Financial Analysis

Introduction

Recall that a basic problem addressed by regulation is an asymmetry between the government and the operator with respect to objectives and information.¹ Gathering information on the operator and the market and applying incentive regulation, noted elsewhere, are two basic methods for dealing with these asymmetries, and that information gathering is generally an integral part of incentive regulation.² The focus of this section is gathering and analyzing financial information and operating information.³ Regulators use information for monitoring operator investments, studying operator financial performance, and performing incentive regulation, which is used primarily to regulate the overall price level of the operator. Financial analysis assists the regulator in performing incentive regulation by providing the regulator with information on how various price levels affect the operator’s ability to obtain capital for investment. The remainder of this section is organized as follows. First is an explanation of the role of information in the regulatory process and various ways that regulators use information. Then the focus turns to the basic financial data found in financial statements, which are the fundamental reports that regulators use to monitor investments, study financial performance, and perform incentive regulation. Rules that regulators impose on operators to ensure that the financial statements are useful for regulators are described next, and then financial analysis is reviewed. The chapter then turns to describe how regulators use this financial information to determine whether the operator’s earnings on the regulated operations are sufficient to attract capital for future investments, including techniques for estimating the cost of capital.⁴ What follows is a look at net present value (NPV) analysis that operators use to make investment decisions and that regulators use (along with other analyses) to value cash flows. Finally, the chapter concludes with an examination of other informational requirements, obtaining and managing information, data quality, reporting information, and public access to information. Following this section’s narrative is a list of references, organized by topic.⁵

Footnotes

1. Rationale for Regulation in Foundations of Regulation covers information asymmetries.
2. See Price Level Regulation for information on incentive regulation.
3. Obtaining and managing information is covered in Financial Analysis. The immediate chapter examines using financial information.
4. Because financial analysis is central to some of the regulator’s key functions, such as regulating prices, the regulatory processes that the regulator uses when conducting financial analyses affect operator performance and how stakeholders view the regulator. Issues in Regulating the Price Level and Regulatory Process note these regulatory processes
5. Arguably topics such as financial statements, uniform system of accounts, and cost of capital are not part of financial analysis, but they are noted here because they are intimately associated with financial analysis.