Underlying disorders: The financial health of UK higher education institutions

It is not difficult to see why university vice-chancellors are perturbed about the future. Take every major income stream they rely on - direct public funding, tuition fees (both undergraduate and postgraduate) and overseas fee income - and each is uncertain and unstable.

Even research income - protected by the government overall - is a problem for the majority owing to the increasing concentration of funding on a small band of institutions.

It is a solemn point not lost on Andrew McConnell, chair of the British Universities Finance Directors Group: "There aren't many areas of our income that won't be of concern at the moment. You can look at every category and say there's an issue here that needs to be addressed in the next 12 months."

But scanning some of the record surpluses notched up by universities in 2009-10 (see related file, right), one would be forgiven for thinking that the sector is booming rather than standing on the edge of a precipice.

A closer look reveals that the surpluses are a result of the sector battening down the hatches, not embarking on an age of plenty. So given the oncoming tempest, will the surpluses be enough to shelter the sector from the storm?

On this, McConnell is wary. With student choice dictating income, the pressure will build on universities to invest heavily in their campuses. But with debt already high and government funding drying up, the academy is in a parlous position. "The surpluses that are being declared here, while they represent a good performance compared with the previous year, are not at the level they need to be to make that investment," he warns.

According to figures taken from Grant Thornton's forthcoming report The Financial Health of the Higher Education Sector, universities and higher education colleges produced a surplus of £810.7 million in 2009-10, a figure nearly two and a half times greater than in 2008-09 and representing 3.1 per cent of total income.

Although the academic year under consideration predated the publication of Lord Browne of Madingley's review of fees and funding in England, universities were well aware of the fiscal storm brewing. The Labour government had announced cuts to higher education in December 2009 and within days of gaining power in May 2010, the incoming Conservative-Liberal Democrat coalition was busy making its own savings.

Luckily, this hardly dented the surpluses most universities had accumulated.

As well as the overall surplus, 79 institutions produced remainders of more than 3 per cent of income - the English funding council's recommended minimum - up from 45 in 2008-09. The number in deficit fell to 26, 16.9 per cent of the 154 institutions measured, from 33 in 2008-09. The biggest deficits on paper were Lancaster University (£11.3 million) - which paid off a long-term debt - Leeds Metropolitan University - still charging a £2,000 fee that year - and Thames Valley University - deemed "at higher risk" by the funding council for 12 years.

Among the mission groups, the Russell Group of large research-intensive universities was way ahead in cash terms, producing a surplus of £324.3 million, but all had surpluses of more than 2 per cent of income. The lowest was the 1994 Group at 2.2 per cent and the highest was GuildHE at 6.1 per cent.

However, it is the underlying figures that tell the story of an academy preparing for the worst.

For example, in the 2009-10 academic year, universities spent a huge amount on restructuring, which often means job losses and cost-cutting. Outgoings on staff, which traditionally universities have needed to keep in check to stave off financial problems, offer further corroboration.

In 2009-10, UK universities allocated £157 million to reorganisations, with the Russell Group spending £67.7 million, by far the largest proportion of the total sector spend on restructuring (43 per cent).

Staff costs, including pension contributions, were still on the rise but the rate of growth appeared to have slowed - they increased by 4 per cent compared with a 16.7 per cent rise between 2006-07 and 2008-09. As a percentage of income, they also fell slightly (54.7 per cent compared with 55.8 per cent in 2008-09). At only three institutions were they higher than 64 per cent, a funding council benchmark for "potential concern", compared with eight the year before.

These statistics point to an attempt by the sector to control the key part of its variable costs, but vulnerabilities are still visible in other important areas, such as the level of debt.

By the end of July 2010, the academy's total borrowing amounted to just under £5 billion. Although this represents a smaller proportion of the sector's overall income (18.7 per cent) than in 2008-09 (19.5 per cent), it can be attributed to solid rises in that income.

There are also big differences between the mission groups. Borrowing as a percentage of income was highest in the 1994 Group - 36.9 per cent - whereas for the Russell Group it was just under 13 per cent.

David Barnes, partner and head of education at Grant Thornton UK, says that these figures are evidence that some institutions have already been investing heavily in their physical estates to make sure they are up to scratch and can impress students.

The risk is that those institutions that have spent money on the basis that they are going to recruit more students might suddenly find that numbers are not only capped but also in decline, he warns.

"They could find quite quickly that they are getting a double hit - losing income from students while also having to service debt that may be rising," he adds.

Delving deeper into the debt figures - especially by looking at the cost of servicing the borrowing - reveals potential problems.

Interest payments, including those paid on pension liabilities, cost the sector £446.4 million, or 1.7 per cent of income. This figure varies from just above 1 per cent for the Russell Group to more than 3 per cent for Million+, which represents post-1992 universities.

Most worryingly, interest payments at 12 institutions were higher than 4 per cent of income - a benchmark set by the Higher Education Funding Council for England, which requires universities to seek permission for further borrowing. At another 18 institutions, interest costs were between 3 and 4 per cent.

An additional area for concern is the ability of universities to meet their short-term financial obligations, measured through the "quick ratio" of current assets to current liabilities. There was a slight improvement overall but 34 institutions had a ratio of less than 1, indicating that they would have been unable to meet their short-term liabilities.

