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Recognizing the Unrealized

Effective financial strategies for small, independent institutions on the brink require accounting and anticipation.

By Michael K. Townsley

The period from 1998 to 2002 was a financial rollercoaster ride for independent undergraduate institutions, with revenue climbing steadily between 1998 and 2000 and then plummeting from 2000 to 2002. Unrealized capital gain, seen as found money waiting to be spent, was replaced by unfathomable financial loss when the bottom fell out of the stock market. When the ride slowed in 2002, institutions faced dilemmas from all perspectives: fallen revenues, expenses that had not slowed, and increased tuition dependency. While independent institutions cannot predict such financial curveballs, campus administrators must anticipate the stock market’s bearing on their financial course and grapple with the uncertainties of unrealized capital income, lest they incline their institutions toward precarious financial positions.

To better understand the financial effects of 1998–2002, a sample of 385 independent institutions was analyzed using data from the Integrated Postsecondary Education Data System (IPEDS) files. These institutions, classified as Carnegie Classes 31 and 32, were selected because research, grants, or graduate programs do not typically distort their financial data. The sample of baccalaureate degree-granting colleges and universities was selected from a pool that ranges from 425 to 565 and varies depending on the number of institutions that filed data for each particular year.

Table 1 Stock Market Performance and Financial Measures

The Stock Market and Institutional Finances

The stock market boom of the late 1990s had direct and positive effects on the institutions analyzed in this study. From 1998 to 2000, while the S&P 500 grew 42.3 percent, the snowballing effects on these campuses included an 11.6 percent increase in total revenue; $12.1 billion cumulative net income; a net income/revenue range of 23–33 percent; and moderate deficit levels. However, during this same period, total expenses grew 4.7 percent faster than total revenue— a disturbing new money consumption trend that surfaced during a volatile market period.

When the stock market tanked in 2001, the ripple effect on institutional finances was just as immediate as the gains of the prior three years. As losses intensified through 2002, the devastating effects began to tally up for small institutions’ finances. Between 2000 and 2002, revenues fell 32.5 percent while expense growth rates remained persistent, for a loss of nearly $2.8 billion in net income. At the same time, the percentage of institutions reporting deficits went through the roof—from 15 percent in 2000 to half in 2001 to nearly 64 percent in 2002. By the end of 2002, institutions’ finances were in recovery.

At the end of the five-year ride, the cumulative net income for the sample set was still a healthy $9 billion. However, it is more dif- ficult to determine the actual cash positions of these institutions for three reasons: 1) net income varies across enrollment and tuition dependency groups within the sample; 2) cumulative net is not equivalent to cash; and 3) IPEDS does not report cash or provide data on receivables, accruals, inventory, and so forth. To account for these data deficiencies, the relationship of net income to cash was imputed by subtracting non-cash transactions (unrealized gains, losses, and depreciation) from total net income. For the 1998–2002 period, this calculation estimates cash generated from cumulative net income to be $3.1 billion or one-third of the $9 billion cumulative net income reported to IPEDS.

Expenses and debt. The financial losses incurred in 2001 and 2002 cut deeply into the financial fabric of the pool of small, independent institutions. Despite revenue losses, total expenses continued to grow at a fast clip—13.4 percent for the two-year period. Institutions could only slow down expenses moderately, suggesting that fixed costs built into total expenses are diffi- cult to modify, and that institutions are not able to quickly respond to changes in revenue when substantial unrealized losses are factored into the financial mix.

The decreased revenues and constant expenses of the poststock bust period imply that the institutions suffered from higher debt levels as well. In the absence of data from IPEDS, it is fair to assume that debt comprises the majority of liabilities in order to analyze an institution's ability to support debt. The ratio of unrestricted net assets/liabilities declined rapidly from 2000 to 2001, finally slipping below the putative debt leverage benchmark (2.0) in 2002 when it bottomed out at 1.8. The lesson learned? Negative returns on revenue significantly impact unrestricted net assets.

The stock market losses in 2001–02 also took a toll on endowment values, and the institutions sampled were not spared. Investment values of endowments fell while endowment draws shrank, and draws from life annuities based on equities were commensurately small. The result was a trend toward increased tuition dependency at a time when tuition income was spread thin.

