Feeling the crunch?
September 2008
Nick Sladden provides an analysis of CaritasData's findings on capital expenditure in independent schools...
Past articles in the Data series (see Cathy Pharoah's article, Income variations) have highlighted the difficulties in analysing information for the third sector as a whole. One such danger previously identified is that a ‘one-size-fits-all’ analysis can reach conclusions that are too general if variations in sub-sectors are not considered. This is particularly pertinent to charitable independent schools, but even within this sub-sector there are significant differences. For example, a mixed day preparatory school with 300 pupils will have many different challenges to a senior boarding school with 1,000 girls.
As such, this article considers the financial performance of schools generically against recent economic indicators and avoids using statistics only applicable to certain types of school. The data used has been obtained from 700 charitable independent schools over the three academic years to 2006/07.
The importance of sustainable surpluses
It is appropriately stated in SORP 2005 that, unlike a profit or loss in a commercial entity, a charity’s net surplus or deficit should not necessarily be regarded as an indicator of a charity’s performance. However, for any charitable school to be long-term sustainable as a going concern, its ability to consistently generate surpluses is paramount although the same rules apply as with any other charity: charitable schools should not be building excessive reserves (see Paul Palmer's article, Something in reserve). Following this assumption (that schools do not either have an excess or, indeed, a deficit of reserves), then the annual surplus is an important measure of a school’s financial viability.
Furthermore, there is, in fact, a need to generate surpluses to provide the cashflows that are required to fund future capital expenditure. After all, a school’s property is fundamental to its existence. This applies equally to those schools that have borrowed to fund capital expenditure as the loan repayments still need to be made from surpluses. For schools with borrowing, evidence already exists to suggest that the credit crunch has already taken hold with an increased reticence from bankers to provide further borrowings or funding for large projects. These current economic conditions make the generation of surpluses critical for future financial security.
However, while the more affluent charitable independent schools may be able to complete successive capital projects within short timescales, it is the majority that are only too well aware of the need to create reasonable surpluses to reinvest in their building stock before it becomes too neglected. The problems associated with a failure to maintain capital expenditure is a lesson to be learned from the state sector where there was a period of low or nil investment in building stocks throughout the final 30 years of the last millennium. Since 2000 this prolonged period of underinvestment has necessitated a £35bn catch-up commitment by the Government to rebuild or substantially refurbish an estimated 3,500 state secondary schools. Some of this rebuilding programme will be achieved through the Academy schools programme but the independent schools sector is not always as fortunate in being able to rely on single multi-million pound sponsors or the state to fund its capital projects. Therefore, and even when borrowing, capital projects cannot be supported without generating financial surpluses.
Overlooking the credit crunch for a moment (if only it were that easy) and considering the recent prolonged UK economic growth to 2007, the average net surpluses being recorded by schools over the past three years appear to show the schools sector to be in a healthy state. A steady level of ‘profitability’ around the £400,000 level is evident during this period as shown in figure 1. The table also shows the average surplus as a percentage of total income and again, at first glance, this looks reasonable and appropriate (i.e. not excessive) for a charitable sub-sector.
Figure 1 also shows the average annual level of capital expenditure for the last three years to be at a higher level than the average surplus. Therefore, through a more detailed analysis, the net return on total income being achieved and the average annual net surplus actually appears to be insufficient given the average annual capital spend. However, it should, of course, be recognised that depreciation is provided in arriving at the average annual net surplus although this only measures the cost of past projects rather than the ability to fund those of the future. In practice schools do not consistently spend similar amounts on capital projects year after year. Instead, the underlying data behind the average capital spend figures reveals that a typical school would complete a ‘once in a decade’ project at a cost of, say, £5m with reduced expenditure (other costs such as equipment, fittings, etc.) in the other nine years. This is the reality behind the most recent average annual capital spend figure of £644,000.
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Figure 1: Financial performance and capital expenditure
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Unless otherwise stated all figures are averages and in £’000
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2006/07
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2005/06
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2004/05
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Net surplus
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388
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407
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358
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Capital expenditure
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644
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710
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594
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Total income
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6,023
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5,796
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5,347
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Net surplus as % of total income
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6.4%
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7.0%
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6.7%
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Based on CaritasData analysis of 700 charitable schools
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Current state of the economy
The credit crunch cannot, of course, be overlooked and it has never been far away from the news headlines in the past year. For example, the Sunday Times reported on 3 August 2008: ‘Middle-ranking private schools are the latest victims of the credit crunch. Six have closed and 12 more are reported to be in trouble. The news has prompted fears that well-known institutions will have to accept pupils from “further down the food chain” because many parents can no longer afford the fees, often in excess of £20,000 a year. Wentworth College, in Sandbanks, Dorset, is closing after 137 years. It has blamed a fall in pupils on the “current economic climate”. Wispers school, in Haslemere, Surrey, and La Sagesse, in Newcastle upon Tyne, are also closing.’
