One of the more disturbing letters a President may receive comes from the Department of Education, indicating that the institution has failed to meet the minimum standards for financial responsibility.  Out of a possible score of 3.0, the letters are sent out to those whose score is below 1.5.  If an institution scores a 1.0 or better, the issues are not all that onerous; the option exists for cash monitoring.  These schools are considered to be “in the zone,” a form of financial purgatory where the DOE still considers them to have adequate resources but is monitoring the situation to ensure that conditions do not degrade. Below a 1.0 and a letter of credit will have to be posted for up to half the funds received by the institution in any given year. Believe it or not, it is possible to score all the way down to a -1.0.

Of course, getting a bank to post such a letter of credit is a stretch for an institution in financial crisis.  Without it, the federal aid tap is turned off.  Smaller schools who serve underprivileged students lose out the most, with Pell grants and Stafford loans drying up.  It’s a recipe for closure, even though the assets of an institution far exceed liabilities.  In stark terms, you are not bankrupt, but the DOE is ensuring that you are fixin to be.

The ratios used to determine financial responsibility cover three areas.  The first attempts to quantify the liquid resources available to pay expenses.  This is called the “Primary Reserve Ratio” and is the most complicated to compute, particularly when the definition of the numerator (Expendable Resources) has been a moving target. The “Equity Ratio” simply shows how much the organization has accumulated in financial surpluses over its lifetime, versus the long-term debt it has amassed.  It is similar to the debt to equity ratio used by commercial enterprises. The “Net Income Ratio” rounds out the three and is the fraction of net income over total income (institutional revenues).  There are worksheets available to assist in calculating these ratios and applying the proper weights and values to arrive at the scale of -1.0 to +3.0.

Some schools that I have worked with on these ratios have not spent a lot of time on them until the audited financial statements are completed.  It is then that those who will eventually receive the dreaded letter learn that the barn door has been broken for a year, the horse is running free and the newspaper photographer is sure to arrive in a few days.  Some await the pronouncement of the Department of Education before giving the ratios much consideration.  Public responses tend to be critical of the process, followed with a resolve to work harder and do better.  The damage has already been done, however.  Competitors who are but marginally better off will point out the existence of your institution on the dreaded list.  The internet winds up abuzz with speculation.  None of this is good.

I must admit some surprise upon learning that some auditors don’t calculate these ratios, or at least require the client to do so.  Results at the margin or in the zone should prompt a management letter comment at least.  Prolonged substandard performance could lead to a condition in the audit opinion, recognizing the importance of federal aid for the health of the institution.

There are, however, some strategies that can be deployed in order to maximize these ratios, at least in the near term.  The goal is to get off the list while working on a longer term fix to operational issues.  Consider these two ideas.

First, if the second ratio (Equity) is strong enough, the institution could add some long-term debt to its portfolio and actually improve the Primary Reserve ratio.  This is because the DOE allows for the addback of long term debt when calculating expendable resources (the moving-target denominator).  Evidently, the government did not want to dissuade institutions from borrowing to improve facilities.  Now, this is not a limitless strategy.  The addback of long term debt is constrained by total fixed assets.  Even so, as odd as it sounds, taking on more debt could actually assist in improving your ratios.  I know, only the government could concoct such a philosophy.

Another approach may be appropriate if either the equity ratio or net income ratio is dragging down the overall computation.  An institution may engage in a sale and leaseback transaction for some of its campus buildings.  The net income ratio is improved immediately with the recognition of a sale at what is likely to be an amount that well exceeds the book value (historical cost-based, depreciated value for accounting purposes).  The windfall could lift a net income ratio from negative to positive, impacting the overall score tremendously, if only for the year in which it occurs.

This strategy also improves the equity ratio by an increase in accumulated surplus (net assets) from the gain recognized on the sale.  Also, a decrease in the long-term debt that was replaced by the lease improves the ratio.  As an aside, there is a benefit for the Primary Reserve ratio as well, from a higher net asset value.  Taken together the sale and leaseback can improve performance at least for one year, avoiding the problems of a prolonged stay in financial purgatory.

These strategies don’t fix the problem, however.  Eventually, the institution must improve its operating performance in order to avoid a return to the list.  Also, both of these strategies may put pressure on earnings for future years, with increased interest expense from a growth in long term debt and/or an increase in occupancy expense for facilities that were owned and are now leased.

The need is for a plan.  Calculate the ratio and, if it is deteriorating, identify a number of strategies that will bolster it over time.  Bring the board into the conversation; particularly the finance committee.  And get out front with the campus community, alumni and donors to communicate the plan.  The federal aid you save may just save you!