Meanwhile, gearing - which measures the ratio of debt funding to internal reserves - also highlights some possible weaknesses: the higher the gearing, the more vulnerable a university is. The sector average was 24.9 per cent, but 12 institutions were geared by more than 100 per cent.

Of course, debt is of less concern if the income is continuing to stream in, and it certainly was until the end of July 2010. As a whole, the sector earned £26.41 billion in 2009-10, an increase of 6.1 per cent on the previous year.

But identifying the sources of this income unmasks the real vulnerability of some UK higher education institutions to the uncertainties of the post-Browne world.

First, there is the degree to which universities are dependent on income from funding councils. In university accounts, these are mainly organisations such as Hefce, but can also include bodies such as the Learning and Skills Council and the Training and Development Agency for Schools.

The main funding council grants traditionally are the most important sources of funding. However, in England, universities with a heavier teaching bias are about to see them drop dramatically owing to plans to slice funding by up to 80 per cent. In other parts of the UK, the main grants are under pressure too, owing to reduced funding settlements for the devolved parliaments (see box, below). As a result, universities are immediately at risk if they are highly dependent on funding council income.

Russell Group and 1994 Group universities derived per cent and 31 per cent of their income respectively from funding council grants. A lot of that income may remain relatively stable if it is quality-related (QR) research funding, but the story is very different elsewhere.

In 2009-10, University Alliance, Million+ and GuildHE members all depended on funding council grants for more than 40 per cent of their income. The vast majority of this is also teaching funding so this pot is vulnerable, especially in England, where fees will largely replace it.

Individual institutions relying on funding council grants for at least half of their income are particularly at risk: in England, they include specialist and university colleges, but also broader higher education institutions such as Bath Spa University and the University of Plymouth (both 52 per cent in 2009-10).

The main funding council grant is not the only source of income that is under threat. Other income streams that rely heavily on government cash include research council funding, teacher training contracts and money from the NHS for educating nurses and other health professionals such as midwives.

Research money may be relatively protected (although it is taking a substantial capital hit), but there is real uncertainty over the future of the other funding streams because of the government's shake-up of the NHS and its school reforms.

Although such funding is unlikely to disappear overnight, Grant Thornton's data do point to the types of institution that stand to lose most if this happens.

More than 60 institutions received money for teacher training, with about 15 getting a grant of more than £5 million in 2009-10. A few got more than £10 million: Canterbury Christ Church University, Edge Hill University, Manchester Metropolitan University and the University of Cumbria.

Fewer universities - fewer than 30 - had education contracts with the NHS, but for those that did, the values were bigger. Some of those with large contracts included Sheffield Hallam University (£ million), Birmingham City University (£26 million), King's College London (£21 million) and Northumbria University (£22 million).

Taking all these strands together, it is easy to see that universities that are highly dependent on the main funding council grant and public money from other "uncertain" sources are more open to risk. Of course, to replace public funding for teaching, the government is planning to allow universities to charge up to £9,000 a year in tuition fees from 2012-13.

However, currently universities know they will get a relatively fixed lump of cash from the government in order to teach students. In the future, this income stream will be more open to fluctuations in demand.

If overall demand falls because higher fees deter students from going to university at all, or if alternative providers such as further education colleges and private companies start to penetrate the market, then this income source will become less reliable, especially for teaching-led institutions.

"We might just see that student numbers aren't quite as robust as people are assuming they are going to be," says Barnes. "If you have a 10 per cent or so decline, that is going to have a significant impact on the income line."

The dependency on existing tuition fees is apparent in the 2009-10 figures, the fourth academic year after top-up fees were introduced by Labour in 2006-07.

After funding council grants - which represented 33.7 per cent of the sector's income - UK and European Union tuition fees and contracts were easily the second-largest source of finance at 21.8 per cent of total earnings (£5.8 billion).

An element of this income comes from taught postgraduate courses, which themselves face uncertain future demand as fees are set to rise dramatically and students will not have access to government-backed loans to fund their studies.

Meanwhile, there is also the other major source of fee income that the sector relies on - overseas students. In the past few years, it has become an increasingly vital revenue stream that has made up for shortfalls elsewhere.

In 2009-10, overseas students were worth £2.4 billion to higher education in the UK - 9 per cent of total income - and in England the figure was closer to 10 per cent. This represents a 18.1 per cent rise on 2008-09. More than 40 per cent of overseas fee income went to Russell Group members, although it represented 9 per cent of their total earnings. For the 1994 Group, it was relatively more important at almost 12 per cent of income.

Many regard this as a success story, with UK higher education being sold to students across the globe, but the truth is that as overseas fee income grows as a proportion of income, it makes the sector increasingly vulnerable to sudden shifts in demand.

This is precisely why universities have been vociferously lobbying government ministers over the reform of the student-visa system. The precedent is there: Australian universities, which are hugely dependent on overseas fee income, are currently suffering directly because the country's visa rules were tightened.

Given all this gloom and doom, there is a need to be positive and McConnell is keen to stress that the "position is generally healthy" when last year's accounts are considered. But as he points out, it is just the beginning of some hard years ahead.

"The problem we've got is that we're thinking about 2012-13, not 2009-10. The state of play in 2012-13 will be considerably different and we've got all those uncertainties to take account of."

Add to this the level of borrowing and worries over key variables such as interest rates and rising inflation, which McConnell thinks will put serious pressure on pay, and it is easy to see why the surpluses of last year - while representing a record - may not be enough.