Important questions Heads should ask their school s Business Manager, and why they are important

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1 John Green MANAGEMENT Important questions Heads should ask their school s Business Manager, and why they are important Retired AHISA member John Green provides new Heads with a toolbox of questions as first steps toward gaining an understanding of their school s financial position. An edited extract of this paper appeared in Independence, Vol 38 No 2, October MANY aspiring and new Principals do not have strong financial or accounting backgrounds. In this article I have no intention of writing mini financial and management accounting textbooks. After all, even though the financial statements and budgets that are presented to your Board will often be called the Principal s Budget they will, even if you helped set some of the parameters, usually be constructed by a Business Manager or school Accountant. However, it is important that in addition to being able to interpret the school s Income Statements, John Green retired as Principal of The Friends School, TAS, at the end of During his career he was Head of x schools and Bursar of one. AHISA is grateful for permission to publish this extract from the draft of a text that John is preparing, with the working title, A Principal s companion. Balance Sheet and predictions of cash flow you should also understand the principles and assumptions your Business Manager has used in creating them. I believe that if you can ask the questions that follow and understand their significance, you will have a clear understanding of your school s financial position and the likely impacts your operational and strategic decisions will have on your school s finances. Numbers and estimates But first, in case you share most lay people s belief that because financial statements are presented in terms of precise numbers, they are precisely accurate pictures of the School s financial position, I need to correct the misconception. The reality is they may not be. At best they are likely to be a good reflection of the school s financial health but only an approximately accurate one. While many of the figures in financial statements can be verified and reflect actual financial transactions, a surprising number of the figures are based on predictions or educated guesses. It is the quality of the assumptions that lie behind the predictions that control the quality and likely accuracy of your school s financial statements. Let me give you just a few examples of lines in your statements that need to be estimated. Many estimates or assumptions have to be made when constructing income and expense budgets for the next financial year and beyond. Your predicted revenue will depend primarily on your predicted enrolments and fee structure. You can determine your fee structure and that will contain accurate figures. But unless you have established waitlists for every grade in your school you have to estimate enrolment numbers for the following year. Through working on various grant committees I have seen scores of enrolment predictions from schools of all descriptions. A staggeringly high percentage of these schools suffered from the blue-sky syndrome in predicting unrealistic future enrolment increases, which in time reflected only wishful thinking. Even if you are certain about the fee structure for the coming year you still need to estimate the percentage of those fees that will be collected. If you or your Business Manager is a clairvoyant this is easy, but if you are not you have to make an intelligent guess about the quantum of doubtful and bad debts you need to include in your budget. In these two examples, an analysis of enrolment applications and deposits paid can help you predict close to accurate enrolments and the recent past history of bad debts

2 as well as an appraisal of the current economic climate and perhaps the percentage of parents in non cyclical occupations, can help you make a good estimate of likely bad debts. But in both cases they still remain estimates. Again, estimates of future costs will be influenced by your, or your Business Manager s, views on future inflation rates and expectations of the impact they will have. The number of estimates, and the way they are made, may substantially change the reported profit or loss of a school or the strength of its balance sheet. These may include the rate assets are depreciated. In other words, the rate at which we reduce the value of our assets as they, through wear and tear or obsolescence, lose value through their productive lives. To do this we have to make predictions about the useful life of our assets. Changing an opinion about the length of the productive life of assets can significantly change the school s published accounting profit or loss. During the year employees may accrue sick, personal, maternity or long service leave. An estimate has to be made about the proportions of entitled sick leave that may be taken, or the numbers of employees likely to take maternity leave or reach the number of required years of service to trigger long service leave. In a school s Balance Sheet the value of its assets can change significantly if the way they are valued changes. For example the reported value of land and buildings purchased many years ago can be dramatically different if measured by estimated current market value instead of historical purchase costs. You may think that surely there must be a standard and agreed way about valuing these assets in a school s financial reports. But there