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

5. Ratio Weighting

Chapter Outline

Recommendations

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

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

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

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

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

Basis for Recommendations

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[Strength Factors Continued]

[Final Composite Score]