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


5. Ratio Weighting


Chapter Outline

Recommendations
Description of the Weighting Percentages
Recommendations Customized to Business Segments
    Weighting Percentages for Proprietary Institutions
    Weighting Percentages for Private Non-Profit Colleges and Universities
    Weighting Percentages for Hospitals
Basis for Recommendations


Recommendations

In the third step of the recommended methodology, the strength factors for each ratio are multiplied by weighting percentages. With the weighting percentages, the methodology make some ratios, and the fundamental elements of financial health that they measure, more important than others. As with the ratios and strength factors, the weighting percentages are customized to accommodate structural differences found in each business segment.

The recommended weighting percentages are as follows:

 

Proprietary Institutions


 

Private Non-Profit Institutions


Primary Reserve Ratio

30%

 

40%

Equity Ratio

40%

 

40%

Net Income Ratio

30%

 

20%

Description of Weighting Percentages

Strength factors allow for comparison between ratios by placing all ratio results on a common scale. Weighting percentages, on the other hand, make possible the comparison of institutions in different business segments by recognizing the relative importance of particular fundamental elements of financial health. The Final Composite Score chapter will describe in full detail the meaning of the score based upon the combination of strength factors and weightings for each business segment.

Financial responsibility, as required by statute, is measured annually and is based on the audited financial statements submitted in accordance with GAAP. In reviewing a financial statement, the most important question to be answered is: Was the institution healthy as of the balance sheet date? The reason why this is the most important question is that the balance sheet captures a cumulative snap shot of all resources amassed by an institution that will be available in the future to support its mission. Therefore, the two ratios (Primary Reserve and Equity) which directly answer this question and which measure four of the five fundamental elements of financial health have been weighted higher than the profitability indicator, the Net Income ratio. In the proprietary business segment, these two ratios combined receive 70% of the weighting. In the private non-profit business segment, their combined weighting is even greater, 80%.

Recommendations Customized to Business Segments

Strength factors, discussed in the preceding section, do not differ substantially between business segments and the weighting percentages are substantially the same as well. However, the weighting percentages have been customized to accommodate some fundamental institutional differences.

Profitability, a fundamental element of financial health is more important to schools in the proprietary segment since one of their (if not their sole) primary missions is to generate an economic return to their owners. Therefore, the Net Income Ratio has a 30% weighting for proprietary schools as compared to 20% for private non-profit colleges and universities. Likewise, expendable capital as measured by the Primary Reserve Ratio is more important to private non-profit colleges and universities. Schools in this business segment do not have access to the same capital markets as their proprietary counterparts and must rely on operating surpluses or donor contributions for operating capital. In addition, their operating cycles are generally tied to a limited number of terms or semesters which are longer than a month or two. Thus, the Primary Reserve Ratio has a 40% weighting for private non-profits and 30% for proprietary institutions. The Equity Ratio receives the same 40% weighting in both business segments.

Weighting Percentages for Proprietary Institutions

For proprietary schools, the weighting percentages are:

  Recommended for this Methodology
  NPRM Methodology

Primary Reserve Ratio

30%

 

20%

Equity Ratio

40%

 

30% (Viability Ratio)  

Net Income Ratio

30%

 

50%

These weightings are different from the weightings proposed in the NPRM methodology. Most importantly, the new weighting represents a shift from considering net income as the single most important factor to focusing on equity (balance sheet strength) as the key element. This concept was confirmed by various representatives of the proprietary business sector who voiced concern that the Net Income Ratio weighting was too high. They believed that placing such emphasis on profitability would encourage proprietary institutions to cut back on educational expenses, thus shortchanging students and lowering the quality of education. In fact, the financial reviews of accrediting agencies such as the Accrediting Council for Independent Colleges and Schools (ACICS) and the Accrediting Commission of Career Schools and Colleges of Technology (ACCSCT) focus first, and foremost, on equity and on profitability second. This observation reinforced our own view gleaned from our review of the empirical data reviewed in chapter three that balance sheet strength, as measured by the Primary Reserve and Equity ratios, is the most important factor in selecting the weighting percentages.

In order for the combination of the Primary Reserve and Equity ratios (measure of four fundamental elements of financial health) to have significance, their relative importance was increased from 50% in the NPRM to 70% in this methodology. The 70% was then allocated between the two ratios as follows: (1) Primary Reserve ratio (30%) and (2) Equity ratio (40%). Because of their ability to obtain capital for their business and generally shorter business cycles, we determined that the Equity Ratio should have more importance than the Primary Reserve ratio for schools in the Proprietary sector.

Weighting Percentages for Private Non-Profit Colleges and Universities

For private non-profit institutions, the weighting percentages are:

  Recommended for this Methodology
  NPRM Methodology

Primary Reserve Ratio

40%

 

55%

Equity Ratio

40%

 

35% (Viability Ratio)  

Net Income Ratio

20%

 

10%

These weighting percentages place less emphasis on the Primary Reserve Ratio and more on the Net Income Ratio than the percentages used in the NPRM methodology. Numerous concerns were expressed by representatives of private non-profit institutions that a 55% weighting for the Primary Reserve Ratio was too high. They argued that such a weighting would produce a disincentive to invest internal funds in plant, even if the assets were revenue producing assets, such as dormitories. The empirical data in the Financial Ratios chapter confirms that much of the capital of this sector appears to be land, building, equipment and permanently restricted endowment. Therefore, the combined weighting for the two balance sheet ratios in this methodology is 80% (40% each). This weighting scheme reflects the importance expendable capital, measured by the Primary Reserve Ratio, while acknowledging the value of less liquid assets measured by the Equity Ratio.

Ten percent additional weighting was given to the Net Income ratio from the methodology to give credit in the methodology to those institutions who had smaller amounts of balance sheet resources, yet were generating surpluses from operations.

Weighting Percentages for Hospitals

The accounting and reporting requirements for non-profit hospitals are substantially the same as for non-profit colleges and universities. Their overall structure and mission is also similar in most regards so the weighting percentages for non-profit hospitals are the same as for non-profit colleges and universities. Likewise, weighting percentages for profit seeking hospitals are the same as those established for proprietary schools.

Basis for Recommendations

As indicated above, KPMG relied heavily on its own experience, professional judgment, and comments received from professionals in the higher education community in developing these weighting percentages. In addition, we used the empirical data obtained during this project to test the reasonableness of our conclusions. The fact that 5% fluctuations in weighting percentages produced insignificant differences in schools' final composite scores seems to confirm or corroborate their overall reasonableness.

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[Strength Factors Continued] [Table of Contents] [Final Composite Score]