How To Manage Debt

Transcription

1 Debt Decision Support NICHOLAS J. WALLACE, Partner National Director of Higher Education Services ext 1225 If you do not ask the right questions, you do not get the right answers American poet, Edward Hodnett Introduction Making a good decision and getting the right answer for a debt decision is important and has long lasting impact. Making a debt decision (usually associated with some capital project) forced primarily by external factors (pressure from donors, students, faculty, parents) can be the right answer to the wrong question and have negative implications the school will live with for a very long time. The importance, therefore, of well asked questions and well planned, strategic management of debt is a critical factor toward helping your college or university achieve its mission. The authors of the KPMG, Prager Sealy, and Attain work titled Strategic Financial Analysis for Higher Education point out that if the debt that is incurred is used to support the mission and the institution is well managed, the institution will be in a better position to achieve its long term goals and build competitive advantages. In contrast, if debt is used to fund activities that do not capitalize on competitive strengths, the financial situation is likely to erode because resources have not been allocated to their highest and best use. 1 So how do we insure that all the right questions are asked and the right answers are delivered in a cogent, timely manner to key decision makers? This paper will focus on key factors involved in debt management decision support. It is not designed to be an all inclusive review of all the many facets of this issue, but will focus on the key factors in major financing decisions. A review of literature on this subject yields several key factors that are important considerations in the debt decision-making process: 1. The decision needs to be focused on the long term and institutional mission 2. The decision needs to be guided by well considered policy 3. The decision needs to be supported by adequate data 4. The decision and the data need to be clearly communicated 1 Strategic Financial Analysis for Higher Education (7 th Ed), KPMG, Prager Sealy, Attain, 2010 p. 31

2 Making the Decision Long Term and Missional An important paradigm in private higher education today is the intergenerational nature of the institution. As an institution that will last for many generations, it is critical to not only consider the value and costs of a decision to the current students and faculty, but also the value and costs to future generations. It is clear that additional facilities have current capital costs and current financing costs, but they also have long lasting cost implications to future generations of students for repair, maintenance and upkeep. In discussing this point of increasing long term costs, Mr. Malcolm Nimick, in his white paper What is the Right Amount of Debt for a Private College or University 2 suggests the credit analysis methodology to help determine the impact of future costs. He points to the use of a statistic known as average age of plant to inform that issue. He also points out one flaw in the use of that commonly used statistic: it is an average for the entire campus. Because it is an average, detailed analysis needs to be done to be sure there are no hidden problems. This can be done by graphically depicting the entire campus and highlighting those individual buildings that are under the average age, those at the average age and those over the average age. A picture like this can identify important additional capital needs on a building by building basis. The average age of plant is a calculation illustrated below: Item Number to use Amount Numerator Accumulated Depreciation $52,100,000 Denominator Depreciation Expense $ 4,083, Computed Ratio The result of 12.8 represents almost 13 years of annual depreciation expense already used up and represented by the accumulated depreciation number. The lower the number, the newer the buildings on average are a high number represents the fact that the buildings may be nearing full depreciation. Typically, a building is depreciated over a 40 to 50 year period of time. An acceptable level for this ratio is 14 years. This ratio has some obvious drawbacks, but it can be used to inform long term decisions and help identify overall campus facility needs. It also helps with the question, is this right capital spending decision for now and into the future given other general or specific capital spending priorities? When used in conjunction with the institutions Master Facilities Plan and Strategic Planning Documents, this will inform the missional nature of the decision. 2 What is the Right Amount of Debt for a Private College or University Malcolm Nimick, CFA Ascension Capital, 2011 White Paper. Available from Ascension capital Enterprises, LLC, mnimick@ascension-ce.com

