.7% of the
8,110 municipalities in the country. The number of municipalities that are part of the sample,
disaggregated by population size and autonomous communities, are shown in Table 4.

Developing the Financial Health Index

According to the methodology, we proceeded to the extraction of the main components of each
of the groups of indicators (Sustainability, Flexibility, and Vulnerability) listed in Table 2 and
we extracted the scores for each municipality using the regression method.
Cabaleiro et al. 739

Table 3. Public spending in subsectors of the Public Administration (2008).

Subsectors (1) (2) (3)

General state administration 286,711.10 56.0 26.3
Autonomous communities 156,466.91 30.5 14.4
Local governments 69,035.63 13.5 6.3
Total public administrations (Total PP.AA.) 512,213.65 100.0 47.1
Note: (1) Volume in millions of Euros. (2) Subsector spending divided by Total PP.AA. spending (%). (3) Subsector
spending divided by Gross Domestic Product (GDP) (%).
Source: Ministerio de Política Territorial y Administración Pública. 2010.

Within each of the dimensions considered, the indicators were reasonably correlated. The
values that were taken by determinants of correlation matrices (0.000 – 0.002) were low, and
the Kaiser-Meyer-Olkin Measure of Sampling Adequacy statistics (0.697-0.812) were satisfac-
tory. Bartlett’s tests of sphericity showed appropriate significances (p values < .001). A high
degree of communality of all indicators was observed in the components extracted. Once this
process was completed, the extraction of components explains a high percentage of data vari-
ance (65.549%-91.027%) in all the dimensions. The process and functions that determine the
values of the components extracted are shown in Table 5.
In the case of Sustainability (Susti) the values were determined from one single component.
However, Flexibility and Vulnerability are explained by two distinct components.
In the Flexibility, we have observed in the first of the two components extracted the impor-
tant weight of the variables F2, F3, F1 and F4, in this order, which explains 49.953% of the data
variability for all indicators of flexibility. These variables provide the general aspects that define
the flexibility. Consequently, we have identified this component as general flexibility (Gen_
Flexi). The second component is characterized by the marked influence of the variables F6, F5
and F7. These indicators have a prominent financial side. Therefore, this second component,
which includes 30.044% of the remaining variability, we termed flexibility due to financial
operations (Flex_Fin_Opi).
The reduction process in a minimum number of the components of the nine indicators used
to measure vulnerability shows that the first of the extracted components highlights the weight
of the variables V4, V3, V6, V5, V7, V2 and V1, in the order listed, and explains 51.751% of
the variability in data. This component consists essentially in current ratios, so it has been
called current vulnerability (Curr_Vulni). The second component highlights the importance of
variables V9 and V8, highly focused on the financial aspects of investment policy, resulting in
the 13.798% of the remaining variability. Consequently, the latter is called capital vulnerabil-
ity (Cap_Vulni).
Then we devise a gross financial health index (GFHIi) with the scores from each of the com-
ponents of the three aspects that integrate the concept of public administration financial health
according to the perspectives of the CICA. Since all components must work in the forward
direction, it was necessary to change the signs of the scores of Susti, Flex_Fin_Opi and Cap_
Vulni. So that the three elements that make up financial health are represented in a balanced way
in this gross index, the scores of all the components collected in each of the aspects were then
standardized based on 0-1 (ESusti, EGen_Flexi, EFlex_Fin_Opi, ECurr_Vulni, ECap_Vulni).
These standardized scores were added to obtain a gross index weighed in function of the per-
centage of every components’ explanatory variance in each of CICA`s aspects (VE (. . .)). The
approach is that the gross index will show a balance between each of the three major aspects
proposed by the CICA according to the following expression:
740
Table 4. Distribution of the Sample by Population Size and Autonomous Communities.

