PART 2 OF A SUSTAINING HIGHER ED BLOG SERIES
Sustaining Higher Ed is a monthly blog dedicated to helping college administrators and board trustees lead their organizations toward greater financial stability so they can stay on mission during challenging times.
Last month, the first post of our four-part series on liquidity in higher education provided key terminology for CFOs when discussing their institution’s cash position with stakeholders outside the finance division. The post offered responses to common questions as well. This second post recommends specific measures and metrics to answer two questions: How much cash do we have, and is it enough? Clear and coordinated responses to these questions are critical for effective financial planning and budgeting at both institutional and local levels.
How much cash do we have?
The answer depends on who is asking. Two common measures of cash appear below but should remain within the finance division.
Operating cash balances support all vendor and labor payments and can be monitored on a daily basis if necessary. The finance division, through the treasurer’s office, should maintain a rolling projection of operating cash balances for the next 12 to 18 months to ensure the institution has cash sources to fund all anticipated cash outlays as they come due. While very important—particularly with the onset of the COVID pandemic—operating cash balances do not address institutional solvency and are not particularly helpful for the strategic planning and budgeting decisions facing institutional leadership.
Unrestricted Resources Available Within One Year
Several institutions produce a note in their audited annual report to quantify the amount of “cash” that is unrestricted and available within one year. While this measure has some value, we recommend it not be used with external stakeholders primarily because it is mired in accounting terms and it implies the unlikely outcome that cash inflows will equal cash outflows during that one-year period.
The best single measure of cash that is reported to stakeholders outside the finance division will satisfy the following criteria:
- Useful: The measure should inform and affect the budget and planning decisions of the institution and its constituents.
- Transparent: The measure should be easy to read and show institutional context, levels of restriction, and measures that may be familiar to a constituent (e.g., department fund balance).
- Holistic: All cash, including invested “cash,” should be captured.
- Trusted: While academic leadership does not need to know or be instructed in generally accepted accounting principles (GAAP), an auditor’s annual endorsement, as a third party, will promote confidence and help dispel unwarranted suspicions.
- Manageable: The cash report should be produced, ideally, each month. This will of course be easier for those institutions that close operating activity and estimate their balance sheet position monthly. The CFO should retain discretion over the report and distribute all or any portion or underlying detail to selected stakeholders as appropriate.
The report proposed below satisfies the criteria:
As a holistic presentation of the institution’s cash position, stakeholders can immediately see the unrestricted and restricted amounts available to them (subject to the institution’s fund balance withdrawal policies) and see the complement of resources across the institution. The report can prompt discussion about whether balances available at both central (Provost, CFO) and local units are adequate and whether the balances enable stakeholders to effectively manage the risks and opportunities in their areas.
The above report includes but does not distinguish investments, though it can reconcile with and is detailed in the investment notes of the institution’s most recent audited financial statements. Fund balance policy, both for accumulation through budget surpluses, indirect cost recovery incentives, gifts, etc., and for withdrawals, is beyond the scope of this post. However, it is imperative that fund balance policies enacted by an institution honor the expectations that were set with stakeholders and align with balances that are actually available in the institution’s cash/investment position. Decisions to invest cash and the tradeoffs between expected return and volatility/access will be discussed in the last post of our four-part series.
Is it enough?
The answer depends on stakeholder risk tolerance, especially at the institutional level. The question “Is it enough?” looks forward—the concern is whether the institution will have enough cash to fund planned outlays. In a world without risk, cash planning is an objective exercise. A planner would determine whether projected cash flows for a given time period were adequate and, if not, adjust income and/or outlays until there was “enough cash.” Of course, the world is not without risk—there will be some variance between planned and actual outcomes. Having “enough cash” will depend not only on funding planned outlays, but also on funding possible adverse outcomes or unanticipated opportunities. At this point, planning for “enough cash” becomes a subjective exercise that will vary by institution. Namely, cash planning will vary by the amount of excess cash the institution wants to set aside as a reserve to manage future uncertainty.
Two familiar metrics can be used with non-financial stakeholders to determine whether an institution’s cash balances are adequate.
- Monthly Days Cash on Hand (MDCOH) = unrestricted cash and investments (green line in report above2) * 365 days /(operating expenses excluding depreciation and any other large non-cash expense)
- Spendable Cash and Investments (SC&I) (green + blue lines above)/Operating Expenses
The above metrics are employed by Moody’s Investors Service as key liquidity metrics in their “global scorecard.” As a result, these metrics can be benchmarked annually against audited financial statements of hundreds of other colleges and universities—an important capability as institutions determine their own level of reserves. While institutions may select other metrics to monitor and plan their reserves, we recommend institutions select only a few that can be readily benchmarked and that retain cash/investment or “asset” rather than expendable resource or “net asset” measures.
MDCOH is a metric for unrestricted resources while SC&I/Operating Expense is a metric that includes restricted, but spendable resources. The numerator for both metrics ties directly to the cash report provided above. It should be noted that SC&I in particular is important for evaluating institutional debt capacity and factors in an additional 20% of Moody’s scorecard (10% total wealth and 10% SC&I/Debt). The metrics can be presented graphically as shown below:
Institutional leadership should discuss the level of risk they can tolerate given their institution’s risk profile, planning aspirations, and position relative to peer and rating agency benchmarks. Institutional “targets” can serve as guidelines for decision-making. As guidelines, actual performance can—and should—veer both above and below targets depending on the institution’s circumstances. COVID, for example, clearly has brought substantial financial stress to higher education and represents an adverse outcome or “rainy day.” A reasonable management response to COVID would be to allow reserves to fall below target if the alternative were expense cuts that jeopardized the institution’s long-term strategic direction. However, any decision to draw reserves below target should be accompanied by either a plan to restore the reserves or a decision to permanently lower the target and accept more risk.
Both metrics (and the cash report) will require a financial projection model to capture numerous assumptions for operating activity, working capital, debt issuance, fundraising and pledges, investment structure, capital expenditures, and other items. Along with cash flows and balances, the model can be used to evaluate sensitivity to changes in assumptions, scenarios for strategic initiatives, and expected physical asset, debt, endowment, working capital, and net asset positions. The next post in the liquidity series will provide guidance for developing cash planning models.
Liquidity in higher education is a complex and multi-dimensional topic. This post proposes a single measure of cash and two familiar metrics to assess whether projected cash is adequate. CFOs can use these measures in conversations with academic leadership, boards of trustees, rating agencies and other external stakeholders. In so doing, CFOs can avoid a minefield of liquidity and cash terminology and focus conversations on institutional resource planning, priority setting, and risk management.
1 “Other” must equal the balance sheet cash and investments less other line items shown in the table. “Other” may be negative due to the interstices of nonprofit fund accounting and the fact that some institutions may carry negative balances on funds not reported to executive, school or department leadership.
2 If amount of investments that could be liquidated within 30 days < “unrestricted,” use amount of investments that could be liquidated within 30 days.