is not. While there are many accounting principles and practices that are, because of convention and tradition, widespread, they are very rarely universal and they can change over time. Accountants will rarely agree about how all an organisation s financial activities should be reflected in their financial documents. This is because unlike mathematics or science, accounting principles are not basic truths or laws. They are simply rules made up by accountants and accounting standards are a selection from a range of possible treatments, many of which are equally defensible. So it is useful to gain some understanding of the standards and principles your School Accountant or Business Manager uses. Financial accounting There are two types of accounting financial and management accounting. Although in practice most of a school s financial transactions will affect both management and financial accounting, I will try to make the distinction between them. Financial accounting is concerned with the reports that will be presented to the school Board and outside agencies. Management accounting is more closely linked to the everyday financial activities of the school, such as, for example, the creation and control of department budgets. Other examples might be deciding the optimum restructuring of debt or when to trade in a school bus for a replacement vehicle. Obviously these accounting outcomes and their treatment will be reflected in the school s financial accounting. My advice to a Principal is concentrate on understanding the school s financial accounting. You should be able to leave much of the management accounting and the tools associated with it, such as discounted cash flows, to the Business Manager or school Accountant. Key questions In this section I am going to suggest the questions you should ask your Business Manager and why you should ask them. They are not presented in an order of importance but in a way where I hope there will be a logical flow. Does the school use accrual or cash accounting? Many small schools use cash accounting because it is a simpler system of accounting. In contrast, the more sophisticated accrual accounting system is preferred by many schools because it not only more accurately reflects the revenues created and costs incurred in a given period but is also not as exposed to financial outcomes being manipulated. A major problem with only recording cash transactions in any given period is that the timing of cash transactions is often discretionary. For example a 2

3 school may owe its staff several weeks wages at the end of a financial year but with cash accounting if the wages owed are paid at the beginning of the next financial year the true cost of running the school would not be recorded in the financial year in which the wage costs were incurred. In this case the profit for the year would be wrongly inflated. Accrual accounting would allocate those wage costs to the period in which they were incurred. Likewise all school fees charged in a period would be assigned to the period related to the fee charges even if not all the fees were collected and banked during the period in question. Accrual accounting is likely to give you a more accurate picture of the school s financial position. Does the school set a surplus target and if so does it achieve it? The concept of a school making a profit does not always sit easily with some school communities but it should. Because nearly all schools are not for profit institutions and have no shareholders expecting returns on their investment, it is often thought that schools should do no more than break-even. In other words, that schools should raise just enough income to cover costs or that in any one year a school s management should spend all generated income for the year. I think such thinking is a dangerous and foolish way to run a school. The aim should always be to make enough surpluses to build reasonable reserves to protect a school from future income volatility and to invest in improved facilities and curriculum development. The alternative to financing improvements in the school through accumulated surpluses is to rely purely on debt. Some debt can be strategically beneficial but debt can also be expensive and put pressure on schools to raise more fee income to finance the servicing of debts. This is why the next major question about accounting and cash surpluses is important. There is no correct answer to the question of what surplus a school should target, but in my opinion a minimum surplus of four or five per cent of annual income would seem reasonable. What were the accounting and cash surpluses last year? For a Principal with a non-financial background it will at first be confusing when the school Accountant or Business Manager talks about accounting and cash surpluses, especially as they will almost certainly be different sums. By looking at each in turn I hope to show you why they are different and perhaps why a school s cash deficit or surplus is so important because, in my opinion, it is a more reliable reflection of your school s current and short-term financial strength. You will, of course, hope to hear there were, in both accounting and cash terms, surpluses and not losses. However, if your Business Manager tells you that one of them or both are in deficit do not automatically feel alarmed. Accounting Profits/Losses A school s Income Statement (sometimes called Profit and Loss Account) is designed to show whether a school is making a profit or loss. The profit or loss shown in this statement is known as an accounting profit