As we shared in our article “The 6 Most Important Financial Questions a Board and President Must Ask About the Budget”, five-year projections are essential tools for university leadership making critical decisions today.
While most for-profit companies leverage this tool, it has been underutilized in higher education. When a company is growing constantly, and there are few financial challenges, we do not focus on the future bottom line because we assume it will be positive.
With so much enrollment uncertainty and net tuition declines from increased discounting, having projections for five or more years is critical. We have been spending 25% of our time over the past 12 months helping institutions develop and stress test the projections to determine if assumptions are reasonable. We thought we would share some of our insights and lessons learned from these conversations.
Decide what tool you will use and who will build and manage the model.
Tactics are important. Many institutions have a budgeting tool, but that tool may not be able to build multi-year projections. You may need to use Excel or upgrade your existing tool. You also need to decide who will build and manage the tool. We can help build the model, but internal ownership is critical for long-term success. Someone on your staff with a sightline into trends like enrollment, discounts, and payroll decisions needs to capture the constantly evolving assumptions.
Agree on a philosophy for assumptions. I prefer most likely.
I keep hearing the term conservative used, where modeled revenue and expenses are at the conservative level. That quickly becomes the worst-case scenario. In this moment, we need the most likely case. I recognize it is difficult to know exact numbers, but we need to hypothesize what is most likely given historical trends and internal operations.
Develop a baseline grounded by the actual audited results.
The first step is to understand what your bottom line would look like if you did nothing differently. To do this, we generally start with at least 2 years of historical data, plus the current year’s budget, and the year-end forecast. We adjust these numbers to strip out unusual activity like one-time federal grants or significant one-time donations for operations.
This data should also be based on the unrestricted operating results and reconciled to the audit. Financial results should also have a relationship to accrual-based statements and include all activity charged to restricted operating funds. If your institution is not used to budgeting this way, consider if it is important to make this shift. I have worked with many institutions who ignore restricted or plant activity and are surprised when they end the year with an unrestricted operating deficit. It’s because they were not looking at the full picture. If your budget reflects $170M in operating expenses but your audit reflects $200M, you are not budgeting for the full picture.
The model should reflect the format of the internal financial statements and the reports that the board and management review. This often means that we categorize more detailed line items by type of expense like salary, benefits, travel, etc. I see little use in budgeting based on functions like instruction, academic support, and institutional support. Lastly, these projections should not be at the same account-by-account level of detail as the budget. Rather, they are at the financial statement level.
Now we are ready to develop a baseline 5-year model that includes:
- Revenue assumptions for:
- Undergraduate and graduate net tuition and room and board (based on core drivers including entering class assumptions, retention rates, discount rates, planned price increases, % students living on campus, etc.). We generally use our enrollment budget model as the starting point for the 5-year model by adding columns to reflect new enrollments.
- Contributions, endowment spend rate, grants, and other revenue. (Make philanthropy assumptions around annual funds and current use of restricted funds available for operations. Do not make them on capital and endowment gifts which will reduce your debt or only be available based on an annual spend rate after 12 quarters.)
- Expenses & cash flow assumptions for:
- Salary and benefits, including cost of living adjustments and benefit rates. You will need full-time, part-time, adjunct and student labor costs. These will become important conversations in later phases of cost reduction
- Meal plan cost structure (fixed vs variable per student)
- Property, plant, and equipment plan including additions, depreciation, and impact on debt
- Capital budget plan with anticipated service dates, impact on debt, etc.
- Other operating costs including assumptions for inflation
Many of the above items will require separate schedules because of the many details necessary to support the calculations. Consider creating an assumption input tab where all major assumptions are entered and linked to other sheets. This allows everyone to see the numbers quickly. They’ll know immediately the number of freshmen, discount rate, spend rate, annual fund amount and be able to make changes and update the entire financial model.
Model all assumptions and stress test them using external data and internal knowledge.
Use the enrollment model from your budget and roll it forward 5 years. This should consider enrollment numbers based on high school graduation predictions and discount rates, overlaying assumptions around endowment growth and capital purchases. It’s a real conversation starter when the leadership team and board discuss enrollment and why you believe it will grow despite a decline in high school graduates. It also clarifies the impact on the bottom line of a new building.
I like to color code each line item based on how certain I am of the outcome. For example, enrollment is likely to be yellow, or orange given all the uncertainties, but depreciation will be green, because I am pretty certain of this number. This allows the management team and board to focus on the riskiest numbers.
Add cash flow adjustments to the bottom.
We should build our models to align with the audited financial statements and on an accrual basis. This is the picture we paint for the outside world. However, we still need to understand the impact on operating cash. To do this, I add a cash flow reconciliation section to the bottom which adds back depreciation and subtracts debt principal and capital investment and related funding. I do not reflect all cash adjustments because things like changes in student accounts receivable and accounts payable are generally short-term timing cycle differences.
Layer in new initiatives and commitments. DO NOT INCLUDE a wish list yet.
Once you’ve developed a baseline budget, you can overlay other initiatives/strategic plan initiatives. It is difficult to stress test assumptions if there are too many moving parts. I recommend building each new initiative as a separate tab in the same format as the projections. This method also provides clarity on the bottom-line impact of each initiative. For example, if you are launching a new program at a cost of $1M per year, but are modeling only 20 new students, will this program contribute to the bottom line? I have had countless conversations with institutions and realized they are unclear about how their new initiative will increase revenue. Often, teams want to increase marketing campaigns or enrollment staffing without the corresponding additional students. How can we better monitor ROI on our new investments?
Now you are ready to answer the important question, how big is your deficit as a percentage of total expenses? Based on your current deficits and liquidity, how long do you have to solve your problem?
This model allows you to examine the real deficits you may be facing each year and provides a clear understanding of your net cash liquidity. In developing this model, an institution will be able to analyze and understand what the shorter- and longer-term future looks like and make decisions based on this analysis. It provides a roadmap to help institutions navigate future uncertainties, enabling them to adjust in a timely manner.
Most importantly it helps you to orient around the problem you are trying to solve rather than focusing on one year at a time.
Many institutions model in placeholders for expense reductions at this stage but this is not the right time to do this. We need to first align around the problem we face, agree on its size and complexity, then set a deadline to solve it.
You may consider including a five-year Statement of Position, and Long-term Operating Liquidity (Operating Cash and Board Designated Endowment) to help provide insight into the implications of decisions.
I shared in prior articles that if you borrow 25% of your restricted funds and are still running a deficit, you have little time to solve your problem. Once you hit the 50% mark, most institutions close (suddenly) within 2 years, so you should consider the ethics of staying open.
With this understanding, you will be ready to model new initiatives from expense reductions to revenue enhancements. Check back next month for more on this!
Please reach out if you have questions or want clarity on any of these topics.
Photo by Paul Skorupskas on Unsplash