Less than 5,000 inh. 5,000 up to 19,999 20,000 up to 49,999 50,000 up to 199,999 200,000 inh. or
(Very small) inh. (Small) inh. (Medium) inh. (Large) more (Very Large) Total
Autonomous
community (1) (2) % (1) (2) % (1) (2) % (1) (2) % (1) (2) % (1) (2) %
Andalucía 511 311 60.9 181 154 85.1 49 45 91.8 24 24 100.0 5 5 100.0 770 539 70.0
Aragón 710 279 39.3 17 17 100.0 2 2 100.0 1 1 100.0 1 1 100.0 731 300 41.0
Asturias 47 33 70.2 24 20 83.3 3 3 100.0 2 2 100.0 2 2 100.0 78 60 76.9
Islas Baleares 28 16 57.1 27 27 100.0 10 10 100.0 1 1 100.0 1 1 100.0 67 55 82.1
Canarias 23 20 87.0 39 34 87.2 18 16 88.9 6 6 100.0 2 2 100.0 88 78 88.6
Cantabria 84 75 89.3 14 14 100.0 2 2 100.0 2 2 100.0 0 0 - 102 93 91.2
Castilla-León 2,191 1,235 56.4 42 36 85.7 6 6 100.0 8 8 100.0 1 1 100.0 2,248 1,286 57.2
Castilla-La Mancha 846 403 47.6 59 45 76.3 7 6 85.7 7 7 100.0 0 0 - 919 461 50.2
Cataluña 743 482 64.9 140 120 85.7 40 37 92.5 18 18 100.0 5 5 100.0 946 662 70.0
Extremadura 343 226 65.9 33 30 90.9 4 4 100.0 3 3 100.0 0 0 - 383 263 68.7
Galicia 199 154 77.4 94 85 90.4 15 11 73.3 5 5 100.0 2 2 100.0 315 257 81.6
Madrid 102 55 53.9 46 35 76.1 11 9 81.8 17 16 94.1 3 3 100.0 179 118 65.9
Murcia 9 3 33.3 20 15 75.0 12 8 66.7 2 2 100.0 2 2 100.0 45 30 66.7
Navarra 251 199 79.3 18 15 83.3 2 1 50.0 1 1 100.0 0 0 - 272 216 79.4
País Vasco 184 152 82.6 49 38 77.6 12 10 83.3 4 4 100.0 2 2 100.0 251 206 82.1
La Rioja 165 114 69.1 7 5 71.4 1 1 100.0 1 1 100.0 0 0 - 174 121 69.5
Com.Valenciana 386 271 70.2 96 89 92.7 45 45 100.0 12 12 100.0 3 3 100.0 542 420 77.5
Totals 6,822 4,028 59.0 906 779 86.0 239 216 90.4 114 113 99.1 29 29 100.0 8,110 5165 63.7
Note: (1) Number of existing municipalities. (2) Number of municipalities that are part of the sample.
Cabaleiro et al. 741

Table 5. Process of Principal Component Analysis.

Block Sustainability Flexibility Vulnerability

Indicators S1 to S4 F1 to F7 V1 to V9
Components Num. 1 2 2
  Determinant. 0.002 0.000 0.001
correlation matrix
  KMO:  
  Sampl. adequacy 0.812 0.697 0.777
  Bartlett Sig. 0.000 0.000 0.000
  Variance explained (VE) Sust: 91.027%
Gen_Flex: 49.953% Curr_Vuln: 51.751%
  Flex_Fin_Op: 30.044% Cap_Vuln: 13.798%
  Communalities High High High
  Component matrix 1 1 2 1 2
  S1 0.963 F1 0.845 0.498 V1 0.681 0.139
  S2 0.978 F2 0.900 0.343 V2 0.704 –0.255
  S3 0.974 F3 0.862 0.134 V3 0.923 0.093
  S4 0.900 F4 0.729 0.347 V4 0.938 0.083
  F5 –0.550 0.746 V5 0.810 0.184
  F6 –0.788 0.815 V6 0.881 0.189
  F7 –0.396 0.633 V7 0.714 –0.377
  V8 0.116 0.342
  V9 –0.095 0.902
 
