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Recognizing, averting risk of financial failure

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Financial failure is an increasing risk for all organizations — due in large part to a confluence of contributing factors. When these factors take hold, it is very difficult to regain financial stability and keep from failing. Colleges and universities finding themselves in this precarious position have been known to compromise their strategic goals, reduce critical investments in infrastructure, cut the extent and quality of services, and make other spending and revenue choices that begin to significantly challenge the institution’s ability to survive.

averting risk of financial failureInstitutions need to be mindful of how shifts in annual enrollments, changing perceptions of academic quality and market performance, and deferred investments in facilities and services will affect their competitive position, and take early remedial action to avoid the serious downturns that can lead to failure.

Monitor and respond to these 10 financial warning signals
This list is not all-inclusive; instead, it highlights indicators that, if ignored, could lead to significant financial difficulties in the not-so-distant future. These signals are not new to higher education, but their impact and velocity are dramatically increasing. This is due to the current economic climate, coupled with the inability of most institutions to differentiate themselves from their peers and adopt an operating model that is responsive to the evolving needs of students and changes in the traditional view of the college experience.

1.   Enrollment declines in core competencies. Nationally, enrollment in four-year colleges and universities of traditional-age (i.e., post-high school) U.S. college students is continuing to trend downward, with some geographical regions affected more than others. The specific impacts on programs that have been institutions’ core competencies need to be addressed aggressively through the identification of new competencies or outreach to nontraditional college-age students. Serving the needs of veterans, foreign students and adult learners has undeniably provided opportunities for new growth markets, prompting institutions to be innovative in introducing new core programs to meet the increasing demands and unique needs of these constituents. Expansions of core programs into new interdisciplinary programs can bring renewed market attention to your institution and differentiate it as well. Examples include graphic design and entrepreneurship, and journalism with an ethics concentration.

A fundamental element in assessing your enrollment challenges is an understanding of market perception about the quality of your programs and faculty. Turning around and redesigning programs may require additional investment in faculty and facilities or establishing affiliations with other institutions. Building the reputation of a new program will necessitate increased focus and investment, as does improving the perception of an existing program’s value. Program reputation will be built in large part on the prestige of the faculty and the extent to which they are published, the power and influence of the alumni who have come through these programs, and the strength and breadth of the interface between the classroom and business enterprise affiliations/partnerships. These programmatic and institutional attributes are not easily accomplished. They are shaped over a long period of time and require the long-term intentional actions of many across the institution.

2.   Discounted tuition exceeded by the cost to educate. While tuition rates continue to increase nationally, this growth has in large part been offset by increasing discount rates required principally to attract and retain students. A National Association of College and University Business Officers study noted that student tuition discount rates, on average, were as high as 46% for the 2013–14 academic year, the highest ever.1 Now that the federal College Scorecard is available, tuition comparisons across institutions and the cost of attendance are in the public realm. A high tuition discount rate attracts families worried about affordability, but before you make such an offer, nail down the true cost of the education you provide. Many institutions have been dismayed to learn that the fully loaded cost to educate a student significantly outpaces the discounted tuition and fees received. Other institutions have realized that the costs of dormitories, meal plans and other auxiliary services are not fully covered by related revenues.

If the operating margin from student-related revenues is negative, substantial analysis is required to align tuition rates with cost structures. You might need to turn to increasing enrollment through lowering the academic standards required for admission, increasing the student-to-faculty ratio above planned levels or generating non-student-related revenue.

 3.   Living off the endowment to cover operating costs. As is the case for other segments of the not-for-profit sector, investment portfolios of higher education institutions have been called upon like never before to provide for operations and strategic investments. With declining margins caused by shrinking and less profitable enrollments and increasing operating costs, many institutions have supplemented their board-approved spending policies with additional board appropriations to fund unbudgeted operating costs, underwrite capital campaigns, pay for voluntary retirement plans, or provide a sufficient level of liquidity for operations or servicing or refinancing existing debt. Additional endowment appropriations, beyond the annual spending policy, can lead to a reduction in the purchasing power of the endowment and an erosion of the principal. Combined with lackluster market performance, the endowment could be significantly diminished.

Economic trends over the past several years have in fact further weakened endowments, which have been reporting losses or lower-than-anticipated returns. This makes smaller institutions particularly vulnerable and increasingly tuition-dependent. Institutions with the largest endowments also have vulnerabilities. Because of their reliance on endowment performance, many have constructed and developed campus facilities and infrastructures that are increasingly costly to maintain. Others with large endowments have adopted tuition pricing models that can significantly reduce individual student tuition if household income is below defined thresholds. These institutions’ strategic decisions to expand their campuses and/or reduce (or eliminate entirely) tuition for certain students meeting defined criteria are predicated on the continued growth and performance of their endowments.

