## 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

6 Final Composite Score (continued)

## Conclusions Drawn From Composite Scores

An institution's final composite score is an arithmetic reflection of its overall financial condition on a scale from negative one to positive three. Schools earning composite scores toward the lower end of the scale pose a greater risk of precipitous closure or inability to deliver educational services than schools at the opposite end of the scale. Thus, in forming conclusions about any particular school's overall financial condition, it is important to understand that the composite scores reflect general areas on the spectrum of financial health.

As with the strength factors and weighting percentages that are integral components of each composite score, the use of estimates, professional judgment, and the subjective nature of financial statements prohibits an answer to a question such as "What's the difference between a final composite score of 1.25 and 1.26?" However, as the difference between their composite scores become greater, answers to such questions become clearer. The rest of this section is devoted to answering questions like what are the general characteristics of schools with composite scores below .90 and those with composite scores above 1.50? What are the general characteristics of institutions receiving a composite scores around 1.00?

### Institutions With Final Composite Scores of .90 or Below

The characteristics of proprietary and non-profit colleges and universities included in the sample with composite scores of .90 or less are as follows:

 Proprietary institutions Private Non-Profit Institutions No. of schools at .90 or lower 100 23 No. of schools with negative expendable resources 67 20 No. of schools with negative equity (adjusted for Equity Ratio) 47 5 No. of schools with no net income or a loss 50 19

Of the 100 proprietary institutions listed above, 29 were negative on one ratio, 36 were negative on two ratios, and 18 were negative on all three ratios.

The profile of the 23 non-profit institutions indicates that 6 were negative on one ratio, 13 were negative on two ratios, and 3 were negative on all three ratios.

These institutions have not demonstrated an ability to consistently earn money and/or retain any earnings in the institution. Generally they have illiquid balance sheets, which is demonstrated by not only considering acid test type assets, but all expendable resources, which will generally be a better test of liquidity because it acknowledges that management intervention can bring these assets into play if necessary. This includes items that could, in some short period, be converted to cash.

The following case studies represent actual schools included in the sample and are presented to further clarify the general characteristics of schools with composite scores of .90 or less. Note that in computing the final composite score for all institutions in the appendix, KPMG used an algorithm that approximates the strength factor tables. That algorithm produced some rounding differences so the final composite scores may vary slightly.

PROPRIETARY INSTITUTION #54

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve -.08 -1.00 30% -.30 Equity .08 .40 40% .16 Net Income .02 1.70 30% .51 Final Composite Score .37

This institution has nearly \$12,000,000 in total assets and approximately \$11,000,000 in liabilities so it has a proportionately small amount of equity as shown by the Equity Ratio. The Primary Reserve Ratio is negative because the small amount of equity the institution does have is invested in plant assets. The school's shortage of equity will make it difficult to borrow additional money at market terms (i.e. a debt to equity ratio of 11 to 1 is well above the RMA means). This institution has no cushion against adversity and although it lived within its means during the year, its operations are not profitable enough to make up for the lack of resources.

The ratios indicate relative weakness in all fundamental elements of financial health except profitability. The institutional ability to continually earn profits will be reflected in the balance sheet ratios in future years.

PROPRIETARY INSTITUTION #73

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .01 .20 30% .06 Equity .03 .10 40% .04 Net Income .02 1.70 30% .51 Final Composite Score .61

This institution is significantly smaller than the first with approximately \$1,000,000 in total assets. The school has just \$89,000 in total equity, \$40,000 of which is comprised of goodwill and \$23,000 in related party receivables. Thus, a negligible amount of its assets are not subject to claims of third parties. The Primary Reserve Ratio indicates that the school has sufficient liquid resources to cover four days of operations. As with the previous institution, this institution has a negligible margin against adversity and its operating profits are not enough to compensate.

Again, the ratios indicate relative weakness in all fundamental elements of financial health except profitability.

PROPRIETARY INSTITUTION #97

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .03 .60 30% .18 Equity .066 .30 40% .12 Net Income .03 2.00 30% .60 Final Composite Score .90

This school has total assets of around \$850,000 and, as its composite score reflects, it is in relatively better financial condition than the first two proprietary institutions discussed here. However, the ratio results indicate a similar (although not as severe) relative shortage of expendable resources and equity. Its Primary Reserve Ratio indicates that it has sufficient liquid assets to fund operations for about eleven days without additional revenue or support. As is the case with the first two schools, this institution?s lack of equity may make it difficult to borrow additional funds at market rates. Although the school lived within its means during the year, its operations did not generate sufficient resources to compensate for its balance sheet weakness.

This institution?s ratios indicate relative weakness in all fundamental elements of financial health except profitability.

