U.S. Department of Education: Promoting Educational Excellence for all Americans

A r c h i v e d  I n f o r m a t i o n

Methodology for Regulatory Test of Financial Responsibility Using Financial Ratios - December 1997


4. Strength Factors


Chapter Outline

Recommendations
Description of the Strength Factors
Primary Reserve Ratio Strength Factors
    Conclusions Drawn From a Strength Factor of Negative One
    Conclusions Drawn From a Strength Factor of Zero
    Conclusions Drawn From a Strength Factor of One
    Conclusions Drawn From a Strength Factor of Three
Equity Ratio Strength Factors
    Conclusions Drawn From a Strength Factor of Negative One
    Conclusions Drawn From a Strength Factor of Zero
    Conclusions Drawn From a Strength Factor of One
    Conclusions Drawn From a Strength Factor of Three
Net Income Ratio Strength Factors
    Conclusions Drawn From a Strength Factor of Negative One
    Conclusions Drawn From a Strength Factor of Zero
    Conclusions Drawn From a Strength Factor of One
    Conclusions Drawn From a Strength Factor of Three
Recommendations Customized to Business Segments
    Proprietary Institutions
    Private Non-Profit Colleges and Universities
    Hospitals
Basis for Recommendations
    Relationship to ED Objectives
    Empirical Evidence
    Addressing Respondent's Concerns and Suggestions


Recommendations

In the second step of the recommended methodology, strength factors are assigned to each ratio based on the individual ratio results. Strength factors put the ratio results on a common scale and makes it arithmetically possible to weight and add the results of the three ratios together to arrive at a final composite score for each institution. To find the appropriate strength factor for any particular ratio, institutions can use the tables developed for this methodology and displayed in this section.

To meet ED's objectives for this project a strength factor scale of negative one to positive three was developed to identify and provide maximum differentiation between institutions on the lower end of the spectrum of financial health without differentiating greatly among the clearly financially healthy institutions. In contrast, the NPRM methodology provided for a strength factor scale from one to five and differentiated between institutions at all points along a broader spectrum of financial health, including the lower and upper ends of the scale.

Description of Strength Factors

KPMG employed the following steps in developing the strength factors for each ratio:

As discussed later in this section, this process was modified slightly in developing the strength factors for the Net Income Ratio.

With the resultant strength factors, relatively favorable ratio results generate the maximum number of weighted points to the final composite score. Unfavorable ratio results equate to a strength factor of zero and generate no points toward the composite score, or generate negative points if the degree of the negative result is severe enough, and detract from the composite score. All other potential ratio results are distributed evenly between these points and the potential strength factors are assigned accordingly.

The spectrum of potential ratio scores is limited to scores that are clearly unfavorable (equate to strength factor of negative one) and minimum scores necessary to conclude that an institution is financially healthy (equate to strength factor of three). The lowest possible strength factor is negative one and the highest possible is three. The strength factors do not distinguish between ratios outside the set range because the methodology was not designed to differentiate between institutions at all points along the spectrum of financial health. The purpose of the methodology, and therefore the strength factors, is limited to differentiating most subtly between institutions on the lower end of the spectrum of financial health.

The process KPMG went through in developing the strength factors for each ratio is shown graphically below using the Primary Reserve Ratio for proprietary institutions as an example.

In developing the strength factors for each ratio, KPMG considered the ability of institutions to fund the following specific areas, all of which are necessary for institutions to successfully carry on their mission.


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[Ratios (part 4 of 4)] [Table of Contents] [Strength Factors (part 2 of 6)]