Managing the Metrics

by Michael K. Townsley | Jun 1, 2022 | Uncategorized

U.S. Department of Education (DOE), credit rating agencies, banks, regional accrediting commissions, and boards of trustees want assurance of financial viability from colleges and universities. Different organizations have devised and adopted metrics^[1] that they believe are indicators of financial viability. For example, DOE uses a test of financial responsibility; Moody’s Investor Services applies a set of financial ratios; regional accrediting agency reports use audited statements and ratios or indexes recommended by the National Association of College and University Business Officials (NACUBO). The impact of financial metrics is to push colleges and universities to develop strategies and operational plans that produce financial results that conform to the measurements built into the metrics. This push seems to have picked up speed over the last decade as state and federal legislatures worry about the cost of a degree. As a result, they are pushing credit agencies, accrediting commissions, and boards to be more attentive to the financial condition of institutions of higher education.

Why do colleges and universities care about metrics established by third parties? The answer is simple these parties – government agencies, banks, accreditors – control access to resources. The consequences to a college that fails to measure up to third-party metrics could include the loss of authority to issue federal financial aid or a lending agency calling for full payment on loan balances. As a result, the college may be forced to substantially alter its way of doing business. Financial metrics coming from third parties are expanding in scope and rigor; and because of their impact on the existence of an institution of higher education, metrics represent powerful incentives for colleges as they design strategies and operational plans.

Basic Definition and Purpose of a Financial Metric

A financial metric incorporates two components – the metric and the benchmark for the metric. A metric can be generally defined as a measurement standard that sets out the performance level for a particular aspect of the finances of an organization. The metric may be a ratio, a rate of growth, or a particular number^[2]. For instance, the metric may be the ratio of net income to total revenue, the rate of growth for total revenue compared to total expenses, or maintenance of an exact amount of money in cash reserves. The benchmark establishes the level of performance for the metric. The benchmark may be defined by government regulations, such as the DOE test of responsibility which specifies passing and failing scores. It may also be defined in terms of standard practice, such as the ratio of net income to total revenue should be greater than two percent or equal to greater than the rate of inflation. Another benchmark could be a metric defined in the covenant section of a debt instrument; for example a covenant may require a college to have cash equal to a portion of bond interest and principle that is available at all times.

The purpose of metric is to signify if performance is better than, less than, or equal to the benchmark, and to indicate if action must be taken to achieve the benchmark or restore the financial condition of the college to the level of the benchmark. Financial metrics exist to compel managers, or in this case college presidents and boards of trustees to take action to assure that they have strategies and plans in place to achieve the designated metrics for their institutions.

Positive and Negative Aspects of Metrics

There are positive and negative aspects to managing by metrics. The positive side is that CFOs and presidents know how external agencies will measure financial performance. The primary advantage of metrics is that they impose financial discipline on presidents, boards of trustees, and chief financial officers. Metrics represent a set of financial performance standards that an institution deems to be relevant to achieving or maintaining its financial condition.

While metrics can have negative consequences as will be noted later, they act as powerful guides as institutions make decision about budgets, capital investments, and fiscal management. When the leadership chooses a set of metrics to measure financial performance, they also accept the implied condition that their financial decisions must conform to the performance levels delineated by the financial metrics of their institution.

For the board of trustees, financial performance when compared to the chosen financial metrics can assure them that current financial strategies and plans are appropriate to strengthening the financial condition of the institution; metrics can indicate that the current financial strategy and plans are not working and a new financial strategy is needed. Using metrics is only useful if they are accompanied by a formal reporting system that compares actual performance to the metrics over time. In other words, the leadership of the institution must see the trend for each metric and if changes in the trend are favorable or unfavorable.

Given that metrics are only as effective as a reporting system that is taken seriously, the following also must occur:

1. The president and chief administrative officers must formally meet, review performance, and determine if and where changes need to be made. By extension, they should prepare a brief formal document laying out the financial state of the college and any strategic or operational changes that are needed to achieve the performance level required by the metrics.
2. The president must present the metric performance report to the board of trustees so that they can evaluate on their own if the plans are appropriate.

