Report 98/52

Analysis of 1998 financial forecasts

Executive summary

1. Purpose

2. This analysis provides a summary of the financial position of the higher education sector. It is based on institutions’ 1998 financial forecasts provided in July 1998.

3. Key points

4. The 1998 forecasts were prepared and submitted before the outcome of the Government’s comprehensive spending review had been announced. However, institutions had taken account of previous Government statements on funding for 1998-99, and those relating to renewed growth and the expected levels of real terms reductions in unit funding in later years.
   
5. These assumptions enabled institutions to forecast marginal improvements in their operating positions compared with 1997. The funding position from 1999-2000 will be known later this year, when it will be possible to reassess these forecasts.
   
6. The financial forecasts continue to be a reliable indicator of the future levels of surplus or deficit, subject to changes in external factors, such as Government policy.
   
7. The expected outturn for 1997-98 is a £161 million operating surplus and represents an operating margin of only 1.7 per cent of total income, despite tight control of costs. Operating surpluses for the remaining years of the forecast period show a declining trend and are all below 1 per cent of total income.
   
8. Against a target operating surplus for the sector of 3 per cent of total income, to provide for reinvestment, the shortfall is over £100 million in 1997-98, rising to over £250 million by 2001-02. This target level is currently under review. We expect the outcome to be a range around 3 per cent, depending on the particular circumstances of individual institutions.
   
9. In all, 36 institutions are forecasting to have operating deficits in 1997-98, rising to over 50 (one third of the sector) by 2001-02. This is an improvement over the forecast position in 1997, when over half the sector was expected to be in deficit by 2000-01.
   
10. Across the sector, institutions have made realistic assumptions about increases in both income and expenditure. However, small variations in key assumptions on pay, inflation and real terms reductions in funding will have an immediate and significant impact on their operating and liquidity positions.
    
11. Liquidity continues to be at a relatively low level. Net cash balances, expressed as the number of days of total expenditure, remain around 15 days throughout the forecast period. Against a benchmark of 30 days, this provides little scope to meet the normal working capital requirements and to act as a cushion to manage change.
    
12. Fewer HEIs than in 1997 are forecasting to have negative cash flows from their operating activities (around a quarter of the sector was forecasting to have negative cash flow from their operations in 1997), but the total is still around 20 by the end of the forecast period.
    
13. As in previous forecasts, institutions are forecasting significant reductions in their capital expenditure. Expenditure on tangible fixed assets is forecast to decline from around £800 million in 1996-97 and 1997-98 to below £400 million by 2001-02, a fall of over 50 per cent. However, the forecasts do not include the substantial additional funding for research and research infrastructure in higher education over three years announced following the Government’s comprehensive spending review.
    
14. These sector positions disguise wide variations between institutions. Much of the sector’s financial strength continues to be concentrated in a few institutions.
    

15. Action required

16. No response is required to this document.
    

17.  
    

    Reliability of financial forecasts
    

18. The Statement of Recommended Practice: Accounting in Higher Education Institutions (SORP) came into force on 1 August 1994 and has been the basis for financial reporting since then. This covers both audited financial statements and forecast information provided to the Council.
19. Annex A presents a time series of forecast and actual operating results (defined as the surplus/(deficit) after depreciation of assets at valuation and tax.) since 1994-95. This shows that institutions’ forecasts tend to be prudent, but given the size of the sector, the variations are marginal and within normal forecasting limits. It is likely that the major factor influencing variations in forecasts between years will be changes in the external environment, such as Government policy.
    

20. Income and expenditure account
    

21. The forecast income and expenditure position for the sector is at Annex B and is summarised in Table 1.
    

22. Table 1 Forecast income and expenditure for the higher education sector

    	Actual results		Forecast
    	1995-96	1996-97	1997-98	1998-99	1999-2000	2000-01	2001-02
    	£M	£M	£M	£M	£M	£M	£M
    Total income	8,639	9,091	9,323	9,654	9,949	10,231	10,529
    Total expenditure	8,532	8,949	9,161	9,569	9,857	10,168	10,479
    Surplus/(deficit) after Depreciation of assets at valuation and tax	107	138	161	90	84	60	49
    Surplus as a percentage of total income	1.2%	1.5%	1.7%	0.9%	0.8%	0.6%	0.5%

