Legal Definitions - lead-lag study

A lead-lag study is a specialized financial analysis primarily used by regulated utility companies, such as those providing electricity, water, or natural gas. Its main purpose is to determine the precise amount of operating cash (known as working capital) that a utility needs to keep on hand to cover its day-to-day expenses.

This study achieves its goal by comparing two critical timeframes:

• Lead time: This is the average number of days it takes for the utility company to pay its own bills to suppliers and contractors after receiving their invoices. It represents the company's outward cash flow.
• Lag time: This is the average number of days it takes for the utility company to receive payments from its customers after sending out bills for services rendered. It represents the company's inward cash flow.

By analyzing the difference between how quickly the company pays its bills and how quickly it receives payments from its customers, a lead-lag study calculates the necessary cash reserves. This amount is then often factored into the rates that customers are charged, ensuring the utility can operate smoothly and reliably without interruption.

Examples of a Lead-Lag Study in Practice:

• Routine Rate Review for a Water Utility:

  Imagine "AquaFlow Water," a municipal utility, is undergoing its annual rate review with state regulators. To justify its proposed water rates, AquaFlow Water conducts a lead-lag study. The study reveals that AquaFlow typically pays its chemical suppliers and pipe maintenance contractors within 35 days (its lead time). However, its residential and commercial customers, on average, take 50 days to pay their water bills after receiving them (its lag time).

  How it illustrates the term: The 15-day difference (50 days lag - 35 days lead) means AquaFlow Water needs to have sufficient cash reserves to cover its operational costs for those 15 days until customer payments arrive. The lead-lag study quantifies this specific amount of working capital, which regulators then consider when approving the new water rates, ensuring AquaFlow can maintain service without financial strain.

• Assessing Cash Flow Impact of a New Billing System for an Electric Company:

  "PowerGrid Electric" is implementing a new digital billing and payment system designed to make it easier and faster for customers to pay their electricity bills. Before and after the system's launch, PowerGrid Electric performs a lead-lag study. Initially, the study shows they pay their fuel suppliers and equipment vendors in 40 days (lead time), but customers take an average of 65 days to pay their bills (lag time). After the new system, they hope to see a reduction in the lag time.

  How it illustrates the term: By comparing the lead time (how quickly PowerGrid pays its own expenses) with the lag time (how quickly it receives customer payments), the study helps PowerGrid determine if the new system has successfully shortened the customer payment cycle. If the lag time decreases, the company might need less working capital, potentially influencing future rate adjustments and demonstrating improved efficiency to regulators.

• Justifying Operational Capital for a Natural Gas Pipeline Upgrade:

  "GasConnect Solutions," a natural gas distribution company, is planning a major upgrade to its aging pipeline infrastructure. To secure regulatory approval for the project and any associated rate adjustments, GasConnect needs to demonstrate sound financial management of its existing operations. They conduct a lead-lag study. The study reveals that GasConnect pays its specialized engineering and construction contractors within 30 days (lead time), but due to seasonal usage patterns and diverse customer payment schedules, it receives payments from its large industrial and residential customers on average within 55 days (lag time).

  How it illustrates the term: The lead-lag study highlights the 25-day period where GasConnect must cover its operational expenses before customer payments are received. This analysis provides regulators with a clear understanding of the company's inherent working capital requirements, ensuring that GasConnect can reliably maintain its current services and manage its finances effectively, even while undertaking a significant capital project.