PRIVATE NON-PROFIT INSTITUTION #19

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve -.06 -.10 40% -.04 Equity .39 2.30 40% .92 Net Income -.017 .50 20% -.10 Final Composite Score .78

Two out of this institution's three ratios are negative indicating relative weakness in three out of five fundamental elements of financial health; viability, liquidity, and profitability. This institution has net plant assets of \$820,000 which is greater than the value of its unrestricted net assets. The institution has less than \$200,000 in permanent endowment. Although the school has some equity in its plant assets as reflected by the Equity Ratio, it has a negative amount of expendable resources. If this institution had lived within its means and added just slightly to its wealth, the combined strength of the Net Income Ratio and Equity Ratio may have been sufficient to offset its unfavorable Primary Reserve Ratio.

The ratios for this institution demonstrate relative weakness in three out of the five fundamental elements of financial health, viability, liquidity, and profitability. Its relative strength in the other fundamental elements, ability to borrow and capital resources, does not materially offset the other weaknesses.

### Institutions With Final Composite Scores Around 1.00

As discussed earlier, institutions can earn a final composite score of 1.00 in a number of ways. A strength factor of one for any particular ratio indicates a lesser degree of weakness than a strength factor of zero or negative one. Strength factors of three equate to the minimum ratio necessary to form a conclusion of financial health. Strength factors of zero equate to ratios that are unfavorable enough to warrant no points being generated toward the final composite score. Farther down the spectrum, strength factors of less than zero indicate ratios that are so unfavorable that strength must be demonstrated in other ratios for positive points to be generated toward the final composite score. Therefore, final composite scores of one point to an area on the spectrum of financial health that is greater than zero, i.e. points have been generated toward the final composite score, but substantially less than three, the maximum score possible.

The following case studies represent actual schools included in the sample and are presented to further clarify the general characteristics of schools with composite scores around 1.00. As noted earlier, in computing the final composite score for all institutions in the appendix, KPMG used an algorithm that approximates the strength factor tables. That algorithm produced some rounding differences so the final composite scores may vary slightly.

PROPRIETARY INSTITUTION #112

 Ratio Result StrengthFactor WeightingPercentage Product Primary Reserve .02 .40 30% .12 Equity .16 .90 40% .36 Net Income .02 1.70 30% .51 Final Composite Score .99

PROPRIETARY INSTITUTION #113

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .012 .20 30% .06 Equity .120 .70 40% .28 Net Income .036 2.20 30% .66 Final Composite Score 1.00

PROPRIETARY INSTITUTION #114

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .09 1.80 30% .54 Equity .33 1.90 40% .76 Net Income -.06 -1.00 30% -.30 Final Composite Score 1.00

PRIVATE NON-PROFIT INSTITUTION #29

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .12 1.20 40% .48 Equity .24 1.40 40% .56 Net Income -.04 0.00 20% 0.00 Final Composite Score 1.04

In the first two examples above, proprietary institutions #112 and 113, the relative weakness demonstrated in their balance sheet ratios (Primary Reserve and Equity) indicate that they have little, if any, margin against adversity. However, they are both profitable enough that the owners may be motivated to invest in the schools and commit to their success. Continued profitability at this level could slowly build up these institutions' margin against adversity. Proprietary institution #113 is substantially larger with total expenses of \$11,500,000 than proprietary institution #112 whose expenses were #\$150,000 but their relative financial condition is similar.

In the third example, proprietary institution #114's, balance sheet ratios are more favorable than the first two but its operating loss was large enough to generate negative points toward the final composite score. This institution has sufficient expendable resources to continue operations for approximately thirty-two days without receiving additional revenue or support. The Equity Ratio of .33 indicates the institution has \$1.00 in assets for every \$.66 in liabilities. This excess of assets over liabilities represents greater commitment on the owners part than the first two examples because a proportionately higher amount of their resources are at risk. The operating loss is significant though and if continued will consume the expendable resources and equity shown in the first two ratios. This institution had total assets of \$116,000.

The last example, private non-profit institution #29, is of a private non-profit institution. In comparing this institution to private non-profit institution #19 discussed in the preceding section that described schools with composite scores of .90 or below, the major difference is in their proportional amount of expendable resources. This school's Primary Reserve Ratio indicates that it could continue operations at its current level for approximately forty-four days without receiving additional revenue or support. This school's four percent loss indicates that it did not live within its means during the year. Although the loss of \$3,400,000 was comprised largely of approximately \$3,000,000 in depreciation expenses, its operations are not funding its minimal capital replacement needs. In both of the last two examples here, had the schools just lived within their means during the year, their final composite score may have significantly improved.

