Spring is here and so are letters from the Department of Education (DOE) about low scores from their Financial Responsibility Test. The purpose of these tests is to assure Congress that every college receiving federal financial funds has the wherewithal to survive so students can complete their education.

Since the financial markets caused significant losses in investments and cut into the size of gifts and grants, net assets have shrunk by as much as 10% to 20% at many institutions. These losses affect all three of the DOE ratios – primary, net income, and net worth. DOE scores that fall below 1.5 and above 1.0 will result in a letter indicating that the college has entered a zone of warning. Translated freely, this means that the DOE will monitor your fiscal performance. When scores are less than 1.0, a college will be asked to provide a letter of credit equal to 50% of its federal funds. The letter of credit does have a cost, but the main concern is that the college moves to a “watch list” to see if the financial decline is a one-time or chronic event. If it is determined to be the latter, the DOE could terminate receipt and/or distribution of federal financial aid funds.

So what do you do?

The answer depends on two conditions. First, is the low score solely due to the recent decline in financial markets? If that is the case, the market has improved enough in the last year to result in sizeable unrealized gains to improve net income and investment values. For colleges in this situation, the problem is episodic and not likely to repeat itself until the next market correction. However, the college should look at revising its investment mix to reduce risk when the next market downturn occurs, which is becoming more frequent. Second, is the low score due to the financial decline and to inherent and continuing weaknesses in the college’s financial condition? If this is the reason, the college needs to immediately begin work on devising a strategy to address its financial condition. This should include a thorough financial review to identify the core reasons for financial decline and the development of an academic, market, revenue, and cost based plan to reach financial equilibrium.

Even though the cost of developing a well-designed strategy may be high, it is not nearly as high as the cost of losing federal financial aid funds.

Originally posted April 20, 2010