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					BACKGROUND INFORMATION FOR SMALL COLLEGE
           FINANCIAL ANALYSIS
     Prepared for Council for Christian Colleges and Universities

                            August 2005



                    Nicholas J. Wallace, CPA
        National Director for College and University Services




                        Capin Crouse LLP
                     720 Executive Park Drive
                            Suite 2300
                     Greenwood, Indiana 46142

                           (317) 885-2620

                       www.capincrouse.com
                            Table of Contents

ACKNOWLEDGEMENTS                                   1

A WORD ON NONPROFIT LEADERSHIP                     1

INTRODUCTION                                       2

BACKGROUND                                        2-4
   Success Stories                                  4
   Lessons from Key Funding Sources               5-6
   Some Sobering Statistics                         6
   Ratio Definitions                                7
   Framework                                      7-8
   Primary Reserve Ratio                            8
   Net Income Ratio                                 9
   Return on Net Assets Ratio                       9
   Viability Ratio                                 10
   Composite Financial Index                       10
   Caveat                                          11

RATIO ANALYSIS                                     12
   Table 1 – Primary Reserve Ratio              12-13
   Table 2 – Net Income Ratio – Form 1             14
   Table 3 – Net Income Ratio – Form 2             15
   Table 4 – Return on Net Assets                  16
   Table 5 – Viability Ratio                       17
   Strengths & Weights Worksheet                   17

FIVE STEPS TO IMPROVED FINANCIAL HEALTH         18-21


CONCLUSION                                        21
ACKNOWLEDGEMENTS

Although this is a small white paper addressing a relatively specific need, the thoughts, talents
and skill of a number of people were involved in its production. I have immense respect and
value for their contributions. Each has either performed detail review or has made significant
contributions to the work.

Special thanks to Dr. Duane Kilty (D.K. Consulting) for his contribution of the five steps to
improved financial health. Also to Mr. Mark Myers (Trevecca Nazarene University) for his deep
insights into the ratios and the language used to describe them. He made very insightful
suggestions to the text. Also special thanks to Patricia Gustavson (John Brown University) for
her review of the draft and her general support and enthusiasm for the project and finally to Dr.
John Zeitlow (Malone College) for his authors’ perspective on the draft.

Special thanks also to Dr. Bob Andringa for the opportunity to share our thoughts with the
CCCU family and for his review of the draft.

Finally, thank you to the partners and staff of Capin Crouse LLP. It is because of this group’s
generosity and focus on ministry that these types of projects are possible.


A WORD ON NONPROFIT LEADERSHIP

Leadership Is a Foul-Weather Job
Excerpted from Managing the Non-Profit Organization, Peter F. Drucker

“Fortunately or unfortunately, the one predictable thing in any organization is the crisis. That
always comes. That’s when you do depend on the leader.

The most important task of an organization’s leader is to anticipate crisis. Perhaps not to avert it,
but to anticipate it. To wait until the crisis hits is already abdication. One has to make the
organization capable of anticipating the storm, weathering it, and in fact, being ahead of it. That
is called innovation, constant renewal. You cannot prevent a major catastrophe, but you can
build an organization that is battle-ready, that has high morale, and also has been through a
crisis, knows how to behave, trusts itself, and where people trust one another.”




                                                 1
INTRODUCTION

Capin Crouse is an audit firm that focuses exclusively on services to Christian organizations
including many Christian colleges and universities. We use and advise campuses on the results
of their Composite Financial Index, known as the CFI, which forms the comparison data of 96
campuses belonging to the Council for Christian Colleges & Universities that was reported
individually to them in September 2005.

In the Spring of 2005 we were invited to participate with the Council for Christian Colleges &
Universities (CCCU) in its efforts to assess the financial strength of its member campuses and to
provide resource materials to help campuses adjust to the economic realities of the marketplace.
This paper is in response to that request and is written as background for the campuses
participating in the CCCU project. It is also for any other campus wishing to use financial ratios
in its financial stewardship.


BACKGROUND

Richard M. Cyert, then President of Carnegie-Mellon University in his foreword to the book
Academic Strategy by George Keller, suggested that “The future of our society depends on a
strong system of higher education, both public and private. I believe that better management and
strategic planning are essential to the continued strength of our colleges and universities.”

The following is our attempt to positively impact Christian higher education with “better
management” by encouraging the disciplined use of some well known analytic tools in your
strategic planning process. The major building block upon which much of the following analysis
was built is contained in the publication Ratio Analysis in Higher Education: Measuring Past
Performance to Chart Future Direction, written by Ronald Salluzzo and Fredric J Prager.
Indeed, the great need of the hour is to answer the following questions posed in this work:

   1.   What is the overall level of our financial health?
   2.   Are our resources sufficient and flexible enough to support the mission of the institution?
   3.   Do our operating results indicate the institution is living within available resources?
   4.   Does financial asset performance support the strategic direction?
   5.   Is debt managed strategically to advance the mission?

Taking one more step back from these institutional level questions to industry-wide analysis
gives us the context and sense of importance in finding answers to these questions.