Component scores functions (Regression method)
Sustainability  
Comp. 1 Susti = 0.264⋅S1i + 0.269⋅S2i +0.268⋅S3i +0.247⋅S4i
Flexibility  
Comp. 1 General flexibility Gen_Flexi = 0.242⋅F1i + 0.257⋅F2i + 0.246⋅F3i + 0.208⋅F4i –
0.157⋅F5i – 0.140⋅F6i – 0.113⋅F7i
Comp. 2 Flexibility due to Flex_Fin_Opi = 0.218⋅F1i + 0.163⋅F2i + 0.064⋅F3i + 0.165⋅F4i +
financial operations 0.355⋅F5i –+ 0.392⋅F6i + 0.301⋅F7i
Vulnerability  
Comp. 1 Current vulnerability Curr_Vulni = 0.146⋅V1i + 0.151⋅V2i + 0.198⋅V3i + 0.201⋅V4i +
0.174⋅V5i + 0.189⋅V6i + 0.153⋅V7i – 0.025⋅V8i – 0.020⋅V9i
Comp. 2 Capital vulnerability Cap_Vulni = 0.112⋅V1i – 0.205⋅V2i + 0.075⋅V3i + 0.067⋅V4i +
0.148⋅V5i + 0.153⋅V6i – 0.304⋅V7i +0.275⋅V8i + 0.726⋅V9i

VE (Gen _ Flex) VE ( Flex _ Fin _ Op)

GFHI i = ESusti + ⋅ EGen _ Flexi + ⋅ EFlex _ Fin _ Opi +
VE (Gen _ Flex) + VE ( Flex _ Fin _ Op) VE (Gen _ Flex) + VE ( Fex _ Fin _ Op)
VE (Curr _ Vu ln) VE (Cap _ Vu ln)
⋅ ECurr _ Vu ln i + ⋅ ECap _ Vu ln i
VE (Curr _ Vu ln) + VE (Cap _ Vu ln) VE (Curr _ Vu ln) + VE (Cap _ Vu ln)

The institutions have been ordered from the lowest to the highest gross financial health index
with the corresponding scores obtained for each of the municipalities in the sample. The aim of
this step was only to identify the 100 municipalities in worse financial health (CLASS_GFHI: 1),
100 municipalities in central positions (50 above and below the median; CLASS_GFHI: 2) and
100 better-off (CLASS_GFHI: 3).
742 American Review of Public Administration 43(6)

Table 6. Classification Results.b,c

Predicted group membership

  Class_GFHI 1 2 3 Total
Original Count 1 99 1 0 100
  2 0 100 0 100
  3 0 0 100 100
  Ungrouped cases 126 4456 283 4865
  % 1 99.0 1.0 .0 100.0
  2 .0 100.0 .0 100.0
  3 .0 .0 100.0 100.0
  Ungrouped cases 2.6 91.6 5.8 100.0
Cross-validateda Count 1 95 5 0 100
  2 0 100 0 100
  3 0 1 99 100
  % 1 95.0 5.0 .0 100.0
  2 .0 100.0 .0 100.0
  3 .0 1.0 99.0 100.0
a. Cross validation is done only for those cases in the analysis. In cross validation, each case is classified by the functions
derived from all cases other than that case.
b. 99.7% of original grouped cases correctly classified.
c. 98.0% of cross-validated grouped cases correctly classified.