or loss. However, it is possible that if two qualified accountants each drew up your school s Income Statement, the two statements could show different profit or loss figures. How can this be? Well, first place the Income Statement in front of you and then look for the expense line Depreciation. As I have already explained, this is an estimate of the value that has been lost on the school s assets during the financial year as the assets proceed through their useful economic life. The depreciation figure does not affect the amount of cash the school holds. It is purely an accounting figure to increase the total recurrent expenses in the Income Statement. This figure is then subtracted from the school s total income. The resulting figure is known as the Accounting Profit or, if expenses are greater than income, the Accounting Loss. Depreciation charges are made on the assumption that assets will need to be replaced in the future. Some assets may need to be replaced within just a few years but for some substantial assets such as buildings replacement may not be for 20 or 30 or even more than 40 years time. 3

4 Also look for any expenditure line containing the word provisions. For example there may be a provision to cover future staff leave. This again is a non-cash item. It is an accrued expense. It is a provision for cash payments to be made in future years. In any one year, two schools of similar size delivering similar curriculums with similar cash incomes and expenditures can, because of the effect of depreciation, end up with different Income Statement outcomes, with perhaps one showing a comfortable surplus and the other a loss. Why is this? The answer is that the two schools may have very different depreciation charges on their infrastructure and capital equipment. There might be quite legitimate reasons for this to be so. For example let us assume that both schools have similar facilities but School A constructed most of theirs 30 to 50 years ago. On the other hand School B has built most of their facilities within the last few years. No matter which way the schools value their buildings, either on historical costs or estimates of current market value, School B will have a much larger depreciation cost. This is because if each school depreciated buildings over an estimated 50-year lifetime (this is not uncommon) on historical costs School A would be carrying a very low or even close to zero value on many of its buildings while School B will be depreciating a percentage of close to recent construction costs. There are two reasons why School A will have lower depreciation costs. The first is that because of inflation the original purchasing costs of its assets will be much lower. The second is that depreciation charges have been applied for many years so the current book value of the buildings will be equal to the original costs less all the depreciation charges that have been applied over many years. Even if the schools both value their buildings at estimated current market values, School B will still have a much larger depreciation charge. This is because current depreciation costs will be calculated as a percentage of current market value less any accumulated depreciation charges that have been charged against the buildings over their lifetimes. At this point I need to say that while valuing a school s infrastructure on estimates of current market value may give a more relevant figure, it is hard to know if such a figure, in terms of accuracy, will be reliable. A market for selling a school as a going concern to another party may not exist. Also the specialised nature of a school s assets limits their possible alternative uses, so estimations of current values are hard to make and a good deal of guess work will be involved. One of the factors that may be considered when estimating the current market value of a school s infrastructure assets is the school s location. So if School A and School B have similar quantities of land and physical assets the valuation of those assets may be very different if School A is in a rural location and School B is located in a high value large city suburb. In this case the locations of the schools would influence depreciation charges and their respective accounting surpluses or losses. On the other hand, while historical costs are reliable because they can be verified, over time they lose relevance. Accountants would like the figures they use, and the ways they process them, to be both reliable and relevant but often they cannot be both. So to recap, if you extract all the non-cash items from the Income Statement s expenses you might discover a healthy surplus of cash income over cash expenses for the year. However, this cash surplus figure is not a true surplus figure. The main reason for this is that the Income Statement only records recurrent cash expenditure. Recurrent expenditure is all the cash expenditure a school needs to carry out in its everyday operations and would include expenditure on such things as staff wages, insurance, teaching supplies, stationery, utilities, advertising and cleaning etcetera. In other words, all these expenses are confined to and exhausted within one financial year. Recurrent expenditure does not include cash expenditure used to purchase capital equipment and infrastructure and also, if a school is carrying debt, repayment of debt. 4