In the mid 1980’s, George Keller, expert advisor on higher education management, warned that
“A specter is haunting higher education: the specter of decline and bankruptcy”. He went on to
predict “that between 10 percent and 30 percent of America’s 3,400 non-profit, degree-granting
colleges and universities will close their doors or merge by 1995. On many campuses the fear of
imminent contraction or demise is almost palpable.” He went on to cite “one-quarter of all
private colleges and universities are now drawing on endowment to meet operating expenses.”
He also cited the significant rise in oil prices and the possible collapse of the social security
system and rising health care and technology costs as reasons for his dim view of the hopes of
higher education. This sounds a lot like today!


                                                  2
Keller warned further that “College presidents who do not look ahead, who do not plan, become
prisoners of external forces and surprises, most of them unpleasant. In the new style of academic
management, the campus leaders are constantly looking ahead to see where the college or
university will be in the next three, five, or ten years. They are deciding now what to do about
the likely tomorrow”. Another higher education author David Ewing says, “A higher order of
management intelligence, once a luxury, is now becoming a condition of survival.”

Fortunately, nowhere near the level of devastation Keller described occurred. Rolling the
calendar forward, however, Michael Townsley in his 2002 book The Small College Guide to
Financial Health, Beating the Odds wrote “as colleges face decreasing enrollments, the
competition for students intensifies leading to increased spending and tuition rates. In this “field
of dreams” syndrome, administrators scramble to satisfy the perceived demand of students for
enhanced personal services and top-of-the-line technology and facilities. They finance huge
construction projects with huge dollops of debt. As competitors begin plotting their own “fields,”
construction wars break out leading to high debt loads with little to no payoff.”

So it is clear that we are not out of the woods. What can be done to insure that our institutions do
not end up like the poor soul buried under the Connecticut tombstone that read “I told you I was
sick?” Studies of colleges that have “made it” suggest that an addiction to planning; a
community that communicates next steps widely and makes sure that the strategies are carried
out and not allowed to become mere paper proposals; and strategic plans based on sagacious
competitive analysis are among the features of sound financial management enabling successful
navigation of the murky waters of our current financial times.

The following is our attempt to win your confidence that there is a way to make the complex
issues surrounding assessment of the institutions true financial well-being understandable. We
firmly believe there is a way to harness the jangling multitude of data into a few simple tools to
allow the decision maker a context and a starting point to either engineer a financial turnaround
or to take your institution to the next level of financial health beyond sufficiency to vibrancy.

Before we introduce the concepts of ratio analysis, let’s begin with some questions and answers:

Q)   Is this ratio analysis proven effective, or are these just more “flash-in-the-pan” theories?

A)   Based on our review of numerous cases and industry practices (including Department of
     Education), the ratio analysis process we will describe has been used over a 20 year period
     and has been proven effective in many real life cases.


Q)   Will collecting the data be time consuming?

A)   No, most of the information comes directly from external documents already prepared
     (audits, 990s, and IPEDS data).




                                                 3
Q)     Are valid comparable benchmarks available to review and compare to?

A)     Yes, the Council for Christian Colleges & Universities has completed a ratio analysis
       project for 96 of their member campuses. In addition, the Association of Business
       Administrators of Christian Colleges has a sister project on the way for their schools. The
       threshold values described have been around for over a decade and have proven to be
       accurate indicators of the financial realities they measure.


Q)     Are there cases available to help us know what steps might be appropriate as we engage
       these concepts?

A)     Absolutely. Several cases for additional study are available and information to allow you to
       review these cases will be presented.


Success Stories

There are several success stories where turnarounds or gaining additional financial strength have
occurred. As discussed more fully later on, using strong fiscal discipline and monitoring
mechanisms to insure the right things happen was a feature common to many of the success
stories we reviewed. Likewise, there are numerous stories where this or similar analysis was not
done and the results were fatal.

A quick review of similarities in cases reviewed by Michael Townsley in his book The Small
College Guide to Financial Health (which promotes the use of ratio analysis), from the Lumina
Foundation New Agenda Series of Monographs and from the Story of Elon College contained in
George Keller’s book Transforming a College results in at least two common attributes:

     1. Fiscal discipline–Enhanced by tools, such as ratio analysis, which included competitive
        analysis.
     2. Enrollment growth–Fueled by finding niches to fill (Marylhurst College), fostering feeder
        programs (Wesley College) and creating innovative programs and centers of study (John
        Brown University and Chatham University).

Other tools and strategies were used as well, but one of the strongest common components
appeared to be the use of financial discipline and related tools for monitoring progress. This is
clearly becoming an expectation of management. The next section discusses the observations and
expectations of a keen evaluator of capital for many colleges.




                                                 4
Lessons from Key Funding Sources

One of the more important elements necessary in cementing firm financial footing is good credit.
A recent article by Susan Fitzgerald, a senior vice president of Moody’s Investors Service Higher
Education and Not-for-Profits Team, notes 10 elements Moody’s looks for when measuring
management strength in Higher Education bond ratings. Of those ten items, seven of them could
be either influenced by or directly impacted by effective use of ratio analysis tools like the ones
suggested in this paper. The following represent elements Moody’s would look at in its
evaluation:

   1. A CEO who understands both the institution’s mission and business aspects.
      Fitzgerald comments that “an institution must balance the myriad demands that a not-for-
      profit mission brings with the need to maintain fiscal stability.” She observes that “Many
      of the organizations we have seen with difficulties are those where the CEO is heavily
      focused on the institution’s program and perhaps on its competitive position and
      reputation, with little or no regard for financial matters.”

