UNDERSTANDING THE DEPARTMENT OF EDUCATION’S COMPOSITE SCORERa ym on d E. Krou se , Jr., CPA

WHAT IS A “COMPOSITE

SCORE?”

WHAT IS A “COMPOSITE SCORE?”

A measure of the relative financial health of an institution introduced as part of the Higher Education Act of 1965

While it measures financial health, it does not indicate educational quality of an institution

Ratio is calculated from audited GAAP financial statements, but the Department of Education requires certain adjustments to amounts from financial statements

The Department of Education’s compliance requirement is found at 34 CFR 668.172

Calculation of score for Not -for -Profits vs. For -Profit schools similar but with a few unique differences

Scores range from -1.0 to 3.0

WHAT IS A “COMPOSITE SCORE?”

Composite score is a combined score of three separate financial ratios Primary Reserve Ratio Equity Ratio Net Income Ratio

Each of these three ratios are weighted when they are combined Primary Reserve and Net Income are weighted at 30% and Equity at 40% for For -

Profit schools Primary Reserve and Equity are weighted at 40% and Net Income at 20% for Not -for -

Profit schools

PRIMARY RESERVE RATIO

PRIMARY RESERVE RATIO

Represents a measure of a school’s viability and liquidity For-Profit schools: Ratio adjusted equity divided by total expenses Not -for -Profit schools: Ratio “expendable net assets” divided by total expenses For For -Profit Schools Adjusted equity is calculated by taking equity and adding

or subtracting various balance sheet line items Items subtracted from equity include:

Intangible assets Unsecured related party receivables Net fixed assets

Items added to equity include: Long -term debt (up to amount of net fixed assets) Post employment liabilities

PRIMARY RESERVE RATIO

For Not -for -Profit Schools Expendable net assets are calculated by taking net assets and adding or subtracting various balance sheet line items Items subtracted from net assets include:

Intangible assets Unsecured related party receivables Net fixed assets Permanently restricted net assets

Items added to net assets include: Long -term debt (up to amount of net fixed assets) Post employment liabilities

PRIMARY RESERVE RATIO

How to improve the Primary Reserve Ratio Securing related party receivables or having related party pay off receivable at year

end Borrowing funds up to net property, plant and equipment Delaying large expenditures at year end that add both short -term liabilities and

increase expenses

EQUITY RATIO

EQUITY RATIO

Represents a measure of a school’s capital resources and its ability to borrow For-Profit schools: Ratio of modified equity divided by modified assets Not -for -Profit schools: Ratio of modified net assets divided by modified assets Modified equity and modified assets are calculated by taking both equity and

total assets and subtracting out a few different balance sheet line items including: Intangible assets Unsecured related party receivables

Note that “Modified Net Assets (or Equity for For -Profit schools)” is NOT the same as “Adjusted Net Assets (or Equity for For -Profit schools),” which is used for the Primary Reserve Ratio due to different treatment with fixed assets and long -term debt

EQUITY RATIO

How to improve the Equity Ratio Securing related party receivables or having related party pay off receivable at year

end Paying down short -term liabilities (accounts payable and accrued expenses) at year

end Note that the modified net assets (or equity), which are the numerator in the equity ratio,

would not change by reducing cash and a payable. However, the denominator (Modified Assets) would decrease and produce a higher equity ratio.

Delaying large expenditures at year end that add both short -term liabilities and increase expenses Note that adding short -term liabilities reduces the numerator and produces a lower ratio

NET INCOME RATIO

NET INCOME RATIO

Represents a measure of a school’s profitability Not -for -Profit school: Ratio of change in unrestricted net assets divided by

unrestricted total revenue Does not consider temporarily restricted revenues

For-Profit: Ratio of income before taxes divided by total revenues

NET INCOME RATIO

How to improve the Net Income Ratio Both For -Profit and Not -for -Profit schools: Delaying expenditures that would affect

net income Both For -Profit and Not -for -Profit schools: Increasing enrollment to generate

increased tuition and auxiliary revenue Not -for -Profit schools: Soliciting unrestricted donations before year end

CALCULATING THE COMPOSITE SCORE

CALCULATING THE COMPOSITE SCORE

Strength factor applied to all three ratios with a 3.0 being the highest strength factor a school can obtain for each of the strength factors

Solid strength factors in one area may compensate for weaker strength factors in other areas

CALCULATING THE COMPOSITE SCORE

The “weighting” of ratios differs for Not -for -Profit and For -Profit schools Weighting of ratios for a Not -for -Profit school

Primary reserve ratio –40% Equity ratio –40% Net income ratio –20%

Weighting of ratios for a For -Profit school Primary reserve ratio –30% Equity ratio –40% Net income ratio –30%

