Use of Financial Ratios in K-setting - An Update

Fri Aug 15 16:24:38 EDT 2003
By Dr. William Baker and Dr. Richard Hern

The role of financial indicators in ensuring bankability at K-setting, and the relationship between financial indicators and the WACC, are likely to be key issues for the water industry at the next Periodic Review, given the industry trend since PR99 of increased leverage, leading to a decline in key financial indicators such as cash interest coverage.

Commissioned by Water UK, this paper develops arguments on exactly how Ofwat should be using key financial ratios alongside the WACC in K-setting -- to emphasize the need for an internally consistent regulatory package and one that will ensure bankability. The authors' key conclusion presented in this paper is that water companies must maintain at least a single A credit rating status if they are to be able to efficiently raise new finance and that Ofwat must ensure that price limits set at Periodic Reviews are consistent with projected financial positions -- in both the central case and range of economic and business scenarios -- that are consistent with at least a single A credit rating.

A complete summary of NERA's analyses for Water UK examining financing issues in the UK water industry are available in "Evidence on the Cost of Capital for UK Water."