The past financial year was one of relative prosperity: tuition fee income from home students was still increasing, international student recruitment continued to grow and many universities enjoyed larger research grants than in previous years.

But as consultancy firm PricewaterhouseCoopers observed in a report published last November, 41 institutions - about a quarter of the sector - had recurring deficits during 2005-08, a period when income from most sources was increasing.

"A track record of recurring and significant operating deficits in such a favourable financial climate has to raise questions around how some of these institutions will cope in more austere funding conditions," PwC warns. "The challenges that lie ahead for the sector as a whole from increasingly tight fiscal constraints may be more significant for those close to or below the break-even point."

Since that report's release, the financial climate in England has worsened considerably. A total of ?449 million has been cut from the ÖйúAƬ Funding Council for England budget for 2010-11, and ?600 million must go from science, research and ÖйúAƬ by 2012-13. Scottish universities have been relatively fortunate, receiving an increased budget for 2010-11, but the ÖйúAƬ Funding Council for Wales announced in February that recurrent grant funding will be trimmed by 3.25 per cent.

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The sector is entering these stormy waters in relatively good shape, to judge from an exclusive analysis of institutions' financial statements for 2008-09 conducted by accountants Grant Thornton for Times ÖйúAƬ. At the end of that period, 33 institutions were in deficit - just over a fifth of the total. However, the net surplus for the sector has fallen slightly since 2006-07 and now stands at ?345.3 million. Across the academy, the mean surplus as a percentage of total income is 1.4 per cent. Only 29 per cent of institutions have a surplus of more than 3 per cent of income, which Hefce recommends as the minimum required to guarantee the ability to cope with unforeseen shocks.

That the surpluses are not larger may surprise some because the sector's total income has risen by 19.5 per cent over two years. Revenue from tuition fees charged to home students has grown by more than 36 per cent since 2006-07, while payments from overseas students jumped by 31 per cent. In the same period, the funding councils handed out ?8.6 billion to universities - a 10 per cent increase - while other research income rose by almost 25 per cent.

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Burgeoning staff costs - which include salaries, pension contributions and social security costs - may explain why such a large rise in income has not translated into a healthier average surplus. Total staff costs have climbed by 16.7 per cent over the two years since the previous THE-Grant Thornton survey of the sector's financial health.

The sector's total borrowings have also increased, by 29 per cent.

David Edwards, director of Grant Thornton's not-for-profit advisory services division, says the financial survey suggests that 2008-09 was "the last of the good years".

"Our concern is that despite a period of plenty, the sector is still in fragile shape to cope with the lean years to come," he says. "An average surplus for the sector of just 1.4 per cent is marginal at best, particularly when the primary source of income for the sector (funding council grants) is being cut, and the next highest (tuition fees) is capped. That gives the sector very little room to move, and despite efforts to bolster other areas of income, many institutions are going to have to look to cost savings to achieve financial sustainability."

In a sector where people account for nearly 60 per cent of costs, savings will most likely equate to staff reductions, he points out.

Philip Harding, chairman of the British Universities Finance Directors Group, agrees that margins are "painfully thin".

"Trying to protect or improve this level of surplus in the teeth of a stiff prevailing wind in the wrong direction will be extraordinarily difficult," he says. "Some universities are better placed than others because they have a diversified mix of income sources, adequate levels of reserves and/or modern and well-equipped facilities - each of which provides some degree of resilience."

He adds: "We're all engaged in scenario planning and trying to interpret the implications of the latest funding announcements for our own institutions, but the degree of uncertainty makes this a hazardous exercise."

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Despite that, he says it's not all bad news for university finances. "Demand is soaring and recent cost inflation has been at historically low levels."

Steve Smith, president of Universities UK, believes that larger sector-wide deficits could emerge when figures showing the full economic costs of the sector's activities (the financial picture adjusted to take account of the Transparent Approach to Costing methodology) become available for 2008-09.

He adds: "We are underfunded by historical and international comparison. The unit of resource was still only 83 per cent of its 1989 level by 2008-09, and we invest less as a proportion of gross domestic product (both public and private funding) than the average across the Organisation for Economic Cooperation and Development and significantly less than our main competitors."

Noting that the recession holds greater danger for some institutions than others, he says: "Our report From Recession to Recovery, due to be published in June, will explore, among other things, institutional strategies for diversifying income streams in response to the economic downturn."

The financial health check that THE and Grant Thornton conducted in 2008 found that the benefits of the "boom years" had not been distributed equally across the sector: the older, and traditionally richer, universities saw their incomes grow at a faster rate than their newer counterparts.

Recently, however, the pattern became more complicated. In 2008-09, GuildHE, which represents university colleges and specialist institutions, recorded the biggest rise in income, 22.1 per cent; just behind it was the 1994 Group, which represents smaller research-intensive universities, registering 21.8 per cent. These two groups also chalked up the largest increases in funding council grants of all the mission groups and representative bodies - GuildHE collected 12.2 per cent more and the 1994 Group 12.4 per cent more, compared with a rise of just 7.7 per cent among members of the University Alliance.

The numbers reveal that the Russell Group of large research-intensive universities is gaining market share in some areas of income compared with rival mission groups and representative bodies.

Its share of the sector's earnings from endowments, subsidiary companies, catering and residential operations grew from 49 per cent to 58 per cent, while the share claimed by Million+ members slipped from 9 per cent to 7.4 per cent.