   2. Recognition of challenges and realistic plans to address them.
      She comments that a high quality management team’s plan will “take into account
      institutional constraints, such as finances, reputation, and depth of donor base…”

   3. A Clear Capital Plan
      She comments that “a clear capital plan that identifies and prioritizes both new capital
      projects and deferred and upcoming maintenance, as well as the sources of funding for
      these priorities, is a sign of strong management. A well-run institution typically has
      multiple means of funding capital: philanthropy, debt, and annually budgeted funds or
      retained surpluses.”

   4. A Midrange Financial Plan
      She comments that “institutions with good management usually have three to five year
      financial budget plans. Ideally, the financial plans encompass both a balance sheet and
      income statement perspective and can be tied to audited financial statements for external
      monitoring of progress.”

   5. Conservative Budgeting
      She comments that “Institutions that achieve consistent financial results…recognize that it
      is not simply enough to break even, but rather that they must generate sufficient excess
      cash flow for necessary capital improvements as well as investment in strategic
      initiatives.”

   6. Prudent Investment Management and Endowment Spending
      She comments that “Well run institutions have comprehensive asset allocation strategies
      that take into account the liquidity and income needs of the organization.”

   7. Integrated Strategic, Capital, and Financial Plans
      She comments “a final sign of good management is the integration of strategic, capital, and
      financial plans.”



                                                5
Strategic use of financial ratios and related benchmarks would be a great place to start as the
institution prepares itself for initial or continuing credit decisions by banks or bond rating
agencies like Moody’s.


Some Sobering Statistics

A recent credit outlook statement from Moody’s points out the following trends and statistics.
These trends point to the need for fiscal discipline and vigilance. We believe that implementing
ratio analysis and related monitoring processes would help provide the necessary level of
discipline and vigilance.

  • Institutions with enrollment under 3,000 students had 12 upgrades and 27 downgrades of
    their credit ratings.
  • The outlook for thinly-endowed regional institutions, especially those with small
    enrollments was negative while the outlook for wealthy national institutions was positive
    (the rich get richer).
  • Weaker private colleges have a decreased ability to raise prices, less ability to absorb
    expense increases, and tend to be highly leveraged with weakening donor bases.
  • Household net worth is declining for the first time in 50 years.
  • If real estate values begin to fall, equity used to finance educations will dry up to some
    degree.
  • Public institutions continue to retain significant price advantages.

Other observations of the higher education marketplace include the following data that are
equally sobering:

  • From 1990 to 2001, the number of for-profit, degree granting college and university
    campuses in the United States quietly increased nearly 80 percent from approximately 350
    to 625 campuses. Just between 2000 and 2001, revenue of the for-profit colleges grew 20
    percent.
  • During the same eleven year period (1990 to 2010, at least 200 non-profit colleges closed
    their doors.
  • Newly aggressive community colleges are busily recruiting top high school graduates.
    Many now offer full-cost scholarship programs and a more challenging honors curriculum;
    168 community colleges now offer honors programs up from 24 fifteen years ago.
  • More community colleges are moving beyond collaborating with four-year institutions, to
    providing their own baccalaureate degrees at the campus.
  • Commercial internet sites are now appearing that rate individual courses and professors,
    making the task of evaluating the course far easier and increasing consumer-like behavior
    in students. As of the March 7, 2003, writing of a Chronicle of Higher Education article on
    the subject, there were at least six such services available to students in a variety of states
    from California, to Texas, to Wisconsin, and Connecticut. Higher education appears to be
    moving to the status of a commodity.




                                                6
Ratio Definitions

Hopefully, the previous sections have convinced you that small private colleges and universities
will need great tools and great diligence to survive the treachery of chronic financial distress and
the challenges of a competitive marketplace. The following sections will describe the ratios that
are part of the CCCU Financial Strength Report recently issued and will hopefully provide
enough detail guidance to enable key leaders, including board members, to know what steps to
take next as the Financial Strength Report Data are read and interpreted.

You need to be aware that the Department of Education also does a similar calculation of
financial health using a slightly different set of ratios and different weighting. That set of ratios is
designed to highlight institutions under severe financial distress and not to measure the general
degree of financial health. A description of those ratios and concepts is beyond the scope of this
report, but knowledge of such is important. Readers should not confuse the two scoring
mechanisms.


Framework

As the KPMG ratio materials point out, “measuring overall financial health is an essential first
step when assessing the impact of transformation on the institution, and serves as a gateway to
four other high level questions.” Financial analysis begins by asking:

WHAT IS THE OVERALL LEVEL OF FINANCIAL HEALTH?

As you will see from the structure of the ratio analysis contained in the Financial Strength
Report, there is a measure known as the CFI, Composite Financial Index.

The Composite Financial Index paints a composite picture of the financial health of the
institution at a point in time. Using the three year averages given in the CCCU report will give a
broader view.

