Executive Summary

Department Objectives

1. The risk that an institution will satisfy the ratio test although it is not financially healthy and later fails to meet the standards of financial responsibility; and

2. The risk that a healthy institution will not satisfy the ratio test even though it meets the standards of financial responsibility.

Although KPMG has worked closely with ED to recommend individual ratios, strength factors, weightings, and overall methodologies to be employed in this report, the ultimate responsibility for setting a standard of financial responsibility in conjunction with the above objectives would necessarily rest with ED. Such a standard must ultimately be based on the level of risk that ED, as a matter of policy, is willing to tolerate. This methodology was not designed to measure financial responsibility of public institutions since we understand that ED is developing alternative regulatory tests of financial responsibility for schools in that business sector.

Basis of Engagement

Throughout this engagement, and in the previous engagement that led to the September 20, 1996 Notice of Proposed Rulemaking (NPRM), KPMG and ED solicited comments and convened public meetings with representatives from the higher education community in an effort to accommodate their concerns. In addition, we devoted considerable resources to reading, understanding, and assisting the Department in responding to written public comments received on the NPRM. We feel confident that the methodology contained in this report reasonably balances the competing interests of the different schools participating in federal financial assistance programs.

KPMG analyzed over 900 financial statements of private non-profit and proprietary schools as part of this engagement. This extensive data analysis enabled us to test the overall reasonableness of our final recommendations and other alternatives considered during the project.

Why Financial Ratios?

Financial ratios offer a capsulated view of key conditions affecting the fundamental elements of financial health and provide answers to certain questions concerning an institution? overall financial condition. Ratios, in their simplest terms, are the relationship between two numbers, a numerator and a denominator, and 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, 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 any institution's overall financial condition.

Financial Responsibility Methodology

KPMG, in consultation with ED and representatives from the higher education community, selected three ratios to measure the five fundamental elements of financial health; viability, profitability, liquidity, ability to borrow and capital resources. The three ratios selected are the Primary Reserve Ratio, the Equity Ratio, and the Net Income Ratio.

The Primary Reserve Ratio is defined as expendable net assets (expendable equity) divided by total expenses. Since this ratio measures expendable resources in relation to operating size, it provides a measure of an institution's relatively liquid wealth or margin against adversity. The Primary Reserve Ratio provides a direct measure of an institution's viability and indirect measure of its liquidity.

The Equity Ratio is defined as net assets (equity) divided by total assets. Net assets or equity represent the residual interest of an entity, i.e. the value of its assets less claims by outside parties. The ratio of equity to total assets can be viewed as the proportion of an institution's assets that are owned 'free and clear' by the institution. By measuring expendable and non-expendable resources, this ratio provides information useful in assessing an institution's ability to borrow and capital resources.

The net income ratio is defined as the excess of revenue over expenses divided by total revenue. In the for-profit sector, it measures the profit or loss experienced by the institution. In the non-profit sector, it measures whether the institution lived within its means during the year. This measure is one of the primary indicators of the underlying causes of a change in an institution's financial condition because of its direct effect on resources reflected in the balance sheet. This ratio provides information useful in assessing an institution's ability to operate within its means (profitability).

Using strength factors and weighting percentages, these three ratios are combined into one final composite score. Strength factors are used to place all ratio results on a common scale from negative one to three. Weighting percentages are then applied to reflect the greater relative importance of certain ratios and the fundamental elements of financial health that they measure. Adding the three weighted strength factors together reduces the assessment of an institution's total financial condition down to one final composite score. All institutions' final composite scores can be placed along a continuum or spectrum thereby providing insight into their relative financial condition. Clearly, this represents an improvement over the current regulation where weakness in any one area (e.g. acid test) could potentially result in an inaccurate assessment of a school's overall financial condition.

The methodology is designed to rank institutions by their financial health. ED will have the ability to use this approach, based upon the level of risk which it chooses to tolerate, to determine whether schools exhibit a minimum level of financial health and thereby be deemed financially responsible to administer the Title IV programs.

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