Impacts of financial decisions
A Primer on Financial Statements for Higher Education Board Members
While many of your institution’s board and committee members are passionate about higher education and eager to serve, few have a strong financial background. This can make it challenging for them to understand an audit report and limit their ability to contribute meaningfully to important decision-making conversations.
You can help your board and committee volunteers get a better grasp of higher education financial statements by offering them this glossary of key terms. This isn’t a comprehensive list of items on a financial statement, but it includes the most important elements for making informed decisions about the use and allocation of resources.
The current ratio measures your college’s or university’s ability to pay off short-term obligations. To calculate this ratio, you divide current assets by current liabilities. Once calculated, it is always good to be in the positive, but a truly good ratio is two-to-one, which means that you have twice as much in current assets than current obligations (liabilities). This figure is more important than the basic cash figure because it shows what you have on hand after all liabilities are accounted for.
Months of cash
Committees often need to know if your institution has enough cash to cover expenses over a certain period of time. The “months of cash” figure gives a quick snapshot of your school’s “survival time,” were it to lose future funding or become unable to generate short-term revenue.
Months of cash is calculated in two steps: first by figuring your total expenses by month (total expenses divided by 12), then dividing your total cash by that monthly figure. Ideally, you should have three to six months of cash on hand, meaning you could operate that long in a funding crisis. If your institution is heavy on investments, you might consider including them in this analysis, because tapping into your investments could potentially help cover expenses if it became necessary.
Debt service coverage ratio
This ratio is particularly important if you have debt or are considering taking on more of it. Bankers and some donors might look at this ratio to see how dependent on debt your institution is. It gives them a sense of how you are handling your finances.
To calculate this ratio, you first need to know your unrestricted earnings before interest, tax, deductions, and amortization (EBITDA) expenses, plus unrealized gains and losses. Then you need to know your debt service, which is sum of all interest expense, principal payments on debt, and any capital leases.
Once you have these your unrestricted EBITA figure, you divide it by your debt service figure. This gives you your debt service coverage ratio. You want this to be about 1.10:1. It’s important to realize, however, that some banks or other institutions might have their own way of calculating the ratio based on the nature of debt they are issuing. But for the purposes of discussion at your school’s monthly committee or board meetings, this basic calculation serves well.
When reviewing your statement of activities (or “income statement” at for-profit entities), you should also review your institution’s sources of revenue. For most colleges and universities, revenue comes mainly from program services (tuition fees, room and board, auxiliary, etc.). But plenty of other sources are in the mix, including events, bookstores, and concessions, just to name a few. A keen awareness of all revenue sources can help you vet new revenue opportunities or discontinue certain programs or activities, based on their contributions to your institution’s financial health and mission.
Your composite score shows your organization’s financial responsibility. As a condition of eligibility for various federal financial assistance programs, higher education institutions are required to maintain financial stability, which is indicated by a composite score standard greater than or equal to 1.5. A composite score of 1.0 or less than 1.5 will be subject to additional monitoring. If it is less than 1.0, your college or university will be required to submit financial guarantees.
The composite financial index is calculated using four ratios, as follows:
- Primary reserve ratio, which is calculated by taking expendable net assets divided by total expenses. This ratio shows the sufficiency of your current funding and flexibility of future funding.
- Net operating revenues ratio, which is calculated by taking the unrestricted operating net income and dividing by total operating revenues. This is known as the “live within our means” ratio.
- Viability ratio, which is expendable net assets divided by plant-related debt. This shows whether debt is managed strategically.
- Return on net assets ratio, which is calculated by taking the change in net assets divided by the beginning net assets. This ratio shows whether the return on net assets is sufficient.
When the four ratios are combined, it results in the composite score ratio. As you can see, this ratio is very complicated and can be tedious to derive from a set of financial statements, but it’s a critical figure. When in doubt, it is a good idea to ask your auditor to calculate.
How we can help
Higher education financial statements are complex, but when properly understood, they paint a clear picture of your college or university’s financial health. They provide administrators, board and committee members, investors, bankers, regulators, and other stakeholders with information necessary to making important decisions. CLA’s higher education professionals can offer training to your board and committee members or other key personnel that helps them better understand and use this critical data.