The Index is built with the values of its four component ratios:

   •   Primary Reserve–A measure of the level of financial flexibility
   •   Net Income Ratio–A measure of the operating performance
   •   Return on Net Assets–A measure of overall asset return and performance
   •   Viability–A measure of the organization’s ability to cover debt with available resources

Once each of the four ratios above is calculated, there is an additional process measuring the
relative strength of the score and its importance in the mix of creating a composite score. This
results in the production of one weighted score for each indicator and when added together, the
result is the Composite Financial Index.




                                                   7
Framework, continued

CFI Scores range from 1 to 10. Between 1 to 1, a school should be assessing its ability to survive
and making immediate changes to avoid further erosion of financial strength. Between 1 and 3,
the school should be rolling out plans and monitoring performance to reengineer aspects of the
school’s operations including efforts to insure the building of reserves and the proper
management of debt. Above 3 to 7, the school should be directing resources to create
transformation and focusing on enabling the school to compete in the future state of higher
education. Scores over 7 allow the school to experiment with new initiatives and deploy
resources to achieve a robust mission.


Following is a plain English explanation of each of the component ratios comprising the CFI.

Primary Reserve Ratio

The first of the four ratios that comprise the Composite Financial Index SM is called the primary
reserve ratio. This ratio is one of the most important as it is weighted heavily (35%) in the final
scoring for the Composite Financial Index (CFI) described a bit later. Financial ratios always
consist of one number being divided by another, and in this case, the total resources that an
institution could spend on operations (expendable net assets) are divided by the total expenses
for the year (see Table 1 for a definition of expendable net assets). So if funds that could be spent
were four million dollars and total expenses were two million dollars, the ratio would be 2.0 (4
divided by 2); or if it were turned around and funds that could be spent were two million dollars
and total expenses over the year were four million, the ratio would be .5 (2 divided by 4). The
most obvious interpretation of this ratio is that in the first scenario with a ratio of 2.0 the
institution could exist for two years with no additional revenue before all the expendable
resources were gone and in the second scenario the institution could operate for six months. No
institution would ever want to do this, of course. The real significance of this ratio is that if the
ratio is below .15, which would mean funds for about two months of operation, then an
institution is probably going to have to borrow short-term to make payments and the institution
does not have the resources it needs to maintain the physical plant and to invest in the future. The
developers of the CFI recommend a primary reserve ratio of at least .4.

So if the primary ratio of your institution is declining over the six year period that this report
covers, you should be concerned; if the ratio is below .4, you should be concerned.




                                                 8
Net Income Ratio

The next ratio in the CFI is called the net income ratio. The point of this ratio is to show if the
results of the institution’s general operations are positive or negative and by how much. In
business terms, is the institution making money or losing money in its basic day-to-day function
of educating students? One understands immediately why this ratio is so important since if an
institution is losing money in its basic operations over a period of time, eventually the institution
will no longer be viable and will have to close. At some point an institution reaches the stage
when it is too late to make the necessary changes in operations or there are no longer the funds
nor the confidence left to make the strategic changes that would turn the institution around. That
point is more easily identified in retrospect than it is at the time, but one of the purposes of the
net income ratio is to provide a bellwether to warn of impending financial distress.

The challenge in calculating this ratio is determining what constitutes “normal operations” and
what items are exceptional or outside of normal operations. We all face similarly difficult
distinctions in our personal finances. Certainly the new sports coat or shoes are part of normal
operations and purchasing a new house is not, but what about putting in a new driveway–which
category would that fall under? The net income ratio is calculated by dividing the change in
unrestricted assets from the beginning to the end of the year by the total unrestricted revenues,
thereby setting aside anything having to do with restricted assets. The net income ratio only
contributes 10% to the Composite Financial Index SM, but this small percentage is somewhat
misleading since the surpluses or deficits indicated by the net income ratio in time have an
impact on all of the other three ratios. A net income ratio of 2%-4% over time is desirable.


Return on Net Assets Ratio

The third ratio, the return on net assets, is more straight-forward. It is easier to understand and to
calculate. One takes the change in total net assets, both restricted and nonrestricted, from the
beginning of the year to the end and divides that number by the total net assets at the beginning
of the year. It might be helpful to compare this ratio to the net income ratio that we just
discussed; whereas the change in net assets used in the return on net assets ratio includes
everything that happened over the year–expected, unexpected, the stock market, operations,
everything–the net income ratio only includes the change in unrestricted net assets, thus limiting
it more to operations. Both unforeseen and planned events can and will affect the return on net
assets ratio and in some years the ratio may be below the level of 3-4% above inflation that is
recommended; but occasional drops in the strength factor of this ratio are not a cause for concern
if the financial reason for the drop is understood and is a one time financial event from which the
institution can recover. If, however, the return on net assets ratio is not 3-4% above inflation for
a period of time, you should be concerned.




                                                  9
Viability Ratio

The last, but not least of the four ratios is the viability ratio. It is not the least of the ratios as it
(like the primary reserve) enjoys a 35% weighting in the computation of the CFI score. In the
first ratio, the primary reserve ratio, the resources that could be spent (unrestricted funds) were
divided by the total expenses for the year; in the viability ratio the same “expendable” resources
are divided by long-term debt. When expendable funds equal long-term debt, for example, the
ratio would be 1. When expendable funds are twice the amount of long-term debt, the ratio is 2.
Falling below a ratio of 1.0 will limit the institution’s ability to fund new initiatives through debt
and will make current creditors nervous. Certainly not all debt is bad, but you will want to keep
your institution above the 1.25 level on the viability ratio.

