Financial Responsibility
Discussion of Possible Strength Factors and Weights

April 3, 1997

The Department of Education is continuing to analyze comments on the financial responsibility proposed rule (NPRM, September 20, 1996), to meet with members of the education community to discuss their questions and the effects of various options that have been suggested, and to develop a final rule that effectively measures financial responsibility of diverse institutions. The Department appreciates the commitment and cooperation of the many members of the community who have shared their comments.

The Department embarked on designing a better approach to measuring financial responsibility for a variety of reasons, including allowing the Department to take a more comprehensive look at an institution’s financial picture, to reduce abuses, and to reflect impending changes in FASB standards that would affect many institutions. As the Department receives financial statements prepared under the new standards, the importance of an improved rule becomes even clearer. Review of the FASB financial statements that the Department is currently receiving suggests that institutions and the Department would have difficulty in consistently applying current rules to the financial statements. In addition, a number of institutions that do not appear to pose a financial risk to the Department might fail the current standards.

The Department is sharing with the community as much working information and information about regulatory alternatives as possible to facilitate this constructive, collaborative exchange. In that spirit the Department is providing the following descriptions of possible criteria, strength factors, and weights in hopes of prompting very specific public comment on how best to use this methodology to distinguish among financially stable and risky institutions. Note that comments have also led the Department to consider changes in the scoring scale, e.g., to a 0-3 rather than a 1-5 scale. The strength factors presented for discussion in this document reflect this new scaling proposal. (For more information on this issue, see the minutes of the 3/11/97 community meeting.)

Commenters may choose to address all sectors, or to comment only on sectors with which they are most familiar. We particularly encourage those who evaluate the financial status of postsecondary institutions from the perspectives of trustee, president or senior officer, administrator, accountant, state higher education official, or other financial analyst to draw on their practical experience and judgments.

These materials are for discussion only, and reflect thinking that continues to evolve as the Department moves toward a final rule. The weights and strength factors presented in this document are intended to spur comments and discussion. The Department does not commit to choosing the weights and strength factors at these levels in the final rule. The community’s comments can help the Department identify areas of agreement and concern, and may lead to other, more effective standards and approaches.

ITEM 1. Equity Ratio

Many comments have been received about the importance of reflecting an institution’s fixed assets in any measure of financial responsibility. The Department is considering substituting an equity ratio for the viability ratio in the financial responsibility methodology to incorporate assets into the methodology. The Department is actively seeking comment on several issues regarding the inclusion of an equity ratio.

Should an equity ratio be included?

Would inclusion of an equity ratio give a more complete picture of an institution’s financial condition? If used, should it replace the viability ratio or be used in combination with the three ratios in the NPRM methodology?

The equity ratio could be used as a substitute for the viability ratio. In this case, the methodology would consist of the equity, primary reserve and net income ratios. Eliminating the viability ratio would help address comments regarding the treatment of debt in the NPRM methodology. In addition, it would remove any possible disincentive for investment that may have been present in the methodology due to the use of the viability ratio. Eliminating the viability ratio would also remove the need to restrict the viability ratio score when the primary reserve ratio score is low.

How should an equity ratio be defined?

Should the equity ratio include permanent endowment for the private non-profit sector? Should the equity ratio include intangibles and goodwill for the proprietary sector?

The equity ratio under consideration is generally defined in the following table.

Private non-profit schools	Proprietary schools
Net Assets Total Assets	Net Worth Total Assets

The Department is seeking comment on whether proprietary school intangibles or private non-profit school permanent endowment should be included or excluded from the ratio. The inclusion or exclusion of these items will have an impact on the strength factor scores adopted. For example, if intangibles are excluded for the proprietary sector, the resulting strength factor scores could be lower since correspondingly lower expectations for the level of the ratio exhibited by a financially responsible institution would be incorporated into the strength factor scores. The same issue arises in the treatment of permanent endowment for the private non-profit sector.

What is the appropriate scale for an equity ratio?

The Department is seeking comment on the appropriate scale for the equity ratio. Specifically, the Department is interested in learning what levels of equity represent a strong, acceptable and weak institution.

The Department is considering the following thresholds and is providing them to help stimulate discussion. This scale is for an equity ratio that excludes intangibles and includes permanent endowment from the calculations.

Equity ratio strength factor scores under consideration for private non-profit schools

Equity ratio strength factor scores under consideration for proprietary schools

ITEM 2. Primary Reserve Ratio

The Department is seeking comment on the appropriate scale for the primary reserve ratio. Specifically, the Department is interested in learning what levels of primary reserves represent a strong, acceptable and weak institution.

The Department is considering the following thresholds and is providing them to help stimulate discussion. This scale is for a primary reserve ratio defined in the manner described in the NPRM.

Primary reserve ratio strength factor scores under consideration for private non-profit schools

Primary reserve ratio strength factor scores under consideration for proprietary schools

ITEM 3. Net Income Ratio

The Department is seeking comment on the appropriate scale for the net income ratio. Specifically, the Department is interested in learning what levels of net income represent a strong, acceptable and weak institution.

The Department is considering the following thresholds and is providing them to help stimulate discussion. This scale is for a net income ratio defined in the manner described in the NPRM.

Net income ratio strength factor scores under consideration for private non-profit schools

Net income ratio strength factor scores under consideration for proprietary schools

ITEM 4. Converting Ratios to Scores

In the NPRM methodology, there were only 5 possible scores (1, 2, 3, 4, or 5). Comments were received that small changes in ratios could lead to extreme and unwarranted variations in scores. For example, a proprietary school that had a primary reserve ratio of 0.30 received an unweighted strength factor score of 2 while a school that had a primary reserve ratio of 0.29 obtained a score of 1. This has been called the "cliff effect" and was present in all sectors.

What is the best method for converting ratios to scores?

The Department is seeking comments on the best approach for ameliorating the cliff effect. Two proposals are being considered.

The Department is considering using a linear algorithm to determine the strength factor score for each of the financial ratios. For instance, a linear algorithm for the primary reserve ratio in the proprietary sector could be:

Unweighted primary reserve strength factor score = 10 x (primary reserve ratio)

Here’s an example of how such an algorithm would work with the primary reserve ratio.

Step 1. Calculate primary reserve ratio.

Adjusted Equity / Total Expenses = 0.30

Step 2. Apply linear algorithm.

Unweighted primary reserve strength factor score = 10 x (0.30) = 3.0

This unweighted strength factor score would be multiplied by the weight factor and added to the scores obtained from the other two ratios (that is, primary reserve and net income) to obtain the final composite score.

An alternative to a linear algorithm would be to increase the number of categories. For instance, the number of categories might be increased to as many as 50. The unweighted strength factor score would be obtained by looking up the score in a table. These tables might be lengthy and somewhat more difficult to use than an algorithm.

ITEM 5. Weights

The weight is a measure of the relative importance of each of the financial ratios in the overall measure of an institution’s financial condition. Various weights are being considered.

What is the appropriate weight for each ratio?

The Department is seeking comments on the appropriate weight that should be given to each financial ratio. For example, would the weights suggested in the table below fairly reflect the importance of each factor in understanding a school’s financial position?

Proprietary schools

Private non-profit schools

<< Back to Financial Responsibility Report