23. These forecasts show an improved operating position from that forecast in 1997, as shown in Table 2.
    

24. Table 2 Forecast operating position for the sector: 1997 and 1998

    	1996-97	1997-98	1998-99	1999-2000	2000-01	2001-02
    	£M	£M	£M	£M	£M	£M
    1997 financial forecasts	64	41	39	-27	-45
    1998 financial forecasts	138	161	90	84	60	49

     

25. The improved operating position for 1997-98 is principally through tight control of expenditure, particularly staff costs. Total income increases by 2.6 per cent compared with 1996-97; total expenditure increases by 2.4 per cent, with staff costs only increasing by 1 per cent. The graph at Annex C shows the rates of change in actual total income and total expenditure from 1994-95 to 1996-97, and then projected to 2001-02 from the forecast data. This shows the slowing in rates of increase in expenditure in both 1996-97 and 1997-98, leading to some improvement in operating margins. The operating position for some institutions in 1997-98 is boosted by one-off surpluses on property transactions.
    
26. The improved position from 1998-99 compared with the 1997 forecasts reflects the marked change in the funding climate following the Government’s response to the Dearing Report. In particular, the additional £130 million funding for 1998-99 announced in November 1997, and the expectations of renewed growth no longer funded on a marginal basis, have been taken into account in these forecasts.
    
27. At the time of writing, the outcome of the Government’s comprehensive spending review is known in outline for 1999-2000 only. We will be able to assess this fully against the financial forecast assumptions when the details are available later this year.
    
28. The levels of operating surplus, while slightly improving from 1995-96 to 1997-98, are still below what should be generated to provide for reinvestment. We have previously indicated a target operating surplus level of 3 per cent of total income. We are undertaking a review of this target level and this is close to completion. We expect that this will lead to a range of operating surpluses, depending on the circumstances of individual institutions, around the current 3 per cent target.
    
29. The shortfall against the 3 per cent operating surplus target is:

30. 		£M
    	1997-98	119
    	1998-99	200
    	1999-2000	214
    	2000-01	247
    	2001-02	267

31. These figures do not reflect the wide range of operating positions for individual institutions. For example, 41 institutions had operating deficits in 1996-97. This is expected to decline to 36 in 1997-98, but the number increases to over 50 by 2001-02. Although this is an improvement compared with the 1997 forecasts, when over half the sector was forecasting to be in deficit by 2000-01, it still represents over a third of the sector and is far from satisfactory. In parallel, the number of institutions with annual operating surpluses above 3 per cent is expected to increase marginally from 35 in 1996-97 to 37 in 1997-98, before declining to only 15 by the end of the forecast period.
    
32. The analysis of the 1997 financial forecasts indicated that institutions may have been over-optimistic in their assumptions about future increases in some sources of income, particularly from overseas students. The assumptions underpinning the 1998 financial forecasts are more realistic across all income sources. The financial problems in the Far East have led to significantly lower estimates for overseas fee income, compared with previous years: forecasts for 1998-99 show a static income level in cash terms compared with 1997-98; and later years include modest increases of around 6 per cent a year.
    
33. On the whole institutions have been prudent in their assumptions of additional student numbers, within the total announced by the Government of 500,000 additional places for higher and further education by 2002. However, there is a wide range of individual assumptions.
    
34. The costs assumptions made by institutions in preparing their forecasts tend to be realistic. Pay inflation is assumed to be around 3 per cent a year from 1998-99 with additional assumptions about incremental drift of around 1 per cent. Non-pay inflation is in line with changes to the GDP deflator. Institutions are assuming that real terms reductions in unit funding will continue at around 1 per cent a year.
    
35. The key sensitivities which impact on the forecasts continue to be pay and non-pay inflation and real terms reductions in unit funding, as shown in Table 3.
    

