How can small institutions be effective at capital planning?
Many small institutions wrestle with the annual assessment of how to manage routine capital projects. A backlog of deferred maintenance items can further complicate planning. And the process often feels next to impossible when you consider ongoing discussions of how to add, renovate or replace student centers, housing, wellness or recreation facilities and academic buildings in the current economic climate where competition for students is very high, growth in net tuition revenue may be limited and capital campaign dollars may be strained. It is critical that institutions take proactive steps to manage the capital planning process to sustain their long-term success, both academically and financially.
Balance both sides of the equation
As a part of the institution’s strategic plan preparation and/or update, ensure that the capital sources are in line with capital uses. This step needs to occur annually and over the full time horizon of the strategic plan. The capital sources -- operating profit, gifts, debt, unrestricted investments, and proceeds from the sale of existing assets of the institution – should balance the uses -- renovations, replacements and expansions of existing buildings, systems and infrastructure supporting the institution, as well as operational needs of the college or university.
Take stock of assets
Identify the asset categories that require routine maintenance and periodic replacement. Each asset has a different use, which impacts how often and how much routine maintenance may be required in addition to major upgrades, renovations or replacements. Create a schedule, identifying the asset, its use, the last major upgrade and routine maintenance completed. This step will help identify gaps and prioritize where scarce resources can be allocated.
Don’t dodge depreciation expense
Every year, an institution incurs depreciation expense, a non-cash item. It’s critical to invest in routine capital, at a minimum, equal to annual depreciation. A key financial ratio that credit rating agencies and others use is the ratio of annual capital expenditures to annual depreciation expense. The minimum standard for that ratio is 1:1 – anything less indicates the institution is underfunded and may not be able to address its needs. Unfortunately, we’ve seen many institutions forgo spending on routine maintenance items. But cutting routine maintenance to meet the budget or operating metrics is a dangerous pattern if it continues for more than one or two years, as the accumulated backlog of needed capital expenditures can grow beyond the capabilities of the institution to fund in a reasonable time period.
There is always a greater need for capital than there are available sources of capital. Many institutions struggle with how to allocate the limited cash available each year and over the 3-5 years of a strategic plan. Projects that receive funding may not be the projects deemed most strategic by senior management and the board. Alternatively, projects may be funded because they are on someone’s wish list, not because it fits the long-term strategy. Many institutions lack the discipline to implement an annual capital allocation process, requiring departments across the campus to justify the need for the project and identify the potential funding source related to it.
To help prioritize, create an objective scorecard
Below is a sample (0 = not important, 1 = important, 2 = very important) that an institution might use to prioritize capital projects during the budget process. The projects with the highest point totals within the defined budget parameters would be funded in the current year and others would be deferred until sufficient sources of capital are identified to fund the project.
Consider funding sources
Identify which projects need to be funded with donor funds, university funds or outside debt. An institution’s ability to borrow for a particular project is based on a number of factors, including its credit profile, ability to repay, as well as the availability and cost of capital. Using financial ratios such as debt service coverage and expendable financial resources to capital can help manage the amount and type of debt financing related to a capital project. When using debt to finance a project, be certain the operational budget includes the full costs related to the debt. As part of calculating the cost, the upfront cost and the annual cost of the building should be factored into the 3-5 year forecast to determine if all costs can be absorbed by the institution. Many successful institutions build operating budgets into the capital campaign gifts they raise for various non-revenue producing buildings such as academic buildings or student centers. This ensures the long-term operational needs for those building are funded from capital campaign gifts rather than tuition, creating a self-sustaining capital project.
Identifying available funding sources each year, as well as setting parameters for evaluating which project is funded based on available resources, will add consistency and predictability to financial results. Additionally, complete planning should result in a longer-term vision for the institution and afford better communication across the institution as to when, how and why capital projects are funded. This discipline also takes pressure off the tuition revenue budget and results in less short-term cost cutting to pay for unexpected capital needs, in the end creating a more viable institution that is better prepared to weather financially turbulent times that may come its way.
Tanya K. Hahn is a managing director at Robert W. Baird & Co., a national firm that provides investment banking and capital planning services to higher education institutions.