Institutions whose fundraising efforts have been focused on specific operating and programmatic purposes may now need to dedicate their fundraising to growing their endowment. Board decisions to supplement annual spending-rate appropriations should only be in support of strategic initiatives. Moreover, the long-term implications of supplementing annual board-approved spending distributions, even if only for strategic initiatives, should be carefully analyzed, with due consideration of how such decisions will reduce the purchasing power of the endowment.

4.   Not selling your brand to alumni and donors. When contribution revenue declines from expected levels, institutions come under additional pressure to salvage operating results by curtailing spending without perhaps sufficiently considering the impact on strategic goals and student choices, preferences and perceptions. Identifying other revenue sources may be a strategy to pursue in response to such declines; however, risks and costs associated with new revenue sources may be difficult to assess. Such short-term decisions regarding cost cutting or revenue enhancement can have long-term effects on the brand, which in turn can greatly affect alumni engagement in fundraising.

Alumni giving (and more broadly, all philanthropy) still has not fully rebounded to prerecession levels and is highly dependent on the overall economy. Institutions that are not constantly engaging with their alumni and courting other donors — both when making strategic changes in direction and promoting ongoing activities and successes — can expect to experience dropping contribution revenue.

In general, if the average annual alumni gift is less than $100, leadership should take aggressive action, because this is a clear indication that alumni are not sufficiently engaged. A comprehensive capital campaign should be considered; performing appropriate feasibility studies to shape, size and guide the campaign is likewise critical.

5.   High cash outflows into new building/capital projects. It is a false belief that new campus buildings and facilities will inherently attract new donors and lead to greater enrollment. New construction instead often leads to additional debt and operating costs. Debt loads can bring an institution to a crisis point and should be considered a key warning sign, especially if there is not a reasonable expectation of donations to support large capital projects.

Movement from variable-rate to fixed-rate debt issuances or even taxable issuances, which afford more flexibility in how the proceeds may be used, should be considered. Careful consideration should likewise be given to debt modeling, which often requires external financial advice. Two general rules to consider are that your total debt service should not be in excess of 10% of your total annual operating budget, and that expendable net assets should be 125–200% of your institution’s long-term debt outstanding.

6.   Deferred maintenance. Over the past decade, institutions have made rational and intentional decisions to defer remediation and restorative projects across their aging campuses in order to focus resources on higher-priority initiatives and imperatives. However, identifying deferred maintenance needs is critical; if not performed, deferred maintenance can leave an institution with deteriorating facilities that are unusable, inefficient and environmentally unfriendly, and in some instances, unsafe. Moreover, an aesthetically pleasing campus can positively influence prospective students and donors. 

As a matter of good operational practice, an institution should perform a comprehensive study of its campus assets to identify, prioritize and determine the restoration cost to meet deferred maintenance needs, including those to bring buildings into compliance with relevant codes and regulations. Further, best practice has been to establish sinking funds ─ which could be determined as a derivative of annual depreciation expense ─ to set aside for these efforts. Before simply building new facilities, consideration should be given to ensuring existing facilities are adequately maintained. Overall, if an institution cannot demonstrate that at least 40% of its deferred maintenance needs are funded, this is a strong indicator of current and future financial strain. Underfunded deferred maintenance needs were noted as a key factor in the closing of Antioch College.2

7.   Low financial scores issued by the DOE. The federal Department of Education (DOE) issues annual financial composite scores for many institutions of higher education. The DOE’s composite metric is used in determining if schools can participate in federal Title IV aid programs, specifically student financial aid, and in assessing the general financial stability of an institution. The DOE evaluates compliance with refund reserve standards, finding answers to questions such as: Does the institution have enough cash to return Title IV aid funds when required? Is it meeting financial obligations, e.g., maintaining sufficient solvency? Is it current with debt obligations and compliant with relevant covenants?

Given the DOE’s structured process for evaluating institutions, your institution has the opportunity for proactive self-examination and improvement. This will better equip your institution to respond to DOE inquiries, as well as to identify potential pitfalls and opportunities. Questions that your institution should be asking include these: What is the overall student default rate on our institutional and federal loan programs (it should not consistently exceed 5% annually)? What are accreditors saying about our institution? Have they placed or threatened to place our institution on probation or issued warnings? Fully understand all DOE rating criteria in order to better gauge your institution’s financial health.3

8.   High tuition dependency. Ideally, core revenues should not be primarily derived from tuition. When more than 85% of tuition accounts for your core revenue, this is a signal that the institution’s operating performance, including cash flows, is highly vulnerable and sensitive to annual enrollments. This tuition dependency restricts the institution’s ability to contemplate long-term investments. Given the trend of lower enrollment, higher tuition discounts and students’/parents’ sensitivity to tuition costs, declines in annual tuition revenue, as compared with prior years and forecasts, should be expected. For an institution highly dependent on tuition revenue, extreme reductions in enrollment can lead to financial crisis. By the time the final size of the academic year’s enrollment is confirmed, substantially all operating costs are locked-in, affording limited flexibility to align operating costs with revenues.