CALCULATING THE COMPOSITE SCORE

Net Income Ratio is weighted higher for a For -Profit institution (income statement focus) than for a Not -for -Profit institution

Primary Reserve Ratio is weighted higher for a Not -for -Profit institution (balance sheet focus) than for a For -Profit institution

Equity Ratio carries the same weighted percentage for both the For -Profit and Not -for -Profit institutions

CALCULATING THE COMPOSITE SCORE

Each strength factor is multiplied by the “weighting factor” to arrive at the three “calculated ratios”

Strength factors are “maxed out” at 3.0 and then multiplied by the “weighting factor”

For example in a NFP, the Primary Reserve and the Equity Ratio are weighted at 40% each so these two components of the composite score would be 1.2 each at their maximum scores. The Net Income Ratio is only weighted 20% so its maximum score can be .6.

CALCULATING THE COMPOSITE SCORE

For example in a For Profit School, the Primary Reserve and the Net Income Ratio are weighted at 30% each so these two components of the composite score would be .9 each at their maximum scores. The Equity Ratio is weighted at 40% (same as a NFP) so its maximum score can be 1.2

The three ratios are added together to obtain your “Composite Score” Composite score cannot be higher than a 3.0 Let’s run through some examples illustrating what we have discussed today

INTERPRETING THE COMPOSITE SCORE

RESULTS

INTERPRETING THE COMPOSITE SCORE RESULTS Composite scores of 1.5 –3.0: school is considered to be financially responsible

and no further action is necessary Composite score of 1.0 –1.4: school is considered to be “in the zone” and could

face increased oversight by the Department of Education Schools can only be “in the zone” for three consecutive years

Composite score of -1.0 –.9: schools are NOT considered to be financially responsible School must obtain a 1.0 in one of the next three years

Schools must either provide a letter of credit of at least 50% of their prior year student financial aid amount (letter of credit alternative)

OR Participate under a provisional certification and provide a letter of credit of at

least 10% their prior year student financial aid amount

EFFECT OF FASB ASU 2016 -14 ON COMPOSITE SCORE

EFFECT OF FASB ASU 2016-14 ON COMPOSITE SCORE

For Years Ending May or June 30, 2019, ASU 2016 -14 will be effective Categories of net assets to be changed to “net assets without donor restrictions”

and “net assets with donor restrictions” Primary Reserve Ratio –net asset categories need to be changed in the

numerator of ratio and total expenses will be taken from “new functional expense statement or equivalent” for the denominator

Equity Ratio –net asset categories need to be changed in the numerator of ratio Net Income Ratio –“Change in Unrestricted Net Assets” to be replaced by

“Change in net assets without donor restrictions” in the numerator while “Total “unrestricted revenue” to be replaced by “total revenue and gains –net assets without donor restrictions” in the denominator

FINAL THOUGHTS ON COMPOSITE

SCORE

FINAL THOUGHTS ON COMPOSITE SCORE Important to note many schools have debt covenant ratios to maintain that

must be considered as well If entity is having an unusually strong financial year, you may consider writing off

additional accounts receivable, incurring expenditures sooner than planned Better to have a 2.0 composite score for consecutive years than a 2.5 and a 1.5 Ratios are based on year end amounts so improving the balance sheet at year

end is really the key Although composite scores are calculated at year end, best practice is for school

to calculate more often to plan for year end action steps The Department of Education’s calculation of composite score may differ from

school’s calculation Schools are encouraged to invest in capital and technology to improve the

student’s experience on campus (long -term approach)

FINAL THOUGHTS ON COMPOSITE SCORE

Government Accountability Office (GAO) publishes composite scores for all NFP and Proprietary Schools https://studentaid.ed.gov/sa/about/data -center/school/composite -scores 1,710 NFP schools listed and 1,970 proprietary schools. The NFP schools average score

was 2.3 and the proprietary average was 1.9 Harvard University had a score of 2.2 while the Pittsburg Institute of Mortuary Science

had a score of 3.0…as did the Boise Barber College

GAO published their report in September 2017 and identified three key limitations to the composite score. Score does not consider changes in accounting practices during the past 20+ years Outdated financial measures Vulnerability to manipulation

GAO noted in interviews that 7 of 10 schools were confused on how score was calculated

FINAL THOUGHTS ON COMPOSITE SCORE

In addition to the composite score, the Department of Education evaluates an institution’s financial responsibility by assessing whether school: Has sufficient funds to make timely refunds to students and the Department of

Education Is meeting other financial obligations Is current on their debt obligations

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