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

2.  Recommended Methodology

Chapter Outline

Recommendations

KPMG recommends a five step mechanism using financial ratios for use as a regulatory test of financial responsibility for schools participating in Title IV programs. The methodology is intended solely for use as a regulatory test of financial responsibility within the context of ED's responsibility under the Higher Education Act of 1992. More detailed discussions of each component of this methodology are included in the following chapters.

Description of the Five Step Methodology

KPMG's basic objective was to develop a methodology that ED could use as a primary test of financial responsibility. Again, as required by the Higher Education Act section 498, a school is considered financially responsible is if it has sufficient resources to:

1. provide the services described in its official publications;

2. provide the administrative resources necessary to comply with Title IV requirements; and

3. meet all of is financial obligations, including but not limited to (a) refunds that it is required to make and (b) repayments to the Secretary for liabilities and debts incurred in programs administered by the Secretary.

The regulatory test recommended is based on information contained in the school?s audited financial statements and focuses on the minimum level of resources that the school must have to satisfy these conditions for a period of twelve to eighteen months following its fiscal year end.

A description of the steps in the methodology follows:

Step One - Calculate the Three Ratios

In the first step of the methodology, users calculate three financial ratios. The three ratios, customized for each sector to accommodate different accounting and reporting standards, are:

• Primary Reserve Ratio - Expendable resources divided by annual expenses;

• Equity Ratio - Net worth (with adjustments) divided by total assets (with adjustments); and

• Net Income Ratio - Revenue in excess (deficit) of expenses divided by total revenue.

This first step of the methodology is discussed in greater detail in chapter three of this report.

Step Two - Assign Strength Factors

Strength factors allow for comparison between ratios by placing all ratio results on a common scale and allowing arithmetic combination of the ratios in the next step. The combination of the ratios is critical to the process because the three ratios together provide insight into the financial health of the institution based on the fundamental elements of financial health they measure. The tables used for assigning strength factors to ratios were developed specifically for this methodology, and their use is limited to application of this methodology. They are discussed in greater detail in chapter four of this report.

Step Three - Multiply Strength Factors by Weighting Percentages

The ratios and their resultant strength factors are weighted in the third step of the methodology. With weighting percentages, some ratios and the fundamental elements of financial health that they measure, become more important than others. The weighting percentages are customized to accommodate the organizational differences of institutions in different business segments. However, in all business segments, through use of the weighting percentages, the methodology places greater emphasis on the cumulative resources amassed by the institution and available to support its mission (Primary Reserve and Equity Ratios) than on its operating results (Net Income Ratio).

The weighting percentages are discussed in greater detail in chapter five of this report.

Step Four - Sum the Resulting Products

The numeric results (products) produced by multiplying the weighting percentages by the strength factors are added together to form a composite score in the fourth step of the methodology. By adding the three products together, the methodology quantifies an assessment of an institution's overall financial condition with one number. This step, along with the final composite score, is discussed in greater detail in chapter six of this report.

Step Five - Rank Institutions by Final Composite Score

Once a final composite score has been determined, a conclusion is formed about the institution's financial responsibility in the fifth and final step of the methodology. The methodology will rank institutions on a range of financial health from negative one to three. Institutions which are financially healthy by design of the test will obtain scores of three. Institutions which are weak financially will fall at the lower end of the scale. If the school's composite score is above a point, or range of points, to be established by ED, the school is considered to be financially responsible (assuming it meets the other regulatory requirements). Schools with composite scores below that point will not satisfy the ratio test.

Establishing the delineating point of financial responsibility requires an overlay of the risk of loss that ED is willing to assume under the Title IV programs. Given the number and nature of factors that must be considered in determining an acceptable level of risk, ED may find it appropriate to establish a range of scores in lieu of one precise point on the final grading scale that defines financial responsibility. A discussion of this final step is discussed in greater detail in Chapter 6 of this report. That section also provides insight into the meaning of various final composite scores and potential financial strengths and weaknesses which can offset each other to obtain those scores.

This methodology is intended to be used to identify institutions that do or do not satisfy the ratio test. Follow-up actions and alternative tests that ED may choose to supply to institutions that do not satisfy the ratio test are beyond the scope of this engagement.

Graphic Examples

The methodology is shown graphically below using a hypothetical proprietary institution and a hypothetical private non-profit institution as examples:

[Introduction]

[Financial Ratios]