Predicting and Communicating Bad Financial News

Last November we heard of a quickly scuttled proposal to predict college closures. Around the same time, Massachusetts passed a law authorizing a screening process for colleges in danger of closing. Both events raised important questions about both financial indicators and how higher education institutions should communicate financial difficulties.

That was all before COVID-19 struck. Now colleges, especially tuition-dependent private colleges, are worried about whether they have enough cash on hand to survive the pandemic, and some higher education officials are calling for a suspension of the enforcement of federal financial responsibility scores. A new report from New America calls for more financial scrutiny of financially endangered colleges in order to prevent sudden closures. Amid everything else they are dealing with in this time of crisis, college presidents need to worry about how to seek clarity on their financial situations, which is surprisingly difficult for many institutions.

Three very basic but complex questions are: 1) What kinds of financial data would predict closure? 2) What data are colleges actually using? And 3) who should know what when?

All three questions are problematic. On the first question, data compiled by one company, Edmit, is refreshingly simple and focuses on the right things. That may be at least partially because it was produced by the fresh eyes of students, with the help of economists, rather than accountants or college CFOs, some of whom are understandably mired in the complexities of accrual-based accounting. According to Inside Higher Ed, which planned to publish the data, the model focuses on long-term trends, predicting the point at which expenses would outpace a college’s financial resources. It also highlights the true cash assets that make up the best part of a college’s balance sheet: investment returns, tuition prices and discounting rates on the revenue side and faculty and staff salaries (almost always the largest expense) on the expense side.

Many questions remain, such as how enrollment trends are factored in. And colleges are right to point out the flaws in IPEDS data: both the lag time of the data and the fact that IPEDS misses a large swath of students by focusing on the decreasing pool of first-time, full-time students. And whether those data are reliable enough to predict the actual years to closure is highly questionable.

The data do, however, provide two kinds of information that are often missing or downplayed in institutions’ financial reporting, as I argued in an essay last May: trends, rather than often misleading snapshots of a college’s situation at one point in time, and true year-by-year operational surpluses and deficits, which are often obscured by the admixture of revenue that is either not cash (such as in-kind donations) or not based on reliable operational sources.

I have two favorite examples of the second type of information. The first is of an institution that counted more than $1 million annually of donated horses as “revenue,” when in fact, despite the donors’ tax write-off, the horses had no cash value once they arrived on campus. (If the owners could have sold the horses, they would not have donated them.) The second involves the president of an institution who touted a balanced budget two years running because each year a major donor died and left a $1 million-plus unrestricted bequest that plugged the deficit hole. Perhaps the Mafia can plan for such revenue on a regular basis, but colleges shouldn’t.

The financial ratios that colleges do use have the potential to mislead, not because they are bad if used for their intended purposes, but because colleges don’t always think through exactly what they measure. The scores all create a “composite” score by weighting very different ratios to produce a single number. Proponents of such scores argue that it makes sense to bundle very different measures together because a good score in one area can balance a bad score in another. But because they measure such different things, an apples-and-oranges problem arises. It’s like saying I have a decently average basket of fruit because I have fresh apples, even though the oranges are all rotten -- in reality, you have a basket of rotten oranges and good apples, not a decently average basket of fruit. So it’s important to understand what each component measures and look at them separately.

I will focus on the four ratios of the widely used Composite Financial Index (CFI), which presents the pluses and minuses of accountability measures most clearly, although two other sets of ratios, the above-mentioned federal financial responsibility score and (for a subset of nonelite nonprofit private colleges) the Council of Independent Colleges' Financial Indicators Tool, are alternative measures worth examining.

Larry Goldstein of Campus Strategies LLC provided a concise and nontechnical summary of the CFI at a 2017 conference session on “Using Financial Ratios to Assess Institutional Financial Health.” As that summary states, 35 percent of the CFI score is the primary reserve ratio, which compares reserves that a college has accumulated to annual operating demands, producing a number that predicts how long a college can operate with no new revenue. Another 35 percent of the score is the viability ratio, which indicates how much of a college’s debt can be repaid with accumulated reserves. Another 20 percent is based on the return on net assets ratio, which calculates whether net assets have increased during the year. And the final 10 percent is based on the net operating revenues ratio, which looks at whether, during a given period, the institution can live within its means by generating more operating revenue than operating expenses.

The problem with using the CFI as an indicator of ongoing financial health, in addition to the fact that the score ignores long-term trends, is that 70 percent of the score is based on either doomsday scenarios or potentially false positives. If you have to think about how long you can last with no new revenue (primary reserve ratio), or how you can survive if the banks call in your debt (viability ratio), you are already in trouble. To use an outdated analogy, it’s like judging the health of a community by how well stocked its bomb shelters are. Of course, we are currently sitting in the 21st-century version of the bomb shelter, isolating ourselves from an invisible enemy that is just outside the shelter door, and in a time of crisis like this, those measures rightly assume more importance than they would in more normal times.