It should, however, be recognized that many tuition-dependent institutions have been able to consistently demonstrate strong enrollment. For these institutions, the stability of their enrollment is likely the result of any one or a combination of the following — uniqueness and strength of program offering and the cachet of their brand, alumni and market affiliations, and credentialed nature of faculty. Capitalizing on these strengths or investing to develop them is critical to the long-term success and sustainability of tuition-dependent institutions.
Recognize nonfinancial indicators of struggle
Even factors not inherently financial can exert a good deal of institutional pressure. The following is a summary of nonfinancial indicators of potential operational strains:
1. Lowered admissions standards – An institution might lower its admissions standards when it is having trouble attracting students. However, lowering selectivity can affect reputation, which in turn may negatively affect enrollment, tuition and, ultimately, contributions. A defensive posture is rarely a successful one. It is wiser to elevate the brand; increase selectivity; and offer campus services, facilities and academic options to be competitive and differentiated from peers.
2. Reduction in full-time faculty – Reducing full-time faculty may be a sensible measure to lower operating costs in the short term — an option attractive to institutions addressing financial challenges. Calculations must be made to avoid concurrently reducing the quality of education and faculty resources for research projects, and negatively affecting the student-to-faculty ratio.
3. Accreditors reconsidering accreditation status – Any threat to accreditation status is a strong indicator of financial challenges. Cost cutting that appeared fiscally responsible a few years ago may be resulting in a lower quality of education, which puts primary mission and reputation in jeopardy.
Consider using key performance indicators (KPIs) and scorecards to assess financial and nonfinancial operational challenges, and recognize key warning signals. See in this report “Keeping strategic goals in focus through KPIs, scorecards” by Dennis Morrone and Mary Foster.

9.   Need for short-term bridge financing. When an institution must obtain short-term financing to fund operations in the fiscal year’s last quarter, it can be an indication that tuition revenues (and cash flows) are not sufficient to cover core expenses and the institution may be in financial crisis. Other cash flow constraints can occur due to an inability to collect past-due student receivables (often caused by poorly developed policies and collection activities) or the coming due of significant unfunded investment commitments tied to alternative investment positions and related strategies to which an institution contractually obligated itself. While it is not uncommon for institutions to experience some level of cash flow strain during the summer months — giving rise to the need to borrow under lines of credit or perhaps liquidate investments on a short-term basis to provide sufficient cash flows — the underlying causes of cash flow strains during this period should be found. Even more dire circumstances may be indicated if an institution is experiencing cash flow strains at other points during the year, e.g., in late fall or mid-spring. If these cash flow strains are the cause of any of the following, your institution may be in or on the cusp of significant financial strain — intentionally aging vendor payables more than 90 days to maintain cash balances, maximizing drawings against lines of credit, borrowing from plant or quasi-endowment investment funds, concerns about funding payroll, reducing or deferring payments to retirement plans, or indefinitely postponing planned capital improvements or maintenance projects.

Each institution needs to evaluate the activities that regularly contribute to pulls on liquidity and the periods in which they occur, take a clear-eyed view as to those underlying causes and their severity, and quickly take remedial action if there is reason for concern.

10.  Unsustainable program additions. Many seemingly profitable and growing institutions have seen their margins consistently decline in recent years. One of the principal drivers of declining profitability is the desire to satiate the expanding academic needs of students. Expanding the extent of academic offerings/disciplines sometimes garners greater enrollments. However, offering additional academic courses doesn’t always result in profitable growth. In fact, additional programs at times generate losses and undermine the profitability of other, perhaps core, academic programs.

Accordingly, if your institution is in this situation, assess the number of students enrolled in these noncore programs, and the fixed and variable cost structures that complement the enrollments. Perform analysis and modeling of all peripheral academic offerings to evaluate their contribution margin or loss. See in this report “Utilizing data analytics to improve performance” by Mary Foster, Anthony Pember and Matt Unterman. 

Historically, institutions of higher education were for the most part believed impervious to macroeconomic events. When the economy was experiencing a downturn, more individuals would return to college for higher-level degrees to better position themselves for success. When the economy was vibrant, college enrollments were strong. Today, neither scenario is a given. With educational paradigm shifts — including the emergence of the lifelong learner, convenient online educational programs and other alternatives claiming market share, unsustainable tuition hikes and the increasing cost of operations — colleges and universities are no longer insulated from ubiquitous market strains. They must take charge of their future by watching out for signs of trouble and acting decisively to keep on track.

1 Marcus, Jon. “Colleges keep increasing discounts to keep students coming,” The Hechinger Report, July 2, 2014.
2 Lyken-Segosebe, Dawn, and Shepherd, Justin Cole. “Learning from Closed Institutions: Indicators of Risk for Small Private Colleges and Universities,” TICUA Research, July 2013.
3 Federal Student Aid, U.S. Department of Education. “Financial Responsibility Composite Scores.”

 

Visit the report overview for more articles:
The State of Higher Education in 2016