What's Left When Unrealized Income Disappears?

Unrealized income, whether it be capital gains or losses, is difficult to predict because it is tied directly to the volatility of equity markets. But analyzing both unrealized and realized income is critical. During periods when equity markets grow rapidly, unrealized income may obscure operational deficits, which become apparent (and dangerous) only after the unrealized gains have transformed into unrealized losses. Budgets are based on activities that have a fair degree of predictability and reliability with the exception of stock markets. Stock markets react to changes in economic conditions that are also subject to highly unpredictable events like 9/11.

The importance of considering unrealized income in institutional financial decisions is illustrated in Table 1, where the performance for the sample is analyzed both including and excluding unrealized income. In general, while the institutions appear better off financially when unrealized income is included, they fare better when unrealized income is excluded. When gains and losses are excluded, total revenue shows positive growth over the five-year period, net income is only moderately negative and for one year only (-3.1 percent in 2002), and the rate of tuition dependency among the sample remains stable. When unrealized income is included, however, total revenue is 27 percent higher overall; the percentage of institutions reporting deficits is significantly lower in the first three years (though higher in the last two years); and total net income from 1998 to 2002 is $9.3 billion versus $838 million when net income is excluded.

If observed in a vacuum, it would appear that the set of institutions is better able to manage net income when gains and losses are excluded, likely because excluding the unknown minimizes risk and affords predictability and control. But institutions must carefully consider the practicality and success of a financial picture that excludes unrealized income.

Chart 1 Comparison of Revenue and Expenses

Make Way for Students

The stock market wasn't the only fluctuating element affecting college and university campuses during the late 1990s. Despite a net increase in enrollment of more than 16,000 students among the sample set from 1998 to 1999, the change in net tuition generated $141,000 in losses. The data imply that the $274.7 million increase in tuition and fees was absorbed by increases in tuition discounts; perhaps these institutions were enticing students with higher-than-practical grants of financial aid. Over the next three years, however, net tuition was sufficiently able to cover the 1998–99 loss.

When the 385 institutions are categorized by enrollment and tuition dependency, the same net/revenue patterns emerge that are evident for the total sample. However, institutions with dependency rates greater than 60 percent are in a particularly precarious position. Even with a strong stock market, net/revenue margins are weak, and when unrealized income is excluded the margin all but evaporates. The uncertainty facing these institutions is apparent when their unrestricted net income/liability ratios are analyzed. These ratios fall below the 2.0 standard each year in this period and by 2001, the ratio hit a low of 1.39. If this ratio trend continues at or falls below this level, these institutions may have trouble servicing their debt. Coupled with insufficient net income margins, the survival of an institution in this position is vulnerable to unforeseen events.

Another trend that materializes is that deficits increase when unrealized gains disappear. When the sample is categorized by enrollment and tuition dependency status, those with especially low enrollment (fewer than 1,000) and high tuition dependency (greater than 60 percent) are at substantial risk for deficits even when unrealized income is excluded. The negative net/revenue and high deficit percentages of 2001 suggest that when unrealized gains or losses are accounted for, a sudden negative change in revenue will push these institutions into reportable deficits.

Institutions with the smallest enrollment also face challenges in establishing the right tuition level for the number of students. This category of institutions was the only group sampled to report losses from year-to-year changes in net tuition. Between 1998 and 2001, enrollment declined 16.5 percent, tuition and fee revenue slid nearly 20 percent, and net tuition fell 30.5 percent, while financial aid increased by almost 14 percent. Net tuition ratios fluctuated between 75.0 percent in 1998 and 64.7 percent in 2001. If the strategy at these colleges was to entice students with higher discount rates, it failed—and added $48 million to their cumulative loss.

Fluctuations or decreases in enrollment have a greater financial impact on smaller institutions than on large institutions. And unfortunately, many small institutions are not experiencing demand sufficient to maintain enrollment. In recent years, the cost of attracting new students has exploded. An institution must offer new programs and services and make capital investments to improve its image. The cumulative effect of low enrollment, counterproductive tuition discounts, and small net income is that some colleges are living on the brink from year to year. Although tuition data for 2002 were not universally reliable, they suggest that net tuition continued to decline. If this was indeed the case, the impact of unrealized gains or losses on these institutions will prove to be trivial in comparison to the potential loss of their market.