Based on this classification, we used the statistical technique of discriminant analysis. This
tool has allowed municipalities to rank among the groups that we have previously defined. This
process was made on the basis of all initial ratios. Having set the discriminant functions, we have
obtained the scores for each of the municipalities in the sample.
The analysis of the classification results shows that the external validation process was
optimal. The results of statistical prediction have 99.0% efficiency for municipalities classi-
fied in the group with poor financial health (a), and 100% for both municipalities framed in
groups of interim financial health (b) and for best financial health (c). Table 6 shows that
99.7% of municipalities have been well classified in their group of origin. We recall that the
classification in the initial group of origin was made through the GFHIi obtained before the
construction of FHIi. The GFHIi is only used as a reference to identify the entities with the
goal of building a different indicator through a discriminant function that takes into account
the values of all the 20 indicators initially selected. To verify that the indicator obtained (FHIi)
scored correctly, there has been a process of cross validation, finding that 98.0% of the munici-
palities that have been selected for the process (294 of 300) have been properly classified
(Table 6).
The eigen-value of the first discriminate function (9.024) is much larger than the second
(1.223). This leads to the first function taking 87.51% of the variance explained. For this reason
the first of the discriminant functions was taken for the construction of the financial health index
(FHIi). The indicators with the highest standardized coefficients and therefore having the most
influence on the discriminant function which classifies the municipalities to different levels of
financial health (worst, intermediate, and best) correspond to the components of sustainability,
current flexibility and current vulnerability. Flexibility due to financial operations and capital
vulnerability play a lesser role for the classification. The FHIi derived from the first discriminant
function based on standardized values of indicators from sustainability, flexibility and vulnera-
bility (zSji, zFji, zVji) is represented as follows:
Cabaleiro et al. 743

FHI i = 0.292 ⋅ zS1i − 1.431 ⋅ zS 2i + 1.042 ⋅ zS3i − 0.699 ⋅ zS 4i − 2.511 ⋅ zF1i + 3.959 ⋅ zF2i
+0.387 ⋅ zF3i − 0.114 ⋅ zF4i − 0.619 ⋅ zF5i + 0.855 ⋅ zF6i − 0.381 ⋅ zF7 i + 0.007 ⋅ zV1i + 1.251 ⋅ zV2i
+0.480 ⋅ zV3i − 2.307 ⋅ zV4i − 0.085 ⋅ zV5i + 0.628 ⋅ zV6i + 0.109 ⋅ zV7 i − 0.133 ⋅ zV8i − 0.381 ⋅ zV9i

With the different values of the previous index for each of the municipalities in the sample we
proceed to develop a standardized financial health index (SFHIi) based 0-100, according to the
following expression:

 FHI i − M í n( FHI i ) 
SFHI i =   .100
 M x( FHI i ) − M n( FHI i ) 
á í

Analysis of the Usefulness of the SFHIi

From the data taken from the SFHIi for all municipalities in the sample, we examined if the
population size or geographic location within an autonomous community could condition the
financial health that a particular municipal government had.
We found that the following hypotheses were inapplicable: normality of residuals and homo-
geneity of variances. Therefore, we could not apply the ANOVA parametric statistical technique.
Consequently, the study has been developed by performing nonparametric ANOVA. As men-
tioned above, we have proceeded to compare to what extent the size and location in an autono-
mous region (according to the classification of the sample shown in Table 4) may be affecting the
financial health of the municipalities in Spain.
In relation to population size, the aim was to ascertain the extent to which the size of the
municipality helped generate economies of scale for the provision of services or that certain
complexities associated with the required services could negatively influence its financial health.
The aim of the tests made based on the geographical location of the municipality was to deter-
mine how the differences presented by each autonomous community (geographic, economic
structure, political, property distribution, climate, etc.) can also be affecting the financial health
of municipalities.
To contrast population size the indices of the municipalities grouped in the five population
segments previously mentioned were used. For contrasting the locations we have taken into
account the 17 autonomous communities. We used the Kruskal-Wallis test with the aim of
comparing whether the samples from each of the segments, population or autonomous region,
followed the same distribution in relation to the values of the standardized financial health
index.
We have noted after reading the results that the distributions are different for population seg-
ments (p < .001) and in relation to the location in any autonomous community (p < .001).
Therefore, both the size and location of the municipality appear to be affecting the values of the
standardized financial health index.
The significant differences found in the financial health of municipalities in Spain by popula-
tion size, in general, indicate a better situation in the smaller the population size entities. This has
been verified by assigning ranks to the municipalities in terms of the standardized financial
health index value and taking note of the average of the ranks in each of the municipal blocks
according to population segments (Figure 1). Benito et al. (2010) show that there is a limit to
scale economies of population in relation to per capita spending for Spanish municipalities (the
function has a U shape): From the point of the minimum per capita spending, if the population
keeps on growing, per capita spending rises.
744 American Review of Public Administration 43(6)