5 Within a school s Income Statement there is the huge assumption that the non-cash expenditure items are equal to a school s cash expenditure on long life assets and debt repayments. Clearly this is unlikely, so hence the reason accounting and cash surpluses or deficits will almost certainly be different. So to conclude, if your Business Manager says the school has achieved an accounting surplus it is a good start, but only a start because, as we will see, a school may achieve an accounting surplus but still not be in a strong financial position. To have a better feel for the school s financial strength we need to find out the school s cash surplus or deficit and analyse the factors that contributed to the deficit or surplus. It is important to know that the existence of an accounting surplus does not guarantee a cash surplus and likewise an accounting deficit does not mean a school must be operating with a cash deficit. Cash Surpluses/Losses While Income Statements are the conventional way of reporting a school or business s profit or loss, it is very important for a Principal to know whether their school is generating a cash surplus or deficit. It is often said that cash is king, and certainly many potentially profitable businesses have floundered because of inadequate or poorly timed cash flows. Simply put, a cash surplus or deficit is found buy calculating a school s annual income from all sources and subtracting its total cash expenditure for the year. To expand this a little, total school income could include income from tuition and perhaps boarding fees, income from uniform and bookshops, canteens, grants, fundraising events, donations, interest on deposits, and maybe rents etcetera. Cash can be spent on a number of different categories of expenditure. These categories include recurrent expenditure, capital expenditure and the repayment of debt. Once we have a figure for a school s total income for the year and figures for each category of spending it is easy to calculate a school s cash surplus or deficit. We can gain some of the information we need from the school s Income Statement. For example the income recorded in the Income Statement is the school s annual revenue from all sources. We can also calculate the school s total recurrent expenditure for the year. We do this by taking the total expenditure recorded in the Income Statement and deducting the noncash items that is, depreciation and any provisions. You must then ask the Business Manager for the annual total cash expenditure on fixed assets and the amount of debt that was repaid to lenders during the year. Fixed assets are long-living assets that are sometimes called nonrecurring assets. Conventionally, they are assets that will be used by a school for more than a year and that will attract a depreciation expense over future years. Most schools will not be hard and fast about the one year rule because it is simply too troublesome to include low cost assets, such as say staplers, in an assets register then estimate each asset s economic life span to work out the associated depreciation charges. Commonly, schools may set a cost limit on assets that will not be subject to depreciation. So it might be decided that any asset costing less than, say, $500 will not be subject to annual depreciation. Instead, expenditure on these assets will be allocated to recurrent expenditure, which means that the whole value of the asset is written off in its first year. It is, of course, important that any depreciation policy, once it is established, is consistently applied year after year. For example if a school purchases new classroom sets of furniture such as desks and chairs a Business Manager may decide not to include them in his or her depreciation schedule because each chair or desk costs less than $500. However, alternatively, he or she may decide to depreciate them as class sets of furniture. Judgements such as the example just given, as well as judgements about the value of assets to be included in recurrent expenditure, will vary from Business Manager to Business Manager and of course those judgements will impact on the accounting profit for any given year. Returning to cash surpluses and deficits, we can take total income as 5

6 recorded in the Income Statement and then deduct all the recurrent expenditure, which can be calculated from the Income Statement (all Income Statement expenditure minus non-cash expenditure items). Then subtract all expenditure on fixed assets and all debt repayments, but add in any new additional debt taken during the year because this would give a school more cash. If a cash surplus is achieved that is excellent, because the school will have larger bank deposits that can be used for further development of the school or to further reduce debt if the school is carrying debt. But even then I must place a caveat on this conclusion and that is a cash surplus may not be a healthy sign if the cash surplus was only achieved because the school had increased its debt levels. Does this then mean a cash deficit is a cause for alarm or that a cash surplus is a cause for celebration? The answer is maybe yes or maybe no. While the answer is correct, I realise that it does not sound very helpful. If in a given year your school has a cash deficit, there is no simple answer to should you feel concerned and if so how much should you be concerned? This is because the deficit should be viewed in terms of a bigger picture. Perhaps I can explain this by way of two examples. The first is a scenario where I would be concerned and the second where I would not. A one off cash deficit or even deficits that last for just a few years may not be too alarming, but if it is part of an entrenched trend, radical action must be taken because any cash reserves that may