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

Primary Reserve Ratio Strength Factors

On the upper end of the scale, a ratio of .30 indicates that an institution has sufficient expendable resources to continue operations for approximately 110 days without any additional revenue or support. Such reserves are indicative of a financially healthy institution and equate to a strength factor of three for private non-profit colleges and universities. For reasons outlined later in this section, a standard of .15 was established for proprietary schools as the ratio necessary to earn a strength factor of three. The ratio result necessary to earn a strength factor of negative one was established by simply extending the incremental strength factors between zero and three ten more increments below zero.

Moody's, a primary bond rating agency, uses an expendable resources to operations ratio that is similar to the Primary Reserve Ratio in analyzing credit worthiness. KPMG compared the Primary Reserve Ratio strength factors developed for this methodology to the standards set by Moody's for similar ratios as a test of reasonableness. It is important to note when reviewing the following Moody's data, that the data was used strictly as a test of reasonableness. There is no perfect correlation between the standards set by Moody's and the strength factors that this methodology employs. This methodology's strength factors are generally lower and appear to be reasonable when compared to Moody's standards for similar ratios.

For private colleges and universities, the median Moody's ratio for schools with a Baa rating is .669 for small schools and .449 for large schools. The median score for schools with a bond rating of Aa is 4.58 for small schools and 3.28 for large schools. It is noteworthy that the values displayed above represent median scores, not high end scores. Many of the institutions in this project's sample represent what would generally be considered to be sub-investment grade institutions. The Moody's definition of their Baa grade is as follows: "Medium grade obligations, i.e. they are neither highly protected nor poorly secured. They lack outstanding characteristics and in fact have speculative characteristics as well." Institutions in this category represent a reasonable credit risk but absent some other factor or set of circumstances would not be considered financially healthy. As this ratio decreases, the relative financial health of the institution being analyzed decreases.

The methodology's ratio necessary to earn the highest possible strength factor (.30 for private non-profit institutions and .15 for proprietaries) is lower than those of investment grade institutions for two basic reasons. First, ED's horizon is short term in nature, twelve to eighteen months as opposed to lenders or bond purchasers who generally have longer term goals (i.e. the repayment period of the bonds being rated). Secondly, the rating agencies are assessing repayment capabilities in the normal course without abnormal events such as spending endowment funds or liquidating fixed assets.

Specific Primary Reserve Ratio strength factors and the ratio results to which they equate for proprietary institutions are shown below.

Proprietary Institutions

Specific Primary Reserve Ratio strength factors and the ratio results to which they equate for private non-profit institutions are shown below.

Private Non-Profit Institutions

Primary Reserve Ratio

Conclusions Drawn From a Strength Factor of Negative One

Institutions earning a strength factor of negative one must demonstrate strength in other ratios to earn positive points toward the final composite score. Because an institution with a negative strength factor from this ratio is financing its daily operations from another source, the negative score requires an institution to demonstrate the other source (i.e. profitable operations, borrowing capacity).

For both proprietary and non-profit institutions, a Primary Reserve Ratio strength factor of negative one indicates weakness in two out of the five fundamental elements of financial health: viability and liquidity.

Primary Reserve Ratio

Conclusions Drawn From a Strength Factor of Zero

For both proprietary and non-profit institutions, a Primary Reserve Ratio strength factor of zero indicates relative weakness in two out of the five fundamental elements of financial health: viability and liquidity.

Primary Reserve Ratio

Conclusions Drawn From a Strength Factor of One

Private non-profit institutions need a Primary Reserve Ratio of .10 to earn a strength factor of one. That ratio indicates that the value of the institution's assets that can be converted to cash exceed the value of its short term debt an liabilities by an amount equal to ten percent of its total expenses. Expressed as a number of days, this institution could continue operations at its current level for approximately thirty-six days without additional revenue or support.

On the relative scale of financial health, this ratio result is superior to the ratio that earns a strength factor of zero because it indicates that there is some cushion against adversity, although not a sizable cushion in relation to operating size. Depending on the length of its school terms and assuming the absence of all other negative factors, an institution with a Primary Reserve Ratio strength factor of one could stay in business until the end of the current term without receiving unusual revenue or other support.

Institutions with the small amount of expendable capital necessary to earn a strength factor of one would have difficulty finding resources internally to handle large, unforeseen, negative economic events. Although this level of expendable resources would generally enable institutions to replace existing capital, it would be difficult for them to finance technology upgrades. They should be able to meet their payroll and other existing obligations but institutions with this proportionately small amount of expendable resources will have difficulty funding new program initiatives and upgrading faculty to meet changing student demands.

Primary Reserve Ratio

Conclusions Drawn From a Strength Factor of Three

Private non-profit institutions need a Primary Reserve Ratio of .30 or better to generate the maximum number of points toward the final composite score. This ratio indicates that the value of the institution's relatively liquid assets exceeds the value of its short term debt and liabilities by an amount equal to thirty percent of its total expenses. Assuming no other factors, this cushion against adversity implies that the institution could survive for approximately 110 days without additional revenue or support. As with the proprietary sector, this relative level of expendable resources is the minimum level necessary to form a conclusion of financially healthy institution.

Institutions with this level of expendable resources will be better prepared to endure unforeseen large negative economic events than institutions with less expendable resources. These institutions have a greater ability to provide seed money for future programs, invest in new technology, develop human resources, and replace existing capital resources.

A Primary Reserve Ratio strength factor of three is an indication of relative strength in two out of the five fundamental elements of financial health: viability and liquidity.
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[Strength Factors (part 1 of 6)]

[Strength Factors (part 3 of 6)]