HOW DO WE GO ABOUT MAKING A POSITIVE IMPACT AS MEASURED BY THESE
RATIOS?


Composite Financial Index

This question represents the essence of the financial analysis process. The first step is to take the
general information we now know about the ratios and their components and unpack each one to
determine the financial moves that would create positive impact and the financial moves that
would turn the factors negative. Once those moves are made, a good monitoring mechanism to
re-measure the ratios at appropriate intervals is one of the keys to success. The score ranges and
the appropriate actions mentioned earlier should be firmly held as directives for the types of
appropriate actions to be considered.

It all begins with the overall assessment of the institution’s relative financial strength. Small
college financial analyst Michael Townsley refers to this as the “college’s financial resilience or
lack thereof.” This is clearly the most important first step. The CFI is that overall measure.




                                                   10
Caveat

Before digging into the details of the ratios, a caveat is in order. It needs to be clear from the
outset that good ratios and good financial strategies and health only act to remove certain barriers
to growth and success. Many other issues (marketing, admissions, instruction quality, financial
aid, human resource management, etc.), if managed poorly, could offset the positive achievement
of financial health.

It is also clear that the sense of what might be the right moves financially might not always slip
seamlessly, hand in glove with other institutional initiatives. It has been observed that some
actions appear to have different results than expected. A perfect example of this is the impact of
the high tuition/high discount concept on many college campuses. Please see the articles
available from the Lumina Foundation New Agenda Series (December 2000) titled Discounting
Toward Disaster and from the Association of Governing Boards Trusteeship Magazine
(July/August 2003) found in their bound articles series titled Responding to New Realities) for a
full report on their research.

The following are the components of each of the ratios and the factors that will make the ratios
and resulting overall financial health positive. Once understood, a careful review of the section
titled Five Steps to Improved Financial Health will complete the picture of measurement to
identify problems and initiatives to react appropriately.




                                                11
RATIO ANALYSIS

As will be seen in all cases for each of the four ratios comprising the composite financial index,
in order to achieve positive results, numerators in each have to increase or denominators need to
decrease. The following tables give the numerator and denominator components of the ratios. It
is followed by the points of entry to achieve those increases or decreases.

Table 1

Primary Reserve Ratio

Total Expendable Net Assets         =      +unrestricted net assets                    A
                                           +temporarily restricted net assets          B
                                           -property and equipment, net of             C
                                            accumulated depreciation
                                           +long-term debt                              D
                                           (related to fixed
                                           assets)


Total Expenses                             Total Expenses                               E

A.    Unrestricted Net Assets
      Unrestricted net assets come about by achieving positive net income year over year in the
      unrestricted column, which is usually mainly operational. Many colleges use different
      factors for the budget than they do for the external financial statements. Because budgets
      most of the time do not budget depreciation, but do budget capital additions, an analysis of
      the capital additions in the budget versus the anticipated depreciation will yield an estimate
      of the likely net income effect on the financial statements. If capital additions (expensed in
      the budget, but put on the balance sheet and capitalized) are in excess of the annual
      depreciation, there is likely to be a positive impact on net income. Conversely, if the
      depreciation expense on the external financial statements exceeds the budgeted capital
      additions, there could be a negative impact on net income from the budgeted amount.

      Debt service is also another component where differences between budgets and external
      financial statements exist. Budgets should list all debt service as expense where the
      external financial statements only charge the interest portion of the payment to expense.

      Increasing revenues and decreasing expenses have a direct impact on the net income and
      thus the unrestricted net assets.

      Ironically, early pay down of debt will decrease this ratio as it is a flexibility measure and
      paying off debt on campus buildings locks those resources into equity factored out of this
      equation, whereas borrowing on the equity in campus buildings can produce better results
      for this ratio. It must be done, however, in conjunction with institutional borrowing
      capacity as discussed in the viability ratio.




                                                12
     One factor to consider when doing this ratio is that sometimes there are very large one time
     events that can occur that might significantly influence the unrestricted net income. Things
     like a large sale of property (like a campus radio station or other similar asset) at an
     unusually large gain or loss and a large or a one-time grant or unrestricted gift are
     examples. Other examples would include large one time grants for either unrestricted
     purposes or for specific purpose restrictions.

     Another factor impacting the interpretation here is the effect of major capital additions. See
     notes below in temporarily restricted.

B.   Temporarily Restricted Net Assets
     Increases to temporarily restricted net assets occur typically when funding drives for
     scholarships, capital campaigns, and other similar resource enhancement initiatives are
     underway.

     Temporarily restricted resources are decreased when the institution meets the restrictions
     on the funds and this balance, therefore, can dramatically decrease as those events unfold.
     This would occur for instance when a large building is funded (increasing the temporarily
     restricted net asset balance), then actually built (decreasing the amount of temporarily
     restricted net assets because the restriction has been lifted). The decrease in temporarily
     restricted net assets is counterbalanced with an increase in unrestricted via the
     reclassification.