36. Table 3 Sensitivity Analysis

    	1998-99	1999-2000	2000-01	2001-02
    	£M	£M	£M	£M
    Cumulative effect of increased pay inflation of 1%each year if no compensatory action taken	-55	-112	-171	-233
    Cumulative effect of increased non-pay inflation of 1% each year if no compensatory action taken	-35	-71	-107	-145
    Cumulative effect of 1% greater reduction in unit funding each year if no compensatory action taken	-34	-68	-104	-140

37. Table 3 indicates the significant impact from small changes in these key assumptions. Any one of these across more than one year, or more than one in any year, would be sufficient to eliminate the operating surplus across the sector.
    

38. Balance sheet
    

39. The forecast balance sheet for the sector is at Annex D. This still shows a declining liquidity position, although the rate of decline is slower than indicated in the 1997 financial forecasts. Current asset investments decline by £295 million (25 per cent) over the forecast period, while cash balances remain broadly constant over the same years.
    
40. Net cash balances, expressed in terms of the number of days of expenditure, remain at 15 days from 1997-98 to 2001-02 for the sector as a whole. Against a benchmark of net cash balances being at least 30 days, to provide for normal working capital requirements and as a cushion to manage change, these low forecast levels remain a matter of concern.
    
41. External borrowing is marginally lower across all years than expected in the 1997 financial forecasts. As a proportion of discretionary reserves (defined as the total of general endowments and the income and expenditure account balance.) this declines from 57 per cent at 31 July 1997 to an expected 52 per cent by 31 July 2002. This is a significantly lower proportion than being indicated by the 1997 financial forecasts (increase from 71 per cent to 77 per cent), largely through increases in general endowments across all years of the forecast period.
    
42. These figures are for the sector in aggregate and mask the wide range of financial positions for individual institutions. For example, over the forecast period: fewer than 10 institutions hold more than 50 per cent of the sector’s net cash balances; approximately 20 institutions hold 90 per cent of endowments; 20 per cent of the sector has no external borrowings, while 20 per cent of the sector accounts for between 55 per cent and 57 per cent of total borrowings; and fewer than 20 institutions account for 50 per cent of discretionary reserves.
    

43. Cash flow
    

44. The cash flow forecast for the sector is at Annex E. The forecast improvements in the annual operating position, compared with the 1997 financial forecasts, work through into the cash flow from operations. However, these are still far from satisfactory and still act as a constraint on the level of reinvestment.
    
45. The number of HEIs forecasting to have negative cash flow from operating activities increases from 26 in 1997-98 to 32 in 1998-99, before declining to around 20 by the end of the forecast period.
    
46. Income from investments declines, reflecting the reductions in short-term investments. This, combined with higher interest costs as long-term borrowing increases, brings the forecast (net of returns on investments and the servicing of finance) to around a break-even position from 1998-99. In previous years, income from investments has been a significant source of finance for reinvestment.
    
47. The previously forecast reductions in expenditure to acquire tangible assets continue. Such expenditure was around £800 million a year for both 1996-97 and 1997-98, but is expected to decline to less than £400 million by 2001-02. However, these forecasts were prepared before the outcome of the Government’s comprehensive spending review was known. The announced additional funding for research and research infrastructure in higher education, totals £1,400 million over three years ( £300 million additional funds for the HEFCE; £300 million for the Science Budget with a matching £300 million from the Wellcome Trust for research buildings, facilities and equipment; a further £100 million from the Wellcome Trust towards the costs of a replacement high intensity X-ray facility; and £400 million for the Science Budget for the recurrent and capital costs of priority research projects). These additional funds will begin to address the backlog in expenditure on research infrastructure highlighted in the Dearing Report.
    
48. The low forecast operating positions, combined with reductions in investment income and the need to service existing levels of external borrowing, limit the funds available for reinvestment across the range of capital needs. Similarly, the scope for institutions to take on further external borrowing is limited by the funds expected to be available for repayment. The impact of the low forecast levels of reinvestment is that large parts the sector’s infrastructure will continue to age, with replacement and refurbishment cycles for some buildings and items of equipment continuing to increase.
    

Annexes

All annexes are available as Excel spreadsheets.

Annex A – Surplus/(deficit) after depreciation of assets at valuation and tax

Annex B – 1998 financial forecasts

Annex C – Total income and expenditure for the HEFCE sector

Annex D – 1998 financial forecasts, balance sheet

Annex E – 1998 financial forecasts, cash flow statement