Financial Management for Independent Schools

Level 4 Casselden Place 2 Lonsdale Street Melbourne Vic 3000 GPO Box 2317 Melbourne Vic 3001 T (03) 9637 2806 F (03) 9032 1579 www.vrqa.vic.gov.au Financial Management for Independent Schools

The effective operation of Factors contributing to financial sustainability independent schools is underpinned by sound financial management. Maintaining enrolments Sound financial management in Maintaining a minimum level of enrolments generates schools requires a proactive approach to income and is therefore necessary for the financial preventing, detecting and treating any sustainability of schools. signs of financial stress. Balancing profitability and developing infrastructure This resource has been produced Poor-quality school infrastructure can contribute to for independent schools operating a decline in enrolments. Infrastructure is generally funded from two sources - the school’s annual surplus in Victoria. It outlines some important (profitability) including fundraising, and borrowings. factors that contribute to financial Financial sustainability depends on an appropriate sustainability, common causes of financial balance between profitability stress, and methods for diagnosing the and borrowings (fig 1). financial health of independent schools. If the school’s surplus is too small, a school may elect to borrow to develop school infrastructure. If borrowings are higher, however, it must be recognised that interest expenses and loan principal repayments will increase which may inhibit the ability of the school to manage outgoing costs and further develop infrastructure in the future. If a school increases fees as a result of increased costs, this in turn may adversely impact enrolments. Common Causes of Financial Stress Factors associated with financial stress in schools include an excessive reliance on borrowing, maintaining an insufficient surplus, and inadequate financial skills Figure 1: Balancing profitability and borrowings among school managers and governors.

2 Financial Management for Independent Schools 1 Completing Form B

Diagnosis of Financial Health Industry surveys indicate the current average There are several ratios that can help school managers student/teacher ratio for independent schools in Australia and governors make informed decisions (their fiduciary is 15.2 primary students per primary teacher and 11.1 and often statutory duty) on matters that influence secondary students per secondary teacher. A school with financial viability and sustainability. relatively low student/teacher ratios (fewer students per teacher) will generally have higher costs per student. Ratio analysis is the practice of comparing absolute These costs may need to be passed on through higher figures with each other to help make informed decisions on fees or offset by other sources otherwise profitability will relative health. A selection of ratios used as an indicator of be adversely affected and financial sustainability of the financial health in schools are summarised below. school may be at risk. Profitability ratios Solvency ratios This class of ratios is at the centre of influencing Solvency refers to the amount of cash a school has financial sustainability. available relative to debts that are due for payment. Net operating margin If the amount of cash is low, relative to debts due and payable in the short term (12 months or less), Net operating margin (calculated before interest and this indicates poor solvency. depreciation/amortisation is accounted for) is a crucial measure of profitability. Profit is necessary to fund asset The ultimate test of solvency is whether a school can pay replacement and service debt. debts as and when they fall due. If it can’t, then the school could become insolvent unless it has support Profitability is affected by a school’s income and expenses from creditors (parties that the school owes money to). relative to each other. It is possible to obtain industry The ramifications of being insolvent include concerns benchmarks for income per student and expenditure over the future viability of the school, as well as the per student, allowing a comparison with your school’s school governors potentially becoming personally relative performance. liable for the debts. Industry surveys indicate that the average independent Working capital ratio school in Australia produces an operating surplus (earnings before interest, depreciation and amortisation This ratio is commonly used to assess solvency. It is ‘EBIDA’) of $115,000 for every $1 million of total calculated as current assets (things owned that are either recurrent income (fees, grants, other income). cash or easily converted into cash) ÷ current liabilities (money owed which is payable within the next 12 months). If a school had $100,000 in current assets and $200,000 Calculating net operating margin in current liabilities, their working capital ratio is 0.5 $ 115,000 EBIDA indicating the school has 50 cents for every dollar due and payable in the next 12 months. Depending on due ÷ $1,000,000 total recurrent income dates, the school may not be able to pay debts when = 11.5 per cent net operating margin due. Ideally for independent schools the working capital ratio Student/teacher ratios is 1.0 or higher. The number of teachers employed relative to the number of students is strongly correlated to the school’s operating costs. On average, about 60 per cent of a Calculating working capital school’s expenditure is spent on teacher wages. $100,000 current assets ÷ $200,000 current liabilities = working capital ratio of 0.5

3 Financial Management for Independent Schools

Sustainability ratios A prudent interest cover ratio is three times or higher. This class of ratios is mostly concerned with a school’s If a school could notionally pay its interest expense three ability to replace property, plant and equipment and meet times or more from its annual operating surplus, then loan obligations. Two ratios commonly used to assess chances are they will also have sufficient surplus to meet ability to meet loan obligations are outlined below. loan principal repayments. By setting a policy of three times or more, this also allows for a margin of error, for Debt per student example if profitability declines or interest expenses Industry surveys indicate the average Australian increase. independent school had debt per student of $8,000 The interest cover ratio represents only one indicator in 2012. The average debt of a school with 500 of financial sustainability and maintaining detailed cash students is $4 million. Schools with relatively more debt flow projections is crucial. In a declining interest rate are generally higher risk, but equally a school with environment, a variation of this ratio, use of the debt relatively low debt could be at risk if its profitability is not servicing cover ratio (EBIDA ÷ interest and principal generating sufficient cash to service the loan. So when repayments) may be more appropriate. assessing debt serviceability it is necessary to consider both the amount of debt held by the school and its Managing Financial Risk profitability. These ratios outlined above are a guide to help schools Schools with relatively high debt and significant assets, manage financial risk. Some additional steps schools need a higher surplus to be financially sustainable. If may wish to consider include: there are any concerns over servicing debt, either the surplus needs to be increased or the size of the debt • calculate the ratios outlined in this resource for reduced (ideally, don’t over borrow in the first instance). your school for immediate past years and future years (budgets) • consider trends and to what extent the results suggest a Calculating debt per student financially sustainable position for your school $4,000,000 debt • ensure the school managers and governors ÷ 500 students have a good understanding of these and other = $8,000 debt per student imperatives regarding the good financial governance of the school • consider attending suitable training offered by Interest cover ratio industry associations. A popular ratio used to test the relationship between debt and profitability is the interest cover ratio. This ratio measures the notional number of times a school could Prevention of financial problems is better pay its interest expense from operating cash flows. than seeking a cure. If you think your school is at risk, seek professional assistance early. For independent schools this is generally calculated as earnings before interest, depreciation and amortisation (EBIDA) ÷ interest expense. Disclaimer This guide has been published for independent schools in Victoria. All material should be regarded Calculating interest cover as information only and individuals should rely on $ 115,000 debt their own enquiries when formulating decisions for ÷ $ 38,000 debt themselves or their clients. = Interest cover of three times This document was produced by the VRQA and John Somerset.