     Likewise grants to jump-start programs or offer special scholarships have the effect of
     increasing revenue and perhaps enrollment for a time. The fact is, once the student is
     attracted or the program initiated, the school has a continuing responsibility for its
     operation. Good scores prompted by heavy giving to programs like this can become an
     anesthetic that could shortly wear thin. Unless long-term plans are in place to carry the
     ongoing program responsibilities, increased pressure will be placed on operations funded
     in many cases by tuition.

C.   Property and Equipment and Accumulated Depreciation
     Because this is a deduction from the numerator, large increases in fixed assets has a
     negative impact on this ratio. The assumption is that by investing in long lived assets, a
     certain amount of financial flexibility is traded off.

D.   Long-Term Debt
     Additional debt against existing assets can have a positive impact on this ratio, but it will
     have a negative impact on viability as will be seen. Additional borrowing in this manner
     can be used as a strategy, but must be done carefully and in accordance with the
     institution’s repaying power firmly in place. Only amounts of debt related to fixed assets
     up to the amount of net book value is allowed as an addition to the numerator of this ratio\.

E.   Total Expenses
     Total expenses represent the operating size of the institution. An increase in expense will
     require a commensurate increase in the liquid equity computed in the numerator in order
     for the ratio value to not fall behind. If expenses grow faster than the institution can
     produce net income and other measures that increase the numerator, then a decrease in the
     ratio will result.
                                               13
Table 2

Net Income Ratio - Form 1

Change in unrestricted net assets                  Change in unrestricted net
                                                   assets from income statement              A



                                             =


Total unrestricted income                          + Total unrestricted revenues and gains   B
                                                   + Net assets released from restrictions   C

A.   Change in Unrelated Net Assets from Income Statement
     The change in unrestricted net assets is driven primarily from operational decisions and
     events like increased or decreased enrollment and success or failure at managing budgeted
     expenses. The success or failure of either annual fundraising campaigns or the impact of
     denominational funding source decisions also can have a significant impact.

B.   Total Unrestricted Revenues and Gains
     Total unrestricted revenues and gains are mostly impacted by enrollment and the success
     of annual unrestricted giving. It can also be impacted by significant one time gains or
     losses and the effects of capital campaigns. Because of this, the second way to compute
     this ratio using only operating measures might yield the most consistent and meaningful
     results.

C.   Net Assets Released from Restrictions
     Total revenues and gains are sometimes included in a separate subtotal from
     reclassifications. In that event, add the net assets released from restrictions separately.
     Reclassifications come from meeting restrictions on gifts and some grants classified as
     gifts. These can sometimes be large and, depending on the long term plans, may recur only
     sporadically, such as when a building is built.




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Table 3

Net Income Ratio - Form 2
(Operational)

Excess of unrestricted                             Change in unrestricted net
 operating revenue over                            assets from operations                     A
 operating expenses



                                             =


Total unrestricted income                          + Total unrestricted revenues and gains    B
                                                   + Net assets released from restrictions    C

A.   Change in Unrestricted Net Assets from Operations
     The change in unrestricted net assets is driven primarily from operational decisions and
     events like increased or decreased enrollment and success or failure at managing budgeted
     expenses. If the operational measure is used in the external financial statements, you will
     find separate net income numbers. The one from operations should be used versus the total
     change in unrestricted net assets.

     As various strategies and revenue enhancement ventures are rolled out, it is important to be
     very aware of the marketplace and the dependence an institution may develop on revenue
     streams, such as degree completion. These programs are the darlings of many non-profit
     four-year institutions. They are also the darlings of the for-profit group as well. As such
     there will continue to be increased competition for the adult student. This population of
     students appears endless, but it is indeed a finite quantity. Excess dependence on debt to
     finance growth in this area should be entered into with great caution and solid estimates of
     enrollment trends.

B.   Total Unrestricted Revenues and Gains
     Total unrestricted revenues and gains are mostly impacted by enrollment and the success
     of annual unrestricted giving. It can also be impacted by significant one time gains or
     losses and the effects of capital campaigns. Because of this, the second way to compute
     this ratio using only operating measures might yield the most consistent and meaningful
     results.

C.   Net Assets Released From Restrictions
     Total revenues and gains are sometimes included in a separate subtotal from
     reclassifications. In that event, add the net assets released from restrictions separately.
     Reclassifications come from meeting restrictions on gifts and some grants classified as
     gifts. These can sometimes be large and, depending on the long term plans, may recur only
     sporadically, such as when a building is built.


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Table 4

Return on Net
Assets


Change in Net                  Total change from all sources (unrestricted, Temporarily restricted and
Assets                         Permanently restricted)                                                   A

                        =


Total Net Assets               Total net assets (Unrestricted, Temporarily restricted and                B
                               Permanently restricted)

A.   Total Change from All Sources
     The change in total net assets is a combination of the net results from many sources. It
     includes operations as does the earlier ratio of net income, but also would include
     endowment gains and losses. As a result, this ratio can be at times driven by market
     conditions similar to those experienced from mid 2000 to 2003 on the negative side and the
     conditions of the market in the years running up to that down cycle on the positive side.

     It is important when interpreting this ratio to keep that in mind, especially when the
     institution has significant endowment assets that could generate either large returns or large
     losses.

