Composite Financial Index (SM)
The Composite Financial Index paints a composite picture of the financial health of the institution at a point in time. The Index is built with the values of its four component ratios:
- Primary Reserve – a measure of the level of financial flexibility
- Net Income Ratio – a measure of the operating performance
- Return on Net Assets – a measure of overall asset return and performance
- Viability – a measure of the organizations' ability to cover debt with available resources
Once each of the four ratios are calculated, there is an additional process measuring the relative strength of the score and its importance in the mix of creating a composite score. This results in the production of one weighted score for each indicator and when added together the result is the Composite Financial Index.
Primary Reserve Ratio
The first of the four ratios that comprise the Composite Financial Index is called the primary reserve ratio. Financial ratios always consist of one number divided by another, and in this case the total resources that an institution could spend on operations ( unrestricted funds ) are divided by the total expenses for the year. So if funds that could be spent were four million dollars and total expenses were two million dollars, the ratio would be 2.0 ( 4 divided by 2 ); or if it were turned around and funds that could be spent were two million dollars and total expenses over the year were four million, the ratio would be .5 ( 2 divided by 4 ). The most obvious interpretation of this ratio is that in the first scenario with a ratio of 2.0 the institution could exist for two years with no additional revenue before all the expendable resources were gone and in the second scenario the institution could operate for six months. No institution would ever want to do this, of course. The real significance of this ratio is that if the ratio is below .15, which would mean funds for about two months of operation, then an institution is probably going to have to borrow short term to make payments and the institution does not have the resources it needs to maintain the physical plant and to invest in the future. The developers of the CFI recommend a primary reserve ratio of at least .4. So if the primary ratio of your institution is declining over the six year period that this report covers, you should be concerned; and if the ratio is below .4, you should be concerned.
Net Income Ratio
The next ratio in the CFI is called the net income ratio. The point of this ratio is to show if the results of the institution's general operations are positive or negative and by how much. In business terms, is the institution making money or losing money in its basic day-to-day function of educating students? One understands immediately why this ratio is so important since if an institution is losing money in its basic operations over a period of time, eventually the institution will no longer be viable and will have to close. At some point an institution reaches the stage when it is too late to make the necessary changes in operations or there are no longer the funds nor the confidence left to make the strategic changes that would turn the institution around. That point is more easily identified in retrospect than it is at the time, but one of the purposes of the net income ratio is to provide a bellwether to warn of impending financial distress.
The challenge in calculating this ratio is determining what constitutes "normal operations" and what items are exceptional or outside of normal operations. We all face similarly difficult distinctions in our personal finances. Certainly the new sports coat or shoes are part of normal operations and purchasing a new house is not, but what about putting in a new driveway – which category would that fall under? The net income ratio is calculated by dividing the change in unrestricted assets from the beginning to the end of the year by the total unrestricted revenues, thereby setting aside anything having to do with restricted assets. The net income ratio only contributes 10% to the Composite Financial Index, but this small percentage is somewhat misleading since the surpluses or deficits indicated by the net income ratio in time have an impact on all of the other three ratios. A net income ratio of 2 to 4% over time is desirable.
Return on Net Assets Ratio
The third ratio, the return on net assets, is more straight forward, both to understand and to calculate. One takes the change in total net assets, both restricted and unrestricted, from the beginning of the year to the end and divides that number by the total net assets at the beginning of the year. It might be helpful to compare this ratio to the net income ratio that we just discussed; whereas the change in net assets used in the return on net assets ratio includes everything that happened over the year – expected, unexpected, the stock market, operations, everything – the net income ratio only includes the change in unrestricted net assets, thus limiting it more to operations. Both unforeseen and planned events can and will affect the return on net assets ratio and in some years the ratio may be below the level of 3 to 4% above inflation that is recommended. Nevertheless, occasional decreases are not a cause for concern if the financial reason for the drop is understood and is a one time financial event from which the institution can recover. If, however, the return on net assets ratio is not 3 to 4% above inflation for a period of time, you should be concerned.
The last of the four ratios is the viability ratio. In the first ratio, the primary reserve ratio, the resources that could be spent ( unrestricted funds ) were divided by the total expenses for the year; in the viability ratio the same "expendable" resources are divided by long-term debt. When expendable funds equal long-term debt, for example, the ratio would be 1. When expendable funds are twice the amount of long-term debt, the ratio is 2. A ratio of 1.25 results in a strength factor of 3. Falling below a ratio of 1.0 will limit the institution's ability to fund new initiatives through debt and will make current creditors nervous. Certainly not all debt is bad, but you will want to keep your institution at or above the 2.0 level on the viability ratio.
Once the four ratios are calculated, a single CFI score is computed by adding together the four ratios after they have been converted into strength factors and then weighted.