have existed will eventually be exhausted and the only way to continue operations will be through the accumulation of debt. Also, if the cash deficit has to be financed by increasing debt, generally we would not think this was a good situation. But again if the deficit had been caused by an unusual one-off large increase or spike in the purchase of long-term assets such as an investment in infrastructure, we might not be too concerned, especially if debt levels were modest before the infrastructure investment was embarked upon. I have been in situations when cash deficits for a year or two have given me little reason for concern. Let me give you an example of a school that for two years budgeted for a cash deficit of $300,000 on a turnover of $25 million. If an institution, or for that matter an individual, overspent their income by just over one per cent, we would hardly think they were letting their debts get out of control. In fact in this particular case the opposite was happening because a major cause for the cash deficit was a $600,000 per annum debt repayment. Further, the $300,000 cash deficit was being financed from the $6 million cash reserves held by the school as working capital. In other words the school, if it was foolish enough to maintain the deficit, could do so for the next 20 years without incurring debt. In the meantime, during those two years the school s Balance Sheet was getting stronger to the tune of $300,000 a year as the school s debt was decreasing much faster than its cash reserves. In this example the school s Balance Sheet gave me comfort. (I will return later to the importance of the Balance Sheet in determining a school s financial strengths and weaknesses.) A useful check to see if a sudden accounting or cash deficit is part of a longer term trend is to ask to see any financial projections for future years as well as the assumptions they are built on. Are there financial projections for at least the next five years? The answer here must always be yes. If the answer is no, things will have to change because it is important to know whether the current situation is a one-off or short-term. The further forecasts are away from the present the less accurate they are likely to be, but if sensible assumptions have been made you should be able to see future trends concerning accounting and cash surpluses or deficits. Such trends can highlight a need to revisit strategic directions in terms of capital investment, enrolment growth and changes in the school s size and structures. Personally, I like to see a series of forward projections where such things as projected enrolments, delaying or bringing forward capital projects or debt repayments are varied. This type of sensitivity analysis can give a range of different outcomes as a 6

7 result of conservative, optimistic and perhaps less extreme assumptions being made about key variables. How accurate have past budget predictions been? This is an important question on two counts. The first is the answer will help determine the level of confidence you will have in your Business Manager s current and future budgets. Also, along with the answer to a supplementary question, it may tell you something about the nature or psychology of your Business Manager. The supplementary question is, Were actual outcomes mostly more favourable or less favourable than budgeted outcomes? A common answer is that actual outcomes have been better than budgeted outcomes. This is because most Accountants and Business Managers come from a cautious tribe. They also realise that school Boards will respond more positively to better than budget outcomes than worse than budget results. If past budgets have consistently been too optimistic, I would not only look at the possibility of the Business Manager perhaps wanting to convince his or her Principal and Board that poor financial outcomes were about to be turned around and improve. I would also like to assess whether the Business Manager had been under pressure to fuel the ambitions of the previous Principal and Board. Some Boards and Principals like to leave monuments as a legacy to their involvement with a school. Unfortunately, I have seen Principals strengthen their CVs by listing the completion of large infrastructure projects and enrolment increases during their tenure as the Head. It is likely that in their application to the Headship of a larger and perhaps more prestigious school, there would be an absence of data about the crippling debt levels being left behind, or the nightmare of controlling fee debts and revenue as the result of boosting enrolments through large scale and arbitrary fee discounting. While generally I would prefer to work with a conservative rather than overly optimistic Business Manager, I am also aware of the negative impact a strongly conservative Business Manager can have on the development and quality of a school. Good schools must engage with change if they are to remain good schools. They need to pursue continuous improvement in their teaching and learning programs and this will need investment in technology and the infrastructure to support those programs. If Business Managers become too conservative they can create too much caution and doubt about positive investment and act as drag chains to essential change and progress. How much debt does the school have and is there a Board policy about debt levels? I know of some schools where their Boards insist the schools have no debt, but these schools are in the minority. The attraction of running a debt free school is that by having no debt