B.   Total Net Assets
     Total net assets include all equity in the organization including operational margins,
     restricted funds, plant and equipment, and endowment equity. The drivers are similar to the
     earlier ratio and add to it the equity generated by large endowment gifts, acquisitions of
     land and buildings, and other major capital assets.




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Table 5

Viability Ratio

Total Expendable Net Assets                +unrestricted net assets                  A
                                           +temporarily restricted net assets        B
                                           -property and equipment                   C
                                           +accumulated depreciation
                                           +long-term debt                           D
                                    =

Long Term Debt                             LT Debt including notes, bonds and        E
                                           leases
                                           payable

A-D. See comments on drivers under primary reserve. This numerator is the same as that ratio.

E.   LT Debt Including Notes, Bonds, And Leases

     Paying down debt will improve this ratio. It does, however, have an opposite effect on
     primary reserve in that debt reduction creates limitations on the flexibility of the
     institutions capital available.

Strengths and Weights Worksheet

The following worksheet explains the strength factor scoring and the weighting of the individual
scores to arrive at the composite index score.

As you can see from the table, the quickest way to make positive progress on the CFI score is to
improve primary reserve and/or the viability ratio. This is due to the fact that they have the most
weight of the component ratios.


                                                 Strength:           Weight:
                                                Divide Ratio        Multiply        CFI Score =
                                                 by These          Strength by       Result of
                                        Ratio     Factors         These Factors    Computations
Primary Reserve                                   / 0.133             x 0.35
Net Income Operations*                            / 0.007             x 0.10
Net Income Unrestricted Net*                      / 0.013             x 0.10
Return on Net Assets                               / 0.02             x 0.20
Viability                                         / 0.417             x 0.35
CFI SCORE (Total of Last
Column)

*Use either form for calculation but not both forms

                                                17
FIVE STEPS TO IMPROVED FINANCIAL HEALTH

So far we have suggested that colleges are experiencing challenging times with no relief in sight.
We have described what organizations like Moody’s look at when evaluating credit worthiness.
The Composite Financial Index (CFI) and the core ratios have been introduced and explained.
You now know your ratio scores and how strong or weak is your college. However,
understanding the CFI and the underlying core ratios is only the first step. Without changes in
behavior that address core issues there will be no improvement.

Chronic financial distress is a dangerous way for a college to exist. Schools that live this close to
the edge are usually only one significant event away from acute financial distress or, worse yet,
closure. Acute financial distress calls for abrupt radical change that is very painful. During times
of crises the viable options for short-term improvement are few. It is far better to engage in
effective planning and disciplined management today.

Regardless of your financial strength or weakness, we encourage you to align resources with
priorities and values. No one can afford to waste either. Nonetheless, a low CFI score should
serve as a “wake-up call”. It may be that drastic change is required on your campus. To that end
we offer a five-step approach to improved financial health. As you will see, the steps represent
solid fundamental management techniques that can be applied in any situation.

Communication, communication, communication is important during every step of the process.
The message should be simple and clear. Everyone should be well-aware of what is happening
on campus. There should be no surprises or confusion.

When done well, healthy change energizes a college campus. It provides the clarity that is so
desperately needed for improvement to take place. Knowing exactly what is important allows
front-line workers to focus their efforts where they count the most. Positive momentum grows
and is self-reinforcing.

Step 1: Awareness and Commitment to Change

As simplistic as it sounds, being aware of your ongoing financial situation is the first step to
improvement. Too often leaders do not employ tools, such as the CFI, that quantify financial
health in a way that can be measured year after year so that progress can be tracked.

It would seem logical that if a college is experiencing chronic financial distress, then governing
boards, presidents, administrators, and faculty would want to make the changes necessary to
improve their condition. Unfortunately, that is not always the case. Too often individuals either
want to protect a favorite program or are not willing to make the difficult changes that are often
required for improvement to take place.




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This kind of significant change, which we are calling for, requires the full commitment of the
entire campus community. Without it, the effort will likely fail. So before you begin, make sure
that everyone understands the process and is willing to experience the pain and discomfort that
will surely follow. With awareness and a willingness to change in place, it is now time to assess
the strength of the senior leadership team and governing board.

Step 2: Assessment of Senior Leadership and Governing Board

Strong effective leadership is required to make the difficult changes necessary to improve the
health of a college. This is just as true for the senior leadership team as it is for the governing
board. The beginning of a large-scale change process is the time to make needed changes. As
uncomfortable as this process can be, the right people are necessary to get the job done. Keeping
the wrong people will doom the effort to failure.

It is important that the senior leadership team function in a high trust environment. They need to
engage in the healthy and passionate debate of ideas in order to solve difficult problems. They
also need to commit wholeheartedly to a course of action once it is determined. Effective
accountability mechanisms need to be in place to keep everyone on track. The governing board
should function in much the same way as senior leadership.

It may be that team building and board education are necessary in order to move forward. Since
team building and board training are best done by solving real organizational problems, the
process itself serves as an excellent working laboratory for growth and development.

With the right people in leadership positions, who have learned how to work together effectively,
it is time to develop a mission-driven strategic plan.