Although it is widely believed that school fees are the last ‘luxury’ to be foregone, there are likely to be casualties arising from the impact of the credit crunch and downturn in the UK economy. The slowing economy is seemingly beyond assistance from interest rate policy in the short-term and there is the increased threat from inflation as seen in the first half of 2008. As well as being detrimental to government receipts, a weaker economy tends to become bad news for earnings and employment which is the means by which most people pay for their child’s school fees.
The impact of a weaker economy may not be as problematic as it has been in the past. Following the introduction of a wide range of new financial products, the proportion of fees funded from employment alone over the past decade has undoubtedly reduced. The significant increase in the number of homeowner equity release schemes has been a salvation for those funding children through school who have been unable to use income from employment alone. However, the 2008 UK property market has also affected equity release schemes as it has been widely reported from the Bank of England’s own figures that the amount of equity released in early 2008 fell to £5.04bn from £13.89bn for the corresponding period in 2007. With pressures on employment from the slowing economy, a rising cost of living from oil and food prices and a stagnant property market, affordability of fees is likely to be the most important issue for the next academic year.
Figure 2 shows both the Average Earnings Index (AEI) and Retail Price Index (RPI) for the 2006/07 academic year. This shows that in the recent strong economy schools have been able to achieve fee income growth in excess of both AEI and RPI. Both of these indices have also been less than the annual increases in total operating costs and teaching costs. The headline fee income growth of 5.37 per cent in 2006/07 fails to show the complete picture as it represents a combination of growth in pupil numbers and increases in published fee rates. Although the number of pupils in independent school education continues to rise, the increase was just 0.9 per cent in 2006/07. The growth in fee income has therefore substantially been achieved through higher rates of fees averaging an increase of 4.4 per cent year on year, which still far exceeds the AEI and RPI indices for the corresponding period. In the post credit crunch era it will be challenging to sustain fee income growth in excess of these indices, which could result in lower surpluses and the postponement of capital projects.
Figure 2: AEI and RPI comparisons for the 2006/07 academic year
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If the economy and property market are unable to provide help to charitable schools and fee payers respectively, then maybe the 30 per cent year-on-year growth in portfolios of listed investments in the three years to 2007 (see figure 3) may be a financial reserve to draw upon. Indeed, the average level of investments held by schools is now £1.6m although, again, this may show schools to be better funded than the reality. Capital expenditure is also central to this financial measure as listed investments are often an effective method of storing surpluses to provide a return until the next capital project. Alternatively, a drawdown of investments can help to fund short-term deficits in any particular year. Listed investments are not always a resource that can be used in these ways as portfolios are often aligned closely to permanent endowments where the capital must be preserved.
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Figure 3: Year on year investment portfolio growth and bursary awards*
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2006/07
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2005/06
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2004/05
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Market value of listed investments
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1,614
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1,120
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959
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Investment income (including property)
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106
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86
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79
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Bursary awards
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303
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290
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256
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*All average figures and in £’000
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Useful income streams can also be provided by listed investments (permanent endowments sometimes included) to fund annual bursaries but these awards have similarly become costlier. There has been some slowdown in the growth of these awards with the substantial 13 per cent increase in bursaries awarded in the 2005/06 academic year shown in figure 3 not being repeated in the following year. Of relevance here is the public benefit test under the Charities Act 2006. The Act itself received Royal Assent in November 2006, although this would have been too late for any change in governors’ policies on bursaries to affect these data. However, since it was introduced in December 2004 the Charities Act took two attempts over two years to get through Parliament as a Bill and throughout that time schools would have been alerted to the need to consider bursaries as an effective method of including those who cannot afford the fees at a charitable independent school. This was a major factor in the rising cost of bursary awards in this period and perhaps reflects the reactions of governors to the public benefit test. (See Viki Bowles's and Michael King's article, Better perticulars, and News review on Public benefit and also News Review, Charities charging "high" fees face benefit challenge).
The good news is that the challenge of the public benefit test (which became effective in the Charities Act from April 2008) can also be met by non-financial strategies. Following guidance issued by the Charity Commission in January 2008 most charitable schools should be confident in being able to pass the public benefit test and many are continuing with and becoming increasingly inventive in ways of including those that cannot afford fees. By their nature, these strategies are not evident from any generic financial analysis of the charitable schools sector. For example, schools are already sourcing bursaries from other charities, providing teachers on secondment and sharing lessons and facilities with state schools. Others are publishing educational material and best practice via the internet or using educational blogs. These activities are reinforcing the core objective of charitable schools to further the provision of education and not solely just benefiting the minority.
Author: Nick Sladden
Nick Sladden is head of Baker Tilly's Charities and Education Group in the south-east and responsible for a portfolio of charities, independent schools, academies and other not-for-profit organisations. Nick has written and lectured on sector regulation as well as governance issues and is also a trustee for a hospice.
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