3 Supporting the Decision with Policy Any decision to acquire debt brings with it the trade off of reduced liquidity. This notion of liquidity is one of the areas of emphasis in today s accreditation and external credit quality evaluations. What will this decision do to liquidity now and into the future is an important question. Another important question is the degree of alignment a given decision has with the overall institutional mission and strategy. A carefully tailored debt policy will consider these and other important factors and help drive the institution to a good decision that is consistent with its long term objectives. This policy should reflect the university's unique needs and strategic objectives. Therefore, there is no model debt policy that should be followed by every college. However, in drafting a debt policy, the following guidelines (as excerpted from the KPMG, Prager and Sealy, Attain publication Strategic Financial Analysis for Higher Education 3 ) should be considered: 1. Include a section regarding debt philosophy. This section should explain to the analyst why the debt policy is being created, and how it will be used to govern the incurrence of debt to achieve strategic objectives. It provides a framework for management and the trustees to interpret the components of the policy. 2. The university should select the few key ratios it will monitor. These financial ratios should include targets in order to indicate the financial bounds under which the institution expects to operate. Generally, no more than four or six ratios are used, since the policy is designed to represent the overall health of the institution in order to make strategic decisions. Including too many ratios will obscure the "big picture. Additionally, there should be a discussion regarding the mix of fixed and variable rate debt. 3. A policy regarding the prioritization of capital projects is usually included, and this process should receive input from the lower levels of the institution. Guidelines should be broad enough to permit management flexibility; however, the policy should prioritize projects that (a) are mission-related, and (b) have a related revenue stream for repayment. 4. The policy should explicitly acknowledge its role in providing trustee oversight of all transactions that impact the credit profile of the institution, and should require regular review and reporting to the trustees. Other items of specific concern or importance to the governance of the institution would be included as well. 5. The policy should contemplate the use of derivative products and establish a policy regarding their consideration. 3 Strategic Financial Analysis for Higher Education (7 th Ed), KPMG, Prager Sealy, Attain, 2010 p. 40

4 The policy should state that the institution will interact with the rating agencies and strive to attain the highest acceptable credit rating. The institution should not specify the attainment of a specific rating as part of the policy. Supporting the Policy with Adequate Data As suggested by the policy components above, monitoring a set of ratios or metrics is an important element in keeping the institution on target and strategically balanced. The result of not using policy statements supported by metrics that can be monitored is usually what has been referred to as the garbage can effect. Various inputs and decisions get dumped into the can at various times and the result is a hodgepodge of transactions that may or may not have coherence. The quip heard in the technology world is true here garbage in, garbage out. Malcolm Nimick in his white paper suggests the use of a credit analysis model to support debt optimization. Credit analysis is actually a number of different analytical methods to predict the likelihood an organization can pay its debt in the future. The higher the probability, the more likely it is that the organization will be extant for its mission for a long time 4. The optimal capital structure of a nonprofit organization is the structure that maximizes credit quality Visualization of Optimal Capital Structure Operating Margin Liquidity Aa A Baa Debt to Capitalization Debt Service Coverage Below 4 What is the Right Amount of Debt for a Private College or University Malcolm Nimick, CFA Ascension Capital, 2011 White Paper. Available from Ascension capital Enterprises, LLC, mnimick@ascension-ce.com

5 The image, above, is similar to an archery target or a dartboard: the best is in the center. Each ring is indicative of declining credit quality the greater the distance from the center. This target is broken into four quadrants in which to measure four prime credit ratios, relative to medians published by the rating agencies. The four quadrants represent liquidity, leverage, operating margin, and debt service coverage ratio. The organization wants to cluster its dots as close to the center as it can to maximize credit quality, as a general rule is slightly stronger as the dots are closer to the center. Communicating the Decision and the Data The 2011 edition of the CapinCrouse LLP Whitepaper Roadmap to Financial Viability for Colleges and Universities states that Presenting KPIs in an integrated dashboard allows board members to see relationships between various KPIs and obtain a much more comprehensive view of the condition and direction of the school 5. This is true generally and also true as it relates to debt decisions. It is clear then, that major debt decisions should be clearly communicated. Among the important issues to be communicated are the following: 1. Data related to current affordability 2. Data related to current debt capacity 3. Data related to the impact on liquidity 4. Data related to the tie between this decision and the strategic plan 5. Data related to longer term impact on cash flows and budgets. See the table in the Ascension Capital white paper illustrating the long term cash flow impact of debt payments. 6. Data related to the impact of the decision on anticipated future revenues CONCLUSION Ideally, debt decisions should not be made under pressure or in a vacuum. Adherence to the suggestions above will assist University leadership in making informed, well communicated decisions that will impact the current and the future health of the institution. 5 Roadmap to Financial Viability for Colleges and Universities, Nicholas J. Wallace, CPA with David Gyertson, PhD and James Downey, PhD, Pg. 14