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

4. Strength Factors

Chapter Outline

Recommendations

To meet ED's objectives for this project a strength factor scale of negative one to positive three was developed to identify and provide maximum differentiation between institutions on the lower end of the spectrum of financial health without differentiating greatly among the clearly financially healthy institutions. In contrast, the NPRM methodology provided for a strength factor scale from one to five and differentiated between institutions at all points along a broader spectrum of financial health, including the lower and upper ends of the scale.

Description of Strength Factors

• The minimum ratio result that would indicate financial health was established to earn the highest possible strength factor of three. Such a ratio result or higher would therefore generate the maximum number of points toward the final composite score.
• A strength factor of zero was established for the ratio result below which indicates clearly poor financial condition.
• The spectrum of potential strength factors between zero and three was divided into thirty equal increments to establish all other possible strength factors between zero and three.
• The incremental units between zero and three were extended evenly down to the negative one strength factor.

As discussed later in this section, this process was modified slightly in developing the strength factors for the Net Income Ratio.

With the resultant strength factors, relatively favorable ratio results generate the maximum number of weighted points to the final composite score. Unfavorable ratio results equate to a strength factor of zero and generate no points toward the composite score, or generate negative points if the degree of the negative result is severe enough, and detract from the composite score. All other potential ratio results are distributed evenly between these points and the potential strength factors are assigned accordingly.

The spectrum of potential ratio scores is limited to scores that are clearly unfavorable (equate to strength factor of negative one) and minimum scores necessary to conclude that an institution is financially healthy (equate to strength factor of three). The lowest possible strength factor is negative one and the highest possible is three. The strength factors do not distinguish between ratios outside the set range because the methodology was not designed to differentiate between institutions at all points along the spectrum of financial health. The purpose of the methodology, and therefore the strength factors, is limited to differentiating most subtly between institutions on the lower end of the spectrum of financial health.

The process KPMG went through in developing the strength factors for each ratio is shown graphically below using the Primary Reserve Ratio for proprietary institutions as an example.

In developing the strength factors for each ratio, KPMG considered the ability of institutions to fund the following specific areas, all of which are necessary for institutions to successfully carry on their mission.

• Technology - In order to remain competitive today and in the future, institutions must continually replace existing technology with new, more expensive technology.
• Capital Replacement - Institutions' physical capital eventually wears out and must generally be replaced with items that are comparably expensive.
• Human Capital - Institutions generally need to at least retain existing faculty and staff, and need to re-train them to meet students' changing needs.
• Program Initiatives - Seed money is generally necessary to develop the new programs that help institutions to grow.

[Ratios (part 4 of 4)]

[Strength Factors (part 2 of 6)]