The negative side of metrics is that they can constrain the options available to a college, in particular, financially-weak colleges that are developing a new financial strategy. Metrics can limit a financially-weak college as they move from their current weak financial position to a stronger more viable financial state. During the transition, the metrics may show that the financial viability of the college is continuing to deteriorate before a turnaround strategy takes hold. An example would be a college that has reported deficits for several years because there is no longer a market for its academic programs.
This college needs to reallocate its resources and invest in new programs. As the strategy is implemented, the cost of the investment may be greater than the savings from a reallocation of and a reduction in staff and faculty. During this period, the financial metrics for the college will probably deteriorate, which could depress metrics and present problems with bank covenants, regulatory tests, and accreditors.

The other downside with managing to the metrics is that it could distort the priorities of the college. That is to say that sustaining the metrics may become more important than the mission of the college and the services designed to deliver on the mission.

Sources and Examples of Metrics

There are several sources for metrics and their associated benchmarks. In several cases, the metrics are required either through government regulation, debt covenants^[3], or accreditation commissions. Other metrics may be selected by the institution because they represent industry standards that can measure financial performance. Benchmarks are either defined by regulation, set-out in debt documents, specified by accreditors, or generally available through published documents. The following list of metrics are commonly required or selected by colleges and universities.

1. The U.S. Department of Education (DOE) test of financial responsibility^{[4] [5]} uses three ratios to indicate if the financial condition of the college is weak and needs to take action to substantially improve its financial condition. If test scores are below designated levels, regulatory guidelines can require the institution to post a letter of credit; or if test scores remain below levels over a number of years, DOE may no longer grant the institution the authority to award federal financial aid.
   1. The three ratios are:
      1. Primary Reserve (similar to CFI)
      2. Net Worth (net assets / total assets)
      3. Net Income (unrestricted net income / unrestricted revenue).
   2. The values for these ratios are adjusted by a set of strengths and weights; and the sum of these values yields the test score.
   3. Test scores less than 1.5 may result in regulatory sanctions.
2. The Composite Financial Index^{[6] [7]} uses four ratios to measure the financial condition of private colleges and universities, as follows:
   1. Ratios:
      1. Primary Reserve Ratio measures operational risk with this relationship: expendable net assets to expenses
      2. Net Income Ratio measures short-term risk with this relationship: net operating income to operating revenue
      3. Return on Net Assets Ratio measures risk to production of wealth with this relationship: change in net assets to total assets
      4. Viability Ratio measures long-term debt risk with this relationship: expendable net assets to long-term debt.
   2. A CFI score less than or equal to three suggests that the financial condition of the college is weak, and it will need to take major steps to improve its financial condition.
3. Debt Covenants are metrics in a loan agreement or debt indenture. Here are several examples:
   1. The condition that the institution not have deficits
   2. Cash income ratio^[8], which relates: net cash from operating activities to total unrestricted income, excluding gains. Median values for this ratio are available in Ratio Analysis in Higher Education^[9].
4. Basic Financial Metrics are a set of metrics that an institution may employ to measure factors that have a direct impact on the financial condition of the institution. These metrics may include:
   1. Net tuition ratio – Measures tuition revenue remaining after deducting unfunded institutional aid. The issue is, if this ratio is changing over time, the ratio is: total tuition and fees revenue minus financial aid to total tuition and fees revenue.
   2. Receivables ratio – Measures proportion of net tuition and fees that are receivables, The issue is, if this ratio is changing over time, higher ratios suggest less cash is being collected; the ratio is: net student receivables to total tuition and fees.
   3. Bad debt ratio – Measures the proportion of receivables that is bad debt. The issue is, if this ratio is increasing over time, it suggests that the institution is unable to fully convert receivables to cash; the ratio is: uncollectable receivables to student receivables.
   4. Deferred maintenance ratio^[10] – Measure potential burden of deferred maintenance. The issue is, if this ratio is increasing, the institution is incurring an ever increasing burden on its financial assets to restore its buildings and equipment to the proper state; the ratio is: outstanding maintenance requirements to expendable assets (the denominator is the same as the numerator for the Primary Ratio in the CFI).
   5. Financial assets ratio – Measures the proportion of assets devoted to financial assets. The issue is, if this ratio is declining, then the institution is potentially losing the capacity to support its operations from endowments; the ratio is: net investments and cash to total assets.
   6. Endowment performance – This metric is the annual rate of return for endowment assets. The issue is the same as with the financial assets ratio.
   7. Enrollment growth – This metric is the annual rate of growth for enrollment by level and by program. There are multiple issues: is enrollment growing, shrinking, or remaining by level, and by program? Any significant shifts could have financial effects.
   8. Average class size – This metric measures total average class size and average class size by full- and part-time faculty. This metric is a rough measure of the efficiency of class scheduling and the constraint imposed by room capacity.
   9. Compensation per student – Since compensation makes up more than sixty per cent of the expenses at most colleges and universities, it is important to know if that burden on students is increasing, decreasing or remaining level. Compensation is a sum of the total salaries, benefits, and taxes, which include social security, Medicare, and other special employment taxes that the institution may have to pay. The following ratios measure the relationship of compensation to students for major functions of the institution:
      1. Administrative compensation per student
      2. Faculty compensation per student
      3. Academic affairs compensation per student
      4. Student services compensation per student
      5. Institutional compensation per student.