Furthermore, the assets you have accumulated over the years may be sufficient but dwindling, so you may not know that trouble is on the horizon when looking at these snapshots of the current situation. If I were a lender, I would look at these ratios carefully, because I’d want to know if I could get my money out of an institution in the event of a collapse. For the purposes of deciding whether you should focus on investing in new programs or considering a closure, those ratios may be helpful. But as indicators of future trends in financial health that would help an institution make granular decisions, they have limited value.

The third ratio, return on net assets, is meaningful only in context. You can have more net assets at the end of a period than at the beginning for any number of reasons, not all of which mean you have more cash to spend. (Think of the horses above.) And your assets can decrease, lowering your score, because you are investing in revenue-generating programs.

Only 10 percent of the score -- net operating revenues -- is based on whether you are living within your means. To me this is the most important ratio, which is why Edmit’s focus on trends in annual operating revenues and expenses is a major improvement over metrics such as the CFI. Some of the colleges in financial trouble have accumulated substantial reserves, often over the course of a century or more, which can prevent them from facing future realities. But tuition-driven private colleges are essentially cash operations, and long-term survival depends on having more money coming in the door than going out on an annual basis. So large cash reserves simply delay the inevitable if they are not invested in programs that will repair an operational cash deficit.

Who Should Know What When?

The question of whether negative financial information should be shared publicly at the national level can be debated endlessly. To me the more important question is when and how that information should be shared locally to an institution’s own constituencies, including boards, faculty and staff members, students, families, and the surrounding community. Negative financial news can seem to come out of the blue for several reasons: 1) the president and board do not actually understand the impending financial danger, or 2) they are hesitant to share bad news, fearing it will cause reputational harm and make the situation worse.

The solution to the first is for the CFO and president to understand the appropriate metrics, as I’ve discussed, and to communicate honestly the financial situation to the board. The board’s corollary responsibility is to educate itself on higher education finance and ask appropriately hard questions of the administration as it makes financial decisions.

The second issue is more complicated, because, especially in today’s competitive market, colleges are necessarily in the business of self-promotion, and it is counterintuitive, especially to some board members -- not to mention admissions officers -- to air financial problems publicly under any circumstances, and especially in the current general climate of bad financial news in general for higher education, such as the recent downgrading of the entire sector from stable to negative by Moody’s. The temptation is to say nothing or to be overly optimistic. But colleges also have an ethical duty, especially to current and future students, to avoid making false promises if the institution is in danger of reducing the resources it supplies to students or closing within the foreseeable future. And the fact is that once the effects of financial difficulties are manifested externally -- as when programs or staff and faculty positions are cut -- local reporters, if not national ones, will be at the president’s door. And “no comment” or denial of the facts is the worst possible response even from a self-interested perspective: you can’t control your message if you don’t have one.

My recommendation is to err on the side of transparency, with the caveat that different constituents need different levels of detail. The board needs to know and understand all major financial indicators and trends, since their primary responsibility is fiduciary, which they can’t exercise if they don’t know the facts and aren’t educated on higher education best practices. Faculty and staff members should also understand the institution’s financial situation in considerable detail because they are an essential part of any potential solution. Students -- especially those in leadership -- should be brought into the loop on at least a general level and receive information that either has a direct impact on them (such as contemplated program cuts or closure) or that they might hear from faculty and staff members, community members or the news media.

The entire campus community should be brought into the process of coming up with solutions to financial difficulties. No internal constituency should hear bad news from external sources first, which means that the board, or at least the board chair, should always be apprised of upcoming media coverage of negative financial information. And local news media should not be given the opportunity to speculate or get their information from unofficial sources. That means that the president and public relations staff should craft honest messages that place the institution’s problems into the appropriate national and regional contexts and emphasize what should be positive news about how the college is responding to financial pressures.

Hampshire College is notable for having been so honest about declining finances as to advise admitted students not to enroll. That decision is still controversial there, but if Hampshire survives, such institutional honesty will be a contributing factor. At the other extreme, Mount Ida’s sudden closure announcement without forewarning got it into potential hot water with both the state of Massachusetts and with students.

Boards, especially if they are mostly businesspeople accustomed to calculating potential profit and loss, may be reluctant to release financial information, even to the campus, until absolutely necessary. But as the Massachusetts attorney general said of the Mount Ida board’s decision not to disclose the college’s situation in a timely manner, “At a minimum, their decision making fell short of what is expected of a charitable board in meeting its obligations to an educational mission.” For both boards and presidents, decisions about what to say when in financial crises should put the educational mission above the institution’s reputation, which will, in fact, only help the reputation of the institution in the long run.