Step 3: Mission-Driven Strategic Planning

A clear and compelling strategic plan must exist to guide the energy and resources of the
institution. At the top-level the plan should consist of three to five measurable priorities. The
more priorities, the more likely confusion will exist over which ones are really important.

One approach includes developing departmental action plans that connect to the top-level. This
allows the opportunity for more detail. This model also suggests that individual action plans be
developed that relate to the departmental and top levels. The individual action plans can then be
used for annual performance reviews.

At each level, plan objectives should be clear and measurable with a strong emphasis placed on
accountability and results. There should be no confusion about the priorities of the institution.
Each cascading level of detail should support the top-level. When asked, each board member
should be able to recite the mission and priorities of the college. Faculty and staff should be able
to do the same, plus indicate what they and their departments are doing today to help the plan
become reality. There should be a sense of excitement and urgency.

Clarity regarding priorities is absolutely essential for effective budgeting to take place.




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Step 4: Re-align the Budget to Support the Strategic Plan

When properly executed, the operating budget represents the implementation of the strategic
plan over a shorter time horizon. The strategic planning process is the time and place for
discussion and conclusions on resource allocation. This type of approach requires a process that
is dynamic in nature and revisited annually.

Essential characteristics of effective budgeting include:

   • The budget is integrated into a strategic plan that is mission-driven
   • Key constituencies support, or at least understand, reasons behind the budget
   • Budget managers are held accountable for performance
   • Budget incorporates substitution (deciding NOT to do a major program or task to fund a
     higher priority)
   • The institution is moving toward its objectives
   • The impact of financial decisions must show their future effect by including budget
     projections for future years

To fund the priorities of the strategic plan it may be that new revenues need to be found or
operating expenses reduced. New revenues are often very difficult to find, so it may be that
outdated academic programs need to be eliminated. Regardless of what changes are required, it is
imperative that the budget support the strategic plan.

Fortunately, several helpful models exist if eliminating programs is necessary. Among them are
Robert C. Dickenson’s Prioritizing Academic Programs and Services: Reallocating Resources to
Achieve Strategic Balance and the Resource Allocation Map found in Strategic Financial
Analysis for Higher Education by KPMG, Prager, Sealy & Co., LLC and Bearing Point. Another
approach is to conduct a cost benefit analysis of all programs. Regardless of the method
employed, most institutions only have adequate resources to fund high priority programs and
would be well-served to eliminate those that are low priority. Colleges can compete more
effectively with fewer well-funded programs than many poorly funded ones.

With the right people in place that are equipped with clear priorities and effective budgets, it is
time to turn our attention toward implementation.




                                                20
Step 5: Disciplined (Management) Implementation

With clear measurable objectives in place, and a budget that supports priorities and values, it is
critical that the complete energy of the college stay focused where it counts the most. To
accomplish this, the governing board and senior administration must function with discipline and
accountability.

The board should review progress toward achieving the strategic plan at each of its meetings. As
part of the process, budget performance should also be examined. Problem areas, successes, and
failures should be openly discussed with the board. Board members should ask hard questions
that hold the administration accountable for results.

As part of the ongoing management of the college, senior leadership should meet with all
departmental managers quarterly to review progress toward achieving strategic plan priorities
and budget performance. These meetings should be characterized by the open exchange of
information and ideas. The objective should be to solve problems, not cast blame. The focus
should be on accountability and results.

Going one step deeper into the organization, the action plans can be used as management tools
by senior leaders. Used effectively, they develop a culture that understands how to execute,
encourages healthy productive teams and continually develops leaders. The model calls for
leaders to perform a rigorous annual review of each department, followed by a six-month check-
up. We recommend a process that includes three components:

     People:

         •   Review organizational structure for clarity and make any necessary adjustments.
         •   Review the performance of each employee based on their action plan and its
             connection to the department’s plan.
         •   Hold supervisors accountable for accurately reviewing the performance of their
             direct reports.

     Strategy:

         •   Review the annual department action plan. This plan is connected to the strategic
             plan and includes milestones, due dates, roles, and responsibilities.
         •   During the second cycle, results from the previous year are reviewed along with the
             plan for the next year.

     Operations:

         •   Key processes are examined to ensure they are documented and customer needs are
             met.
         •   Continuous quality improvement measures are developed to track progress from
             year to year. This should be the heart of the institutional assessment program.
         •   Conduct a general assessment of each department’s overall effectiveness and make
             necessary changes.


                                               21
This approach connects senior management with front-line workers. During the reviews,
problems are solved and issues addressed that may have been dormant for years. This exercise
creates momentum and excitement that builds as the cycle is repeated.

Conclusion

The five steps require much hard work from all levels of the college. It takes a significant
amount of time and energy to work through each of them, but as indicated at the beginning of
this section, they are simply solid fundamental management techniques. Once the five steps have
been completed it is time to take everything that has been learned and apply it to the next cycle.

We believe that our approach, applied diligently over time, will change the behavior of everyone
involved. The result will be that the status-quo is continually challenged and everyone will be
pushed to perform at a higher and higher level. Organizational and individual performance will
increase and job satisfaction will soar, but most importantly, the Christian mission of your
college will be advanced. Women and men will be better equipped to function effectively in the
marketplace while exercising their Christian faith.




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