Figure 1. Financial health of municipalities.

Table 7. Test Statistics.a,b

Standarized Financial Health Index

Less than 5,000 5,000 up to 19,999 20,000 up to 49,999 50,000 up to 200,000 inh. or
  inh. (Very small) inh. (Small) inh. (Medium) 199,999 inh. (Large) more (Very large)

Chi-square 612.123 124.495 21.861 12.501 16.329

df 16 16 16 16 16
Asymp. Sig. .000 .000 .148 .709 .129

a. Kruskal-Wallis Test.
b. Grouping Variable: Autonomous Community.

Having observed heterogeneity in the municipal financial health among the various autono-
mous communities, it is of interest to check if it is conditioned by the distribution of municipali-
ties by population strata in each community. Therefore, we performed a segmentation of the
whole sample by population strata. Next, we performed for each segment a contrast between
different autonomous communities. We have noted that significant differences in financial health
exist for small (p < .001) and very small (p < .001) municipalities among autonomous communi-
ties. On the contrary, we have not observed significant differences in financial health for munici-
palities with 20,000 inhabitants or more (Table 7).
Lastly, we have examined the data showing the mean rank reached by the municipalities
according to population strata where there were significant differences in the levels of municipal
financial health among the autonomous communities. Accordingly, the segments considered are
those for very small and small municipalities.
In the case of very small municipalities, Canarias and Murcia are the autonomous communi-
ties with a worse mean rank of financial health. On the contrary, the very small municipalities of
the autonomous communities of La Rioja and Castilla-León are those with a better average level
of financial health (Figure 2).
Performing this same analysis for small municipalities, those of the autonomous community
of Canarias have stood out for their very poor financial health, whereas the municipalities
located in the La Rioja are those in the best situation (Figure 3).
Cabaleiro et al. 745

Figure 2. Financial health position of Autonomous Community. Municipalities < 5,000 inh.

Figure 3. Financial health position of Autonomous Community. 5,000 inh. < Municipalities< 20,000 inh.

The conclusions to be drawn from the test carried out should be seen only from the perspec-
tive of how socioeconomic variables are reflected in the financial health index obtained by us.
This is to verify the validity of the index constructed beyond the specific relationships that may
exist between multiple financial health and socioeconomic variables.
The influence of population size and location on different economic and social aspects have
been the subject of several studies related to financial management of public governments, and
these effects have also been studied in the local environment from different perspectives and
746 American Review of Public Administration 43(6)

with varying results (Benito & Bastida, 2004; Bastida et al., 2009; Clark et al., 1994; Carruthers
& Úlfarsson, 2003, 2008; Ladd, 1994; Ladd & Yinger, 1989; Passel, 1994; Smith & Edmonston,
1997; Zafra, 2009a, 2009b).
The results obtained by some of these studies are in line with those obtained here. Ladd and
Yinger (1989) show that population size is a factor in the deteriorating financial health over the
years studied and this deterioration was more prominent in larger cities than smaller cities.
Benito and Bastida (2004) conclude that the geographical location of the municipalities in Spain
affects their levels of indebtedness. Therefore, the location has implications for the financial
health of municipalities.

