Failing: Results of New Tests of Financial Strength

The last time I checked on the financial health of colleges and universities the news was not good: in 2010 the finances at 150 private nonprofits were so fragile that they failed the Education Department’s test of financial responsibility.  The Feds provide financial aid to students who attend responsibly managed educational  institutions, so it’s not unreasonable for them to ask whether audited financial returns reflect sound management. The 2011 test results were released in late October.

What does it take to pass the test? The ability to meet current and projected debt obligations is a factor, but the heart of the test is a numerical score: DOE looks at a weighted composite of  three ratios:

1. Primary reserves: Ratio of adjusted equity to total expenses, a basic measure of liquidity
2. Equity: Ratio of modified equity to modified expenses, an indication of an institution’s ability to borrow (modifications include things like one-time charges, allowances and extraordinary events)
3. Net Income: Ratio of  before-tax income to total revenues, a  basic measure of profitabilty (incongruous for a non-profit but even the purest non-profit institutions do not like to deplete their cash positions)

A composite score of 1.5-3.0 indicates healthy finances. 1.5 is a passing grade.  Anything  less than 1.5 is not a passing grade.

A  score in the range of 1.0 to 1.4 — which DOE calls the zone — indicates a need for additional oversight.  This is a sore point with colleges– many of which would howl to high heaven if a Wall Street bank raised the same objection — who decry the bureaucratic heavy-handedness of a federal agency that would want to impose a modicum of accountability.

Anything below 0.9 is a failing score, and to continue receiving Federal Student Aid, a failing institution must supply additional letters of credit.

More than 180 private non-profits scored below 1.5 and 56% of those scored below 1.0.  A complete spreadsheet can be found here. Mind you, this is not the ragtag collection of colleges of cosmetology that populate the for-profit component of the DOE report. I’ve stripped those out of the spreadsheet. They are in awful shape too, but federal student aid to a future hair stylist never made much sense to begin with.  More on this in a later post.

No, the non-profits tested by the Department of Education are mainly liberal arts colleges, schools of design, independent schools of medicine and law, and denominational institutions (many with important historical roots).  They are in many ways the same schools whose free-wheeling approach to financial management gave John D. Rockefeller and Andrew Carnegie fits when they established the first philanthropic foundations to support higher education in the early 1900s.

By FY 2010 the stock market had begun to recover and endowments had started  to regain some of their lost value. The expectation was that the DOE scores would reflect an improving fiscal outlook for the nation’s private institutions. That obviously did not occur.

In most circumstances, these numbers would need no further elaboration.  In fact, news of the dismal  2011 report appeared  in Inside Higher Education and The Chronicle of Higher Education back in October. It was a press release issued by the National Association of Independent Colleges and Universities (NAICU) that caught my eye and raised my blood pressure. It said in part:

It must be noted that the list is under increased scrutiny by accounting experts who believe [federal] financial analysts are not always using the right accounting definitions.

and

The overwhelming majority of institutions that have appeared on the list in previous years continue to provide a quality education to their students.

I other words, despite the continued price inflation needed to prop up badly managed institutional priorities — and despite the mounting evidence that a many of these institutions are simply not delivering value to their students at the inflated prices —  the NAICU position seems to be that it’s the definitions that should be blamed.  If you’ve read this blog before or if you’ve scanned my book, you know that I can’t let this pass without comment.

There is a lot of complaining in the ranks of private non-profits about the accuracy of the test, but it is hardly a secret that there is something wrong with your business model  if the only way you can continue to operate is to continually and without warning raise prices to locked-in customers who are  (1) resigned to take on crushing debt or (2) eligible for unbounded federal, state and local subsidies to offset price increases.

How different would the picture have looked if construction of a few of those new dorms or fancy student centers had been delayed or an invitation to a money-losing post-season tournament had been declined? Would fiscal health have improved if administrative offices had shed some of their bloated staff? Might instructional costs have been held in check if clusters of small institutions had merged some of their general education requirements and created cost-efficient teaching pools for introductory English, history, and math courses?

Yes, the majority of the failing institutions probably do continue to provide a quality education to their students. But at what cost?