All of the examples above demonstrate that the schools had insufficient margin against adversity (expendable and other assets) to earn higher final composite scores. Even the third proprietary school listed, proprietary institution #114, had insufficient balance sheet ratios to off set its sizable operating loss.

### Institutions With Final Composite Scores of 1.50 or Above

The characteristics of a group of proprietary and private non-profit institutions included in the sample with composite scores of 1.50 or more follows. For illustration, we selected the first thirty institutions in each sector with composite scores of 1.50 or more. These institutions provide insight into the characteristics of a group of financially improved institutions as compared to those with composite scores below .90.

 First 30 Schools with Composite Scores of 1.50 or Above Proprietary institutions Private Non-Profit Institutions No. of schools 30 30 Range of calculated scores 1.51 - 1.72 1.50 - 2.10 No. of schools with positive expendable resources 29 26 No. of schools with positive equity (adjusted for Equity Ratio) 30 30 No. of schools with positive net income 21 18

As can be seen, this next group of schools exhibits distinctly improved financial health over the institutions with scores under .90. While some significant structural financial health issues exist with these institutions, ED's time horizon for assessment of twelve to eighteen months indicates that these schools are in relatively better financial condition than the schools with scores under .90.

Beyond the institutions summarized above, the vast majority of the sampled institutions are clearly in better financial health. Institutions with a composite score of 2.00 or better totaled 253 (out of 507) for the proprietary schools and 313 (out of 395) for private non-profits.

The key differentiating factor between institutions with composite scores below .90 and those with composite scores over 1.50 is the demonstrated ability of the institutions to retain some wealth in the institution which is demonstrated by the Equity Ratio. Note that all of the institutions with a composite score of 1.50 and higher have a positive Equity Ratio. Of the institutions with a composite score of .90 or less, 47 of the proprietary institutions and 5 of the private non-profit institutions had a negative Equity Ratio. Since this is calculated net of intangibles and related party items, the wealth represents items that the institution can claim readily, as its equity, although some components may be somewhat illiquid.

The following case studies represent actual schools included in the sample and are presented to further clarify the general characteristics of schools with composite scores of 1.50 or more. Note that in computing the final composite score for all institutions in the appendix, KPMG used an algorithm that approximates the strength factor tables. That algorithm produced some rounding differences so the final composite scores may vary slightly.

PROPRIETARY INSTITUTION #195

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .15 3.00 30% .90 Equity .08 .40 40% .16 Net Income .02 1.70 30% .51 Final Composite Score 1.57

This institution?s Primary Reserve Ratio has generated the maximum number of points toward the composite score. Its total expenses for the year were only approximately \$500,000 yet it had total assets of approximately \$1,000,000. Since total expenses are the denominator of the Primary Reserve Ratio, a small amount of expenses reflects small operating size and results in a favorable Primary Reserve Ratio. This entity bought another school during the year so its expenses were relatively low in relation to its assets. Its Equity and Net Income ratios are moderate and neither of them are weak enough to generate negative points. This institution has sufficient liquid resources to continue operations at its current level for approximately fifty-five days without receiving additional revenue or support.

This institution demonstrates relative strength in two out of five fundamental elements of financial health, viability and liquidity, and does not show extreme weakness in any of the other fundamental elements.

PROPRIETARY INSTITUTION #227

 Ratio Result Strength Factor Weighting Percentage Product Primary Reserve .01 .20 30% .06 Equity .71 3.00 40% 1.20 Net Income .02 1.70 30% .51 Final Composite Score 1.57

This institution?s Equity Ratio, by itself, generates 1.20 points toward the final composite score. This school has approximately \$181,000 in total assets, \$118,000 of which is comprised of plant assets. However, on the liability side of the balance sheet, the school has no long-term debt; there are no third party claims against their plant. This fact contributes to a relatively unfavorable Primary Reserve Ratio because so much of the institution?s resources are non-expendable but a strong Equity Ratio since there is such a small amount of liabilities. Since neither the Equity nor Net Income ratios are weak enough to generate negative points, the relative strength shown by the Equity Ratio is sufficient to place it higher on the spectrum of financial health than institutions with final scores closer to 1.00. This is a good example of an institution that has retained wealth over time. Although the Primary Reserve Ratio indicates a relative shortage of expendable resources, the Equity Ratio indicates that for every \$1.00 of assets there is \$.29 in liabilities. This excess of assets over liabilities should make it easier for this school to borrow money at market rates. It also implies a capital resource base upon which the school can build for the future.

This institution demonstrates relative strength in two out of five fundamental elements of financial health, ability to borrow and capital resources, and does not show extreme weakness in any of the other fundamental elements.

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[Final Composite Score (part 1 of 2)] [Other Considerations]