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

Equity Ratio Strength Factors

Robert Morris Associates (RMA) compiles survey data from institutions in various industries and uses a total liabilities to tangible net worth ratio that is similar to this methodology's Equity Ratio. RMA forms no conclusions about entities, it simply compiles ratio data. Using RMA statistics, lending institutions and other investors can see how a particular institution's ratio result compares to industry averages. As with the Moody's data used for the Primary Reserve Ratio, KPMG used the RMA data simply as a test of reasonableness. Again there is no perfect correlation between the Equity Ratio strength factors and the liabilities to tangible net worth ratio results that RMA compiled. However, review of the RMA data supports the overall reasonableness of the Equity Ratio strength factors.

In the RMA 1996 Annual Statement Studies, the median total liabilities to tangible net worth ratio score for colleges and universities (SIC #8221) was generally around .50 depending on their size (ranked by total assets and by total sales) but went as high as 2.7 for very small schools. For SIC #8299, Services-School and Educational Services, the median was around 1.3 and went as high as 2.4. A debt to tangible net worth ratio of .50 indicates that for every $3.00 of assets, there is $1.00 in liabilities. The fact that the median RMA scores are significantly stronger for the private non-profits is consistent with the empirical data gathered for this project. That data shows that institutions in the private non-profit business segment have a greater amount of their resources invested in plant and equipment.

The two to one (assets to liabilities) relationship necessary to earn the highest possible strength factor in this methodology (Equity Ratio of .50) is just slightly less than the median score for proprietary schools that the RMA statistics demonstrate. The fact that the strength factor standard is lower than the median score is indicative of the methodology's objectives. The methodology provides differentiation between schools at the lower end of the spectrum and measures a time horizon of twelve to eighteen months, whereas users of RMA statistics, like Moody's ratings, would be attempting to evaluate institutions over a much longer time frame.

Specific Equity Ratio strength factors and the ratio results to which they equate are shown below.

All Institutions

Equity Ratio

Conclusions Drawn From a Strength Factor of Negative One

Institutions with a negative amount of equity will have a diminished ability to borrow money at market terms because they have limited or no resources, not already subject to third party claims, that can be offered as collateral. The fact that these institutions' liabilities exceed the book value of their assets will make it difficult for them to meet their technology needs and capital replacement needs. Furthermore they will be less able to fund new program initiatives.

For both proprietary and non-profit institutions, an Equity Ratio strength factor of negative one indicates relative weakness in three out of the five fundamental elements of financial health: viability, ability to borrow, and capital resources. It may indirectly indicate weakness in a fourth fundamental element, profitability, since continued losses or operating deficits will deplete an institution's resources.

Equity Ratio

Conclusions Drawn From a Strength Factor of Zero

In the case of a proprietary school, an absence of equity provides no evidence of owner commitment to the business because there are no accumulated earnings or invested amounts beyond the liabilities that are at risk. For private non-profit institutions, the absence of net assets indicates that there is little or no permanent endowment from which the institution could draw in extreme circumstances.

Similar to institutions with negative ratios, institutions in this category could have difficulty obtaining additional financing because there would be no assets with which it could be secured. For schools with relatively old plant assets that have been fully depreciated, negative or zero equity / net assets imply that the school must rely on additional revenues, capital infusions, or donations in order to build or invest in the future. Institutions with newer plant assets that have no equity / net assets have stretched their borrowing ability to or beyond a reasonable limit.

For both proprietary and non-profit institutions, an Equity Ratio strength factor of zero indicates relative weakness in three out of the five fundamental elements of financial health: viability, ability to borrow, and capital resources. It may indirectly indicate weakness in a fourth fundamental element, profitability, since continued losses or operating deficits will deplete an institution's resources.

Equity Ratio

Conclusions Drawn From a Strength Factor of One

In the case of a proprietary school, the existence of equity may imply a greater commitment to the business on the owners' part since that portion of the institutional resources financed by owner investment, contributions, or accumulated earnings in excess of liabilities has been left in the business. For private non-profit institutions, this small amount of net assets may reflect a permanent endowment which will continue to provide some revenue or may be drawn upon in extreme circumstances.

The small amount of equity necessary to earn a strength factor of one will still make it difficult for such institutions to borrow significant amounts of money at market rates. However, as we move up the spectrum of strength factors from negative one to zero and now to positive one and beyond, the proportional amount of equity in the institutions increases. At the point where a strength factor of one is earned, institutions are just beginning to demonstrate equity (assets in excess of their liabilities). Thus, at this point, they demonstrate a very limited ability to meet their technology and capital replacement needs. These institutions will not have large amounts of capital readily available for funding new program initiatives.

Equity Ratio

Conclusions Drawn From a Strength Factor of Three

Again, with the proprietary schools, this proportionately increased amount of equity may indicate greater commitment to the business on the owners' part.

The amount of equity or net assets necessary to earn a strength factor of three make it more likely that an institution will have the financial resources necessary to borrow significant amounts of money at market rates. The fact that these institutions have a proportionately smaller amount of their assets subject to third party claims implies an increased ability to replace existing technology with improved more expensive technology. It follows that these institutions will be able to replace physical capital as needed and will be able to provide seed money internally for new program initiatives.

A strength factor of three for the Equity Ratio indicates financial strength in three fundamental elements of financial health: viability, ability to borrow, and capital resources. Indirectly, it may signal strength in the element of profitability since continued operating surpluses will increase an institution's resources.
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[Strength Factors (part 2 of 6)]

[Strength Factors (part 4 of 6)]