25.2 Capacity and Affordability
(Last Modified on May 14, 2015)
Section 9.8.3 of the BOR Policy Manual addresses capital liability capacity and affordability as follows:
“Capital liability capacity is limited and directly impacts the affordability of education and services provided to USG students. Therefore, resources used to fund capital liability lease payments must be managed strategically from both an overall system and institutional perspective and from an institutional perspective. Capacity is an institution’s ability to service capital liabilities through operations and is driven by strength in income, cash flows, and overall financial leverage.”
Affordability is an institution’s ability to service capital liabilities through operations and is driven by strength in income and cash flows, while capacity relates to an institution’s financial leverage. Capital liability capacity and affordability are most commonly measured by ratio analysis.
25.2.1 Liquidity Ratio
(Last Modified on July 9, 2020)
Before any decisions about capital liability capacity and affordability can be made, the first fundamental financial metric that will be examined is liquidity. An institution encountering liquidity problems with daily operations will have an elevated risk profile when considering the institution’s ability to absorb the additional burden of servicing payments for long-term capital obligations. The basic financial measure for liquidity is the current ratio.
Current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories, prepaid expenses and other liquid assets that reasonably can be expected to be converted to cash within a year in the normal course of business. Conversely, current liabilities include accounts payable, accrued liabilities, short-term debt and other obligations that are due within one year.
A current ratio of 2.0 is preferable; a current ratio of 1.5 is considered the minimum ratio necessary for consideration of expanding capital liability capacity, if the capital liability burden ratio discussed below is at or above the 5 % threshold.
25.2.2 Capital Liability Burden and Debt Service Coverage Ratios
(Last Modified on July 8, 2016)
After liquidity concerns have been addressed, USG will employ primarily two capital liability ratios to measure capacity and affordability: the capital liability burden ratio and the debt service coverage ratio.
The capital liability burden ratio will be the USG’s key measurement ratio in accordance with Section 9.8.3 of the BOR Policy Manual. This ratio measures capital lease payments (rental payments) as a percentage of total revenues.
The numerator should be base rent, which is effectively the principal and interest portion of the annual rental costs. On several projects, base rent has been adjusted to allow the projects to cash flow properly. For those projects, the additional base rent also will need to be included. The renewals and replacements portion of the rental payments are not included in the numerator.
The denominator of the fraction, total revenues, should include operating revenues and non-operating revenues, excluding capital grants and gifts and special item transfers.
Section 9.8.3 of the BOR Policy Manual sets parameters for capital liability capacity as follows:
“The capital liability burden ratio shall not exceed five (5) percent for the USG taken as a whole; therefore, institutions shall strive to ensure that new PPV projects submitted for approval do not exceed five (5) percent. Institutions may, consistent with approved strategic objectives and sound fiscal management, submit proposed PPV projects that result in a capital liability burden ratio that exceeds five (5) percent; however, the proposed PPV project should not result in a capital liability burden ratio greater than seven (7) percent. Finally, institutions may, under extraordinary circumstances, submit projects that exceed the seven (7) percent capital liability burden ratio, but under no circumstances shall an institution submit a project for approval that exceeds a ten (10) percent capital liability burden ratio.”
This ratio measures the institution’s ability to cover annual debt service payments from current year resources and is essential in verifying that annual lease payments do not consume an inordinate amount of current operating income. USG institutions should strive for a Capital Liability Service Coverage Ratio (Coverage Ratio) of at least 2:1.
The numerator comes from the Statement of Revenues Expenditures and Changes in Net Position (SRECNP). It includes operating income (loss) plus depreciation expense plus net non-operating revenues plus interest expense. Depreciation expense is added back because it is a significant non-cash expense and interest expense is added back to reverse the netting effect against non-operating revenues. Capital grants and Gifts are not included in the calculation.
The denominator is the same as the numerator used for the Capital Liability Burden Ratio, which is the base rent (principal and interest portion of the annual rental costs). As stated above, on those projects in which base rent has been adjusted to allow the projects to cash flow properly, the additional base rent also will need to be included. The renewals and replacements portion of the rental payments are not included in this calculation.