and, therefore, no servicing costs such as interest payments, recurrent expenditure can be kept lower. Despite this being a cogent argument, there may be very good reasons for schools taking on debt. One justification for a school to be carrying debt is that the cost of large infrastructure projects benefit not only current families but also future students and their families and so some of the costs should be borne by them. Commercial enterprises will take on debt if they think they can use the extra cash to increase the organisation s income by a larger amount than the cost of the debt. This is the prime reason why most of the companies listed on stock exchanges carry quite large amounts of debt. However, the reasons for schools holding debt can be more complex and involve more value judgement. Nevertheless, the principle that still holds is any perceived gains of using debt should be greater than the cost of debt. Appropriate levels of debt may depend on factors such as a school s location, competitive pressures, the level of interest rates, a Board s level of risk aversion, the perceived benefits that can be achieved with debt financed investment, and where the school is in terms of its history. For example a young school being established in new suburbs that are generating 7

8 increasing enrolment demands that, if satisfied, will increase school income, should be a lot more comfortable about taking on debt than a long established school in an area with a stable or declining school population. Debt levels can be expressed in a variety of ways. For example commercial enterprises will talk in terms of companies being low or highly geared. The gearing is expressed as a debt to equity ratio and the equity in this case is the proportion of company assets that is owned outright by the company. While this ratio can be calculated from data in a school s Balance Sheet, there are for schools better ways to express levels of debt. Debt can of course just be expressed in numbers of dollars for each school, but given the wide variation of size and wealth between schools, it will tell us very little about whether the levels of debt for each school are appropriate. When the financial data of groups of schools is compared and benchmarked against averages it is not uncommon for debt to be expressed in terms of debt per student. It might be useful to compare your own school s debt per student figure to the average figure for all schools, but it is only really useful if your school is close to average. For example, a debt per student of say $6,000 may be quite appropriate for a large high-income school but may be far too high for a small low-fee school. A more relevant way of measuring debt is to measure debt per student as a percentage of average income per student. I prefer to use a simpler calculation and measure the debt level in terms of a percentage of the school s annual income. If the school is well established and in a stable environment I would be happy with debt levels in the range of zero to 25 per cent of annual income. If the school was in a phase of rapid growth that was going to result in increased enrolments, my comfort zone could increase to 35 to 40 per cent of annual income in the short to middle term. I have known some monument building Principals leave schools with debt close to 100 per cent of annual income. Has a break-even analysis been done for different sections and cost centres of the school? I suspect in most cases the response to this question will be in the negative. Initially the model may take a little time to set up, but it is not a demanding exercise even for schools that cover 14 years of schooling. Once set up, the model very clearly shows which classes or sections of the school generate financial surpluses and losses. A school s fees and grants schedules tell the Principal and Business Manager the direct income each student generates at each year level. Other forms of income can be averaged out to pupils on a per student basis. At the primary level, where children are taught in class groups, the direct teaching and teacher aide salary costs are easily identified. Total variable and fixed costs for each section of the school can then be distributed on a per student basis. In the secondary and senior secondary sections of the school, because electives can create varying class sizes, the total costs associated with each section can be averaged out on a per student basis. As Principal you need to know which classes make losses and the size of those losses. It is also helpful to know break-even points, for example, that a minimum of 13 students is required for classes in the junior secondary school and 11 students in senior secondary school classes if those classes are to cover their total costs. There are, of course, many educational and social reasons why you are willing to run loss-making classes. However, sometimes those reasons may at best be marginal and then you might want to consider if those resources could be better employed. When you first use a break-even analysis model, you could end up scratching your head about why your school s fees are structured the way they are. You may also realise that many Principals have a fixation with total enrolments as the only true indicator of a school s success and prosperity. I will briefly consider both those propositions. In a large proportion of schools the tuition fees for younger children are lower than those charged to older students. This is often the case even within the primary section of a 8

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