Archived: Archived: Strength Factors

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 (continued)

Basis for Recommendations

Relationship to ED Objectives

ED's objectives for this project were paramount in the development of the strength factors. With the original methodology, the objective was to categorize institutions along the spectrum of financial health to help ED efficiently exercise its regulatory responsibilities. With the methodology recommended in this document, the focus is on differentiating institutions on the lower end of the spectrum while providing a more general standard of financial health. Given the new objective, we based our recommendations on input from the higher education community, empirical data, evidence of factors leading to closed schools, KPMG experience and judgment, and discussions with ED personnel.

Empirical Evidence

The empirical data obtained during this project demonstrates a few key issues. First, a large proportion of institutions in the proprietary business segment appear to be very thinly capitalized. Almost 10% have negative equity. Private non-profit institutions, on the other hand, appear to have much greater equity supporting their operations and a significant component of that equity appears to be land, building, and equipment.

Using the recommended strength factors, Primary Reserve Ratio results are distributed as follows:

	Sample Size = 395 Private Non-Profits		Sample Size = 507 Proprietaries
Strength Factors	Number	Percentage		Number	Percentage
-1.00 - -.01	40	10%		74	15%
0.00 - .99	28	7%		101	20%
1.00 - 1.99	39	10%		143	28%
2.00 - 3.00	288	73%		189	37%

Using the recommended strength factors, Equity Ratio results are distributed as follows:

	Sample Size = 395 Private Non-Profits		Sample Size = 507 Proprietaries
Strength Factors	Number	Percentage		Number	Percentage
-1.00 - -.01	6	1%		46	9%
0.00 - .99	7	2%		92	18%
1.00 - 1.99	18	5%		104	21%
2.00 - 3.00	364	92%		265	52%

Using the recommended strength factors, Net Income Ratio results are distributed as follows:

	Sample Size = 395 Private Non-Profits		Sample Size = 507 Proprietaries
Strength Factors	Number	Percentage		Number	Percentage
-1.00 - -.01	32	8%		9	2%
0.00 - .99	37	9%%		89	18%
1.00 - 1.99	83	21%		118	23%
2.00 - 3.00	243	62%		291	57%

Addressing Respondents' Concerns and Suggestions

In formulating the strength factors recommended for this methodology we addressed a number of major concerns raised by the higher education community during the NPRM comment period. First, in the NPRM methodology there were five thresholds, or what are now called strength factors. Every ratio result produced one of five strength factors (1, 2, 3, 4, or 5), with no possible strength factors between them. Many commenters believed that five strength factors were insufficient to adequately differentiate between institutions. For example, for any particular ratio, the difference between an institution that barely earned a factor of three and an institution that almost earned a factor of three was very small but there was a 20% difference in the strength factors they earned. By creating forty incremental thresholds, the new strength factors address this concern of respondents to the NPRM.

Many commenters felt that many of the former thresholds were generally too high. Specifically, in order to earn a Net Income Ratio threshold of five (highest possible) under the original methodology, a proprietary school needed a Net Income Ratio result of at least .12. Some commenters believed that by requiring such high profitability, the methodology gave schools an incentive to maintain high profits at the expense of program quality. They also argued that most proprietary institutions did not earn that high a profit. The empirical data collected in this project seems to support that argument. It shows that over 50% of the institutions in the sample have a net income ratio of less than .05. With the new methodology, a proprietary school only needs a ratio result of .06 to earn the highest possible strength factor. In addition, the new methodology allows proprietary institutions to incur minor losses yet still earn points toward their final composite score.

Representatives from the proprietary business segment generally felt that the thresholds for the Primary Reserve Ratio were too high as well. Some even felt that existing tax regulations concerning the accumulated earnings tax would penalize proprietary institutions for retaining enough liquid capital necessary to be classified as financially healthy by the methodology. Results of the new empirical data, the methodology's new regulatory objective, and reduced time horizon led KPMG to reduce the these strength factors. With this methodology, a proprietary school with a Primary Reserve Ratio result of .15 earns the highest possible strength factor whereas with the original methodology, a school needed a result of .30 to earn a threshold factor in the middle of the range. Lowering the strength factors is consistent with the community's responses.

As for the private non-profit business segment, strength factors for the Net Income Ratio have been modified allowing institutions to incur minor losses yet still earn points toward their final composite score. Empirical data showing that on average, depreciation is equal to four percent of a non-profit institution's revenues supports this modification.

Many representatives from the private non-profit sector objected to the former methodology's strength factors being set higher for institutions whose financial statements were prepared based on the new FASB Statements No. 116/117 standards than for those using traditional fund accounting. In the original methodology, a school whose financial statements were prepared in accordance with FASB Statements No. 116/117 needed a Primary Reserve Ratio of .50 to receive a "financially healthy" strength factor whereas a ratio of .30 sufficed for schools employing the traditional fund accounting model. For the institutions that ED wants to focus on with this new methodology, i.e. those in financial distress, there is no evidence to suggest that the new accounting rules for recognizing investment gains incorporated in SFAS Nos. 116/117 have a material impact. This, in conjunction with input from the community, contributed to our decision to set a Primary Reserve Ratio of .30 as the result necessary to earn the highest possible strength factor.

Some commenters felt that the difference in strength factors between business segments caused the methodology to treat those in the proprietary business segment unfairly. Strength factors for one of the three ratios, the Equity Ratio, are identical between business segments. Net Income Ratio strength factors are more demanding for proprietary institutions but the standards for the Primary Reserve Ratio are less stringent than those set for the private non-profit business segment. These differences tend to offset each other so the strength factors together impose appropriate and comparably stringent overall standards to each business segment.

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