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

3.  Financial Ratios

Chapter Outline

Recommendations

As the first step in the methodology, KPMG recommends calculation of three financial ratios, using data obtained from general purpose financial statements. Using data that is readily obtainable from financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) and audited by an independent certified public accountant is critical to ensuring consistency of information obtained from various schools. This approach provides ED with a methodology that can be used with a manageable level of effort. Each individual ratio is designed to measure different fundamental elements of financial health and the three ratios viewed together provide a measure of an institution's overall financial condition. The three ratios recommended for use in the first step of the methodology are:

• Primary Reserve Ratio;

• Equity Ratio; and

• Net Income Ratio.

In selecting these ratios, KPMG built upon two fundamental concepts. First, financial ratios can be used to make an assessment of an institution's financial condition. Second, the financial condition of institutions in different business sectors can be assessed by measuring the same five fundamental elements of financial health regardless of sector differences in accounting and reporting requirements or organizational differences. The specific components included in the ratios may vary by institution type but the same fundamental elements should be always be measured.

Why Financial Ratios?

General purpose financial statements are an important device for communicating the financial condition and operating results of postsecondary education institutions. Typically they follow principles and standards set forth in various publications of the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB). However, the implications of the financial activities described in these statements are not necessarily understood by all users. Financial ratios offer a capsulated view of key conditions affecting the fundamental elements of financial health and provide answers to certain questions concerning institutions' overall financial condition.

In simplest terms, a ratio is the relationship between two numbers, a numerator and a denominator. Each ratio's utility lies in its ability to impart greater knowledge than is readily discernible from each of the numbers standing alone. In converting amounts from financial statements to ratios on a single scale, comparison between different size institutions is made possible.

Since individual ratios provide insight into specific elements of financial health, carefully selected ratios, viewed together as a whole, provide an efficient means for assessing institutions' overall financial condition. Specifically, they provide insight in answering two fundamental questions:

• Is the institution clearly financially healthy or not as of the reporting date?

• Did the institution live within its means during the year?

The first question is answered from the balance sheet (Primary Reserve and Equity Ratios) which is the most common means of communicating an entity's financial condition at a given time. The second question is answered from the income or activities statement (Net Income Ratio). A positive answer to these questions is a good indication that the institutional resources are sufficient to support its mission.

KPMG introduced its first edition of Ratio Analysis in Higher Education in the 1970s (now in its third edition) to use as a tool to better understand and interpret an institution's financial results. From working with our clients over more than 25 years, we concluded that financial ratio analysis provides a ready means of focusing on a few key elements that indicate how well the institution is performing. Today, rating agencies, investors, accrediting bodies, accountants, and company managers in many industries use ratios from the general purpose financial statements prepared in accordance with GAAP to compare similar institutions' basic financial performance.

Fundamental Elements of Financial Health

KPMG believes the fundamental elements of financial health relevant to ED's objectives in this project are:

1. Financial Viability - The ability of an institution to continue to achieve its operating objectives and fulfill its mission over the long term.

2. Profitability - The determination of whether an institution receives more or less than it spends in an operating cycle. The term profitability may seem inappropriate for the non-profit environment but as defined here, profitability is a fundamental element of any institution?s financial health. Any non-profit institution that consistently spends more than it receives will eventually cease to exist.

3. Liquidity - The ability of an institution to satisfy its short term obligations with existing assets.

4. Ability to Borrow - The ability of an institution to assume additional debt.

5. Capital Resources - An institution?s financial and physical capital base that supports its operations.

[Recommended Methodology]

[Financial Ratios (part 2 of 4)]