Conclusions
A prerequisite for achieving the objectives justifying the existence of different public adminis-
trations is that they have adequate financial health. The result is a complex concept that financial
literature has known under many different names and with different nuances. The study and
analysis of the literature reveals the existence of approaches that differ both by the extent of the
aspects covered as well as the factors that are considered as key factors.
In this paper we have used a broad set of indicators that make up the financial health approach
developed by the CICA (1997, 2009). We have used a set of statistical techniques on a very large
sample of Spanish municipalities that has allowed us to obtain a single index that shows the vari-
ability in each of the aspects measured.
The process that we have followed was based on reducing the size of 20 initial indicators to a
smaller number of components, which includes most of the variance explained. The analysis has
shown that sustainability can be summarized by a single explanatory component, which empha-
sizes the homogeneity of the concept. The sample highlights the existence of two sub dimensions
in the dimension of flexibility: general flexibility and flexibility associated with financial trans-
actions. In relation to vulnerability, there are two components: current vulnerability and capital
vulnerability.
After studying the dimensions of sustainability, flexibility and vulnerability in a balanced
manner, we generated a reference which we used to realize our objective: developing an aggre-
gate indicator, using all initial ratios, which optimizes the measurement of the variability of the
broad set of indicators that measure the complex concept of financial health. The success rate
of our indicator was very high because the analysis correctly identified 99.7% of the munici-
palities that were already classified with the other technique. We emphasize the neutrality of
the methodology used in relation to the problem encountered in the literature related to the
weighting of variables.
The function that best allows to identify municipalities according to their financial health
includes all the components extracted and gravitates primarily on Sustainability (S2, S3), Current
Flexibility (F2, F1) and Current Vulnerability (V4, V2). The Flexibility due to Financial
Operations and Capital Vulnerability act to a lesser extent. These conclusions are deduced from
the standard coefficients of the discriminant function.
To verify the usefulness of the indicator, we proceeded to test how two factors, already stud-
ied in the literature, may have been affecting the financial health of the Spanish municipalities.
The results are consistent with those of previous studies.
This study describes the development of a new theoretical and practical tool that can be
applied in any geographical or institutional setting. The method developed here can be useful for
building a global indicator that can extract the key issues contained in the following: the many
indicators of the “Comprehensive Area Assessment” developed in UK; the set of indicators of
the “Financial Warning System” for the municipalities in France; the different sets of indicators
Cabaleiro et al. 747

used in the U.S. (ICMA, 2003, Brown, 1993, Kloha et al. 2005a); the indicators of the model
used in The Netherlands. Obviously, the method can be applied even in countries with no estab-
lished framework for analyzing the financial health of the territorial public entities, such as
Spain. In this country, the method can be applied to the Provinces too.
Finally, our indicator can support the implementation of economic and / or legal policies.
For example, the Spanish government has made available funds to all municipalities for pay-
ment of pending bills (Royal Decree Law 7/2012 of 9 March, which created the Fund to
finance payments to suppliers) regardless of their financial situation. Besides facilitating a
more efficient implementation of such policies, the indicator would save taxpayer funds,
because municipalities that have good financial health would be known and no aid would be
wasted on them.

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or
publication of this article.

Funding
The author(s) received no financial support for the research, authorship, and/or publication of this article.

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Author Biographies
Roberto Cabaleiro is a Professor of Public Sector Accounting (Department of Financial Economics and
Accounting) at University of Vigo in Spain. He has diverse publications in national and international books
and journals. His research interests include public accounting, state and local finance, and public
accountability.

Enrique Buch is a Professor of Accounting (Department of Financial Economics and Accounting) at

University of Vigo in Spain. He has diverse publications in national and international books and journals.
His research interests include public accounting, state and local finance, and accounting harmonization.

Antonio Vaamonde is a Professor of Statistics (Department of Statistics and Operations Research) at

University of Vigo in Spain. He has diverse publications in national and international books and journals.
His current research interests include applied statistics, unemployment, and multivariate analysis.