The U.S. Department of Education (ED) has been calculating an institution’s Composite Score as part of its annual assessment of Financial Responsibility. However, new Financial Triggers can cause ED to require a school to recalculate its Composite Score making it more important than ever to really understand how it is calculated.
This article is Part 2 in a series on the Composite Score. You may also be interested in Part 1, which outlines the purpose of the score, definitions, and how the different aspects of it are calculated. In this article, we’ll pivot to identify the factors within an institution that can positively or negatively affect their Composite Score. With decades of experience advising schools and universities on Title IV compliance, we’re intimately familiar with the issues that can trigger additional review and reporting to ED. Hopefully, this article can help you prepare for and possibly even avoid such outcomes.
The Key Drivers of an Institution’s Composite Score
Equity
As a reminder, the Composite Score is calculated from three weighted ratios:
- Primary Reserve Ratio (30%)
- Equity Ratio (40%)
- Net Income Ratio (30%)
Your equity impacts 70% of the Composite Score calculation, divided across Primary Reserve Ratio and Equity Ratio. These are reflected as Adjust Equity / Total Expenses and Modified Equity / Modified Assets respectively.
A range of factors influence an institution’s equity:
- What is the original funding source — debt or equity?
- Are profits left in the company or taken as distributions?
- Do Unsecured Related Party Receivables exist?
- Is company growth funded by profits or additional debt?
Profitability
Profitability influences the Composite Score through two primary means:
- Profitability directly impacts the Net Income Ratio, which makes up 30% of the Composite Score
- Profit/Loss each year increases or decreases equity, which influences the Primary Reserve and Equity ratios as noted above
Goodwill and Intangibles
Goodwill and intangibles are unique compared to Equity and Profitability as they are typically created through acquisition. In turn, it is not impacted by operations.
In calculating the Primary Reserve and Equity Ratios, Goodwill and Intangibles are subtracted from Total Equity. Depending on the amount of the Goodwill and Intangibles, they can have a significant detrimental impact since they are included in 70% of the final score.
The impact of Goodwill and Intangibles to your Composite Score can only be overcome by contributing additional equity to the balance sheets, or allowing profits to flow through to equity over time.
Subtle Drivers Affecting Higher Ed Composite Scores
Some forces can negatively impact an institution’s composite scores in less obvious ways. Here, we’ve outlined some circumstances to watch out for.
Fixed Assets Acquired Without Debt
Acquiring fixed assets without taking on debt effectively decreases the numerator in the Primary Reserve Ratio and drives up the denominator of the Equity Ratio. Note that these assets are treated differently in the Composite Score rules depending as to whether they are pre or post implementation.
Fixed asset acquisitions affect calculations in the following ways:
- Fixed assets are subtracted from Equity to determine Adjusted Equity in the Primary Reserve Ratio.
- Certain types of long-term debt obtained to purchase fixed assets can be added back reducing the impact of increasing fixed assets.
- Addback is capped at the amount of fixed assets purchased, so obtaining debt greater than fixed assets doesn’t help improve the Composite Score Ratio.
Right of Use (ROU) Assets
The new Lease Standard impacts the ways that Right of Use assets are calculated. These assets increase Total Assets, which is the denominator in Equity Ratio. This impact can be significant. The amount of ROU Asset and Lease Liabilities are determined by payments in the lease. The longer the lease, the larger the impact on your Equity Ratio.
Institutions should carefully review the impacts of the treatment of capex costs related to buildouts of new locations or capital improvements as part of a lease renewal to determine the best course of action.
Understanding the Composite Score Ratios
Now that we’ve reviewed the elements of your balance sheet with the largest impacts on a school’s Composite Score, let’s break down how the calculations affect each component of the Composite Score.
The Composite Score can range to 3.0. Each component is also subject to the same minimum and maximum score. Schools need a score of 1.5 to “pass” and be deemed financial responsible. To conclude this article we list the ratio required between the numerator and denominator for each component expressed as a percentage. The key thresholds listed for each are:
- Ceiling of 3.0 (percentages above amount listed won’t increase the score any more)
- Passing of 1.5
- Inflection point between hurting or helping of 0.0
- Floor of (1.0) (percentages below amount listed won’t decrease the score any more)
The following example percentages represent the ratio needed between the numerator and denominator to meet (1.0), zero, 1.5 and 3. Percentages below the floor or above the ceiling do not further contribute to the score beyond that point.
The Primary Reserve Ratio
This accounts for 30% of your total Composite Score.
It is calculated as: Adjusted Equity / Total Expenses X 20
Here, examples represent adjusted equity % of total expenses.
| Adjusted Equity: 15.0% | Score: 3.0 |
| Adjusted Equity: 7.5% | Score: 1.5 |
| Adjusted Equity: 0% | Score: 0 |
| Adjusted Equity: (5.0%) | Score: (1.0) |
The Equity Ratio
The Equity Ratio accounts for 40% of a school’s Composite Score. It is calculated by:
Modified Equity / Modified Assets X 6
Here, examples show Modified Equity % of Total Assets
| Modified Equity: 50% | Score: 3.0 |
| Modified Equity: 25% | Score: 1.5 |
| Modified Equity: 0% | Score: 0 |
| Modified Equity: (16.7%) | Score: (1.0) |
Net Income Ratio
The Net Income Ratio compares Income before Taxes to Total Revenues, and is counted as 30% of the total Composite Score. It is calculated as: (Total income Before Taxes / Total Revenues X 33.3) + 1
Here, we show scores based on Income Before Taxes as percentage of Total Revenues.
| Income: 6% | Score: 3.0 |
| Income: 1.5% | Score: 1.5 |
| Income: (3%) | Score: 0 |
| Income: (6%) | Score: (1.0) |
To gain a deeper insight into how ED treats PPE and debt, visit our detailed article on the components of the Composite Score.
McClintock is Your Partner in Higher Education Finance
Looking to understand how your school’s financial statements are reflected in the Composite Score? For 50 years, McClintock & Associates has specialized in Higher Education Accounting and Title IV compliance.
We offer expert post-secondary institution auditing to help you quickly navigate the strict regulatory environment and adapt to changing requirements. Schedule an introduction today.