There is one analysis that can be better understood by excluding rather than including unrealized net income (net growth rates) because large losses obscure net growth rates when unrealized gains and losses are included. Net growth rates generally exceed revenue growth rates and, when examined excluding unrealized income, fall into a narrow range between -1.2 percent and -1.8 percent, with the exception of institutions with enrollments greater than 2,000 (.2 percent). This is the "burn rates" range—the rates at which net income is being consumed for the given enrollment and tuition dependency groups. Because all sample institutions reported a net growth rate (excluding unrealized income) of -1.8 percent from 1998 to 2002, it is distressingly clear that expense and revenue growth rates are struggling to find their balance.

Chart 2 Deficits Under Two Revenue Conditions

Implications for Financial Strategy

To build successful financial strategies, small institutions must optimize financial resources by balancing expense and revenue growth rates and anticipating the impact of unrealized income on net income and financial statements. As stock markets return to positive growth, revenue and expense growth rates should moderate and, independent of unrealized income, other types of revenue tied to market performance (such as endowments and gifts) should increase. But for heavily tuition-dependent colleges or those that enroll fewer than 1,000 students, market stabilization will not suffice in achieving balanced revenue and expense growth rates. Presidents and senior officers must act as entrepreneurial leaders when analyzing past financial performance to develop an innovative financial strategy for the future. These individuals must:

• Find new sources of revenue by adding programs, establishing or expanding gift campaigns, forming cooperative ventures, or offering degree courses at high schools. Because new revenue brings new expenses, administrators must ensure that changes in revenue cover expenses and that revenue growth rates (excluding unrealized income) are balanced with expense growth rates.
• Cut expenses, even if cut-to-the-bone operations are already standard fare. Administrators must account for how expenses are used and whether money was spent on projects outside of the budget.
• Develop a long-term strategic plan rather than short-term fixes, no matter the extraordinary efforts involved in garnering time and funds. When planning for the long term, administrators must identify trends, such as whether year-to-year changes in revenue, net tuition, and net income are growing or shrinking.
• Produce positive net income from basic operations (excluding unrealized income) to ensure the long-term viability of the college.
• Research the financial condition of the college to the extent that 1) the implications of unrealized gains or losses can be understood (unrealized gains overstate revenue; unrealized losses understate revenue), and 2) net income, which does not produce any cash, does not distort the current condition of the college.
• Develop conservative estimates of revenue and target expenses to this level. For these estimates, use current enrollment as the target for the next year, subject to information that indicates reasons for growth or decline. If this conservative estimate is used, then real growth produces excess income, which can be used to expand financial resources.

Chart 3 Net/Revenue for All Institutions and by Tuition Dependency

The chief financial officer should use cash flow statements, which wring out distortions associated with non-cash transactions, to convey a college's financial condition to the president, finance or audit committees, and board of trustees. The CFO must adhere to the strategic plan of the institution while ensuring that expenses are accounted for and within reasonable budget estimates. If nothing else, the events of 1998–2002 teach institutional planners an important lesson: Unrealized income cannot be easily dismissed. Though it is generally difficult to model unrealized income, CFOs can work to analyze the multiplier effects on net income, total revenue, expenses, enrollment, and tuition dependency, among other financial indicators.

Planning for the Future

In today's accounting environment, stakeholders at independent institutions must be mindful of the interconnectivity of their institution's finances. For the small institutions that are living on the brink—experiencing deficits, decreased enrollment, or high levels of tuition dependency—all decisions must be carefully scrutinized to avoid further financial hardship. In particular, marginal decisions (those made to add programs, increase expenditures, change tuition discounts, or make capital investments) need to be assiduously tracked if actual financial performance is to stay connected to a strategic financial plan.

Author Bio Michael K. Townsley is a consultant in Indianapolis and former senior vice president for finance and administration at Wilmington College, Delaware.
E-mail mtownsley@stevensstrategy.com