Summary

Financial metrics should support the analysis of equilibrium and development of plans to achieve a state of equilibrium (see Chapter XIII) and strategies and plans flowing from using the financial paradigm (see Chapter XII) to efficiently use the financial resources of the institution. Financial metrics should be seen as the web which ties together financial strategies and the plans that should strengthen the financial viability of the institution.

Endnotes

1. Another term for metrics is “key performance indicator” or KPI. ↑

2. 1988; Cave, Martin, Stephen Hanney, Maurice Kogan and Gillian Trevet; The Use of Performance Indicators in Higher Education; Jessica Kingsley Publishers, London; pp: 17-18 ↑

3. Debt covenants are conditions imposed by a bondholder, bank, or other financial institution to which the college has a debt obligation, which an institution must meet if they are to avoid having the balance of their debt called. ↑

4. Because the test of financial responsibility involves a complex set of computations, anyone computing a test score should go to the DOE site for computational guidelines. This site http://www2.ed.gov/finaid/prof/resources/finresp/finalreport/execsummary.html also provides institutions with their test score. ↑

5. 2004; Financial Aid Professionals: Methodology for Regulatory Test of Financial Responsibility Using Financial Ratios; (September 29, 2004); (Retrieved November 1, 2010) http://www2.ed.gov/finaid/prof/resources/finresp/finalreport/execsummary.html ↑

6. The Composite Financial Index (CFI) adjusts computed ratio values for strength and then weights the preceding computation according to the importance of the particular ratio. The sum of the prior computations is the index score. The scores can then be compared to a set of ranges that suggest the financial condition of the institution. For more information about CFI see the latest edition of Salluzzo, R.E., Tahey, P., Prager, F.J., & Cowen, C.J. (2005); Ratio analysis in higher Education, 6^th edition published by KPMG, LLP & Prager, McCarthy & Sealy, LLC. ↑

7. 2005; Salluzzo, R.E., Tahey, P., Prager, F.J., & Cowen, C.J.; Ratio analysis in higher Education, 6^th edition published by KPMG, LLP & Prager, McCarthy & Sealy, LLC; pp 94-99 ↑

8. 2005; Salluzzo, R.E., Tahey, P., Prager, F.J., & Cowen, C.J.; Ratio analysis in higher Education, 6^th edition published by KPMG, LLP & Prager, McCarthy & Sealy, LLC; p 109 ↑

9. 2005; Salluzzo, R.E., Tahey, P., Prager, F.J., & Cowen, C.J.; Ratio analysis in higher Education, 6^th edition published by KPMG, LLP & Prager, McCarthy & Sealy, LLC; p 109; p 124 ↑

10. 2005; Salluzzo, R.E., Tahey, P., Prager, F.J., & Cowen, C.J.; Ratio analysis in higher Education, 6^th edition published by KPMG, LLP & Prager, McCarthy & Sealy, LLC; p 109; p 81