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

6 Final Composite Score

Chapter Outline

Recommendations

In the fourth and fifth steps of the methodology, the products derived from multiplying the strength factors by the weighting percentages are added together to form a composite score. Comparing that composite score to the regulatory standard that ED establishes will determine the institution's position relative to the financial responsibility standards.

Description of the Final Composite Score

The methodology provides ED with a mechanism that measures institutions' overall financial condition and can be used to set a regulatory standard, or minimum of financial health. KPMG has recommended financial ratios, strength factors, weighting percentages, and a methodology for combining all elements into one composite score. The final determination point or range of points at which the Secretary deems institutions to be financially responsible must be based on the amount of risk that ED wishes to bear. No other judgment can be substituted for that ultimate appetite for risk because ultimately ED will bear the sole burden of the decision on risk assumption.

The methodology delineates institutions, in relation to each other, by assigning an overall score from negative one to three to each one. Schools that earn a composite score of greater than 2.00 pose a negligible risk of precipitous closure, inability to deliver educational services, or inability to handle administrative responsibilities. Institutions earning a composite score of less than .50 represent a clear risk of all three, absent other factors such as capital infusions from another source.

It is important to note that, regardless of where or how ED ultimately decides to set the regulatory test of financial responsibility, there will probably be some institutions that pass the financial responsibility test yet will not be able to meet the statutory standard or will precipitously close in the following twelve to eighteen months. Some institutions that fail the ratio test may in fact be capable of delivering quality educational services to students for another eighteen months and beyond. No methodology is capable of being perfectly predictive because there are individual factors creating circumstances in specific institutions that cannot be accounted for entirely. For these and other reasons, ED may decide to establish a range of composite scores rather than one precise point for determining financial responsibility. A range of intermediate scores could provide for greater differentiation between those schools that clearly satisfy the ratio test and those that do not. The methodology fits the needs of ED well because it provides a scale of relative health, gives a systematic measure, and is reliable across a wide range of institutions

Returning to the Fundamental Elements of Financial Health

Recommendations Uniform Between Business Segments

Different Ways to Earn a Similar Composite Score

Consider the following three hypothetical institutions with significant structural differences between them but all of whom receive a similar final composite score. For illustrative purposes, we have selected a final composite score around 1.00 to demonstrate the interaction of the ratios.

INSTITUTION A: PRIVATE NON-PROFIT INSTITUTION

Ratio	Result	Strength Factor	Weighting Percentage	Product
Primary Reserve	.10	1.00	40%	.40
Equity	.167	1.00	40%	.30
Net Income	0.00	1.00	20%	.20
Final Composite Score				1.00

With this first hypothetical example, Institution A's ratio results all generated strength factors of 1.00 and it is a matter of arithmetic therefore that their weighted products will add up to 1.00. This institution's expendable resources measured by the Primary Reserve Ratio indicate that the institution could continue operations for approximately 38 days without additional revenue or support. The Equity Ratio result of .167 shows that for every $10.00 of assets, there are approximately $8.33 in liabilities so the value of the institution?s assets exceeds its liabilities but not by a large margin. The Net Income Ratio of 0.00 shows that the institution lived within its means during the year but that it did not add substantially to its margin against adversity.

INSTITUTION B: PROPRIETARY INSTITUTION

Ratio	Result	Strength Factor	Weighting Percentage	Product
Primary Reserve	-.003	-.10	30%	.-.03
Equity	.076	.40	40%	.16
Net Income	.058	2.90	30%	.87
Final Composite Score				1.00

In this second example, Institution B's balance sheet ratios (Primary Reserve and Equity) are materially weaker than those of Institution A. However, the Net Income Ratio of .058 indicates relative strength in the area of profitability and the resultant strength factor of 2.90 offsets the lower strength factors for the Primary Reserve and Equity ratios. Although this institution?s margin against adversity is proportionately less than Institution A's, its operations generated a surplus during the year and added to the institution's wealth. If this institution continues to operate this way, it will improve its balance sheet ratios because it will be continually adding to its own wealth. The profits generated by institution B also provide a motivation for its owners to invest additional capital or make other commitments to its success.

INSTITUTION C: PROPRIETARY INSTITUTION

Ratio	Result	Strength Factor	Weighting Percentage	Product
Primary Reserve	.068	1.30	30%	.39
Equity	.312	1.80	40%	.72
Net Income	-.038	-.30	30%	-.09
Final Composite Score				1.02

In this third and final example, Institution C has not lived within its means during the year and therefore earned a negative strength factor for the Net Income Ratio. However, its two balance sheet ratios generated higher strength factors than those for Institutions A & B. The combined weighting for those two ratios, 70%, make the effect of incremental changes in them greater than for the Net Income Ratio which is only weighted 30%. This institution did not live within its means during the year but has a slightly greater margin against adversity built up.

All three of the examples above represent institutions that fall very near each other on the spectrum of financial health even though they are in different business segments. The examples are intended solely to demonstrate how relative weakness in one component of financial health can be offset by strength in another.

Satisfying the Ratio Test

Not Satisfying the Ratio Test (Alternatives)

One Composite Score Versus a Range of Composite Scores

• exemplary financial condition;
• financially sound;
• potential problem; and
• immediate problem.

Schools deemed to be in exemplary financial condition were separated from those deemed to be immediate problems by a wide range of scores and two intermediate categories, financially sound and potential problem.

In using this methodology as a basis for new financial responsibility regulations, ED may choose to set one particular composite score, above which a school would be deemed to be in compliance with financial responsibility standards. ED might also select a composite score, below which a school would be expected to demonstrate financial responsibility through some other means. Those two points might be the same point or they could be separated by a range of composite scores. The financial health of schools with composite scores within that range would be uncertain. A range of scores would provide greater differentiation between schools that satisfy the ratio test and those that do not, but it could also impose additional administrative responsibilities on ED. Just as the final determination point must be based on the amount of risk that ED wishes to bear, the responsibility for deciding whether to set one particular composite score or a range of composite scores also rests with ED. KPMG makes no recommendations concerning the selection of a particular composite score or range of composite scores.

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[Ratio Weighting]

[Final Composite Score (part 2 of 2)]