The Russell Group also gained strength in international recruitment - it now rakes in 41 per cent of the sector's ?2 billion overseas-student income, up from 39 per cent in 2006-07. The 1994 Group's share of the same category fell from 19 per cent to 16 per cent.

The expanding power of the Russell Group was even more pronounced in terms of research income excluding that from the funding councils. It enjoyed the biggest rise in this category - 24.6 per cent - although its market share remained relatively stable at 67 per cent.

In 2008-09, the Russell Group's total income was ?10.2 billion, which accounted for 41 per cent of the income earned by the sector as a whole, ?24.9 billion. This proportion has remained stable since 2006-07. By contrast, Million+ universities took in ?2.8 billion, 11.7 per cent of the sector's total, a slip from the 13 per cent market share they had in 2006-07.

To give a more detailed picture of individual universities' strengths and vulnerabilities, Grant Thornton analysed four different areas: dependence on Hefce grant income, size of surplus, staff costs and borrowing. Problems in a single area will not weaken a university significantly, but a combination of heavy reliance on funding council grants, large borrowings, high staff costs in relation to income and a deficit or a tiny surplus could cause severe difficulties.

Income

The sector earned a total of about ?25 billion in 2008-09, up 19.5 per cent since 2006-07.

As was the case in our previous financial health check-up, the largest incomes were reported at the University of Cambridge, the University of Oxford, the University of Manchester, University College London and Imperial College London. Cambridge was streets ahead of the others, raking in ?1.14 billion - 19 per cent more than the ?958.2 million it earned in 2006-07. In the same period, Oxford's income rose to ?862.5 million, a boost of per cent, and Manchester expanded its earnings to ?754.6 million, a rise of 18 per cent.

Throughout 2008-09, the government loudly repeated the message that it was imperative for universities to reduce their reliance on funding council grants. After the announcement of ?449 million cuts in Hefce budgets for 2010-11, David Lammy, the ÖйúAƬ minister, ordered institutions not to "cut their cloth and accept cost-cutting and contraction as the price of dependence on the taxpayer".

He went on: "A different and, in my view, much better approach ... is for universities to try to diversify their sources of income."

It will please ministers to learn that the sector is already moving in this direction: in 2008-09, 34.5 per cent of its income came from funding council grants, down from 37.5 per cent two years ago.

Individually, however, some institutions are still highly dependent on these grants - and therefore vulnerable to cuts in public funding.

Scottish universities and specialist institutions are most reliant. At the top of the scale is the University of the West of Scotland, which receives 72 per cent of its income from public funding. It is followed by Ravensbourne College of Design and Communication (66 per cent), the University of the Highlands and Islands Millennium Institute (65 per cent) and Glasgow Caledonian University (63 per cent).

The institutions at the more self-reliant end are a mixed bag. Least dependent are the London Business School and the Scottish Agricultural College, both of which rely on the funding councils for just 8 per cent of their income. The London School of Economics (15 per cent), City University London (23 per cent) and Imperial College (26.5 per cent) also feature among the 10 institutions that are least reliant on the funding councils.

In 2008-09, the first cohort of students who were charged variable tuition fees entered their third and final year, and tuition-fee income from home students grew by 36.4 per cent. Income from overseas students almost kept pace, rising by 30.8 per cent since 2006-07 to more than ?2 billion.

Manchester earned ?78.3 million in fees from students outside the UK and the European Union, while Imperial collected ?68.6 million. For both these institutions, overseas fees account for about 10 per cent of total income. In contrast, the LSE's ?61 million take from overseas fees represents 30 per cent of its total income; this means that it is more vulnerable than most UK universities to threats from US, Australian and European rivals and to changes in the international market. The University of East London is also highly reliant, receiving 21 per cent of its earnings from overseas students.

Across the sector, income from research grants and contracts not paid for by the funding councils rose by almost 25 per cent. Oxford led this category: it brought in ?341 million in 2008-09 (39 per cent of its income), well ahead of its nearest rivals Imperial (?287 million, 43 per cent) and Cambridge (?260 million, 23 per cent), although Imperial wins in percentage terms.

Lammy has frequently directed universities to raise more funds through endowments and private investment. Oxford earned the highest total last year, ?37.1 million (4 per cent of total income), followed by Cambridge with ?.7 million (2.4 per cent). However, more endowments are likely to have been made to individual Oxbridge colleges.

The University of Surrey collected the greatest private income as a percentage of total funds: its ?10.5 million represented 5.5 per cent of its total earnings.

Surpluses

The fact that an institution is in the red may not mean that it is in poor financial health: only sustained, recurrent deficits worry the funding councils. Similarly, large reserves are not necessarily an indication of wealth: many universities that find themselves in profit prefer to spend the excess immediately, which keeps the figure for annual surpluses small.

Hefce recommends that institutions maintain a surplus of at least 3 per cent to cope with financial exigencies. Of course, the exact amount each institution needs depends on its capital investment plans - the assets essential to its mission that must be purchased - and its need for "working capital" to fund growth. Surpluses also cushion institutions against unforeseen risks.

Across the sector in 2008-09, the mean surplus as a percentage of total income was 1.4 per cent. Overall, 21 per cent of institutions were in deficit, 33 per cent had a surplus of up to 2 per cent of total income, 17 per cent had a surplus of between 2 and 3 per cent and 29 per cent had a surplus of more than 3 per cent.

Large surpluses may often be explained by asset sales. Surrey, for example, sold a spin-off company, Surrey Satellite Technology, in 2008 for a profit of ?36.8 million.

Excluding such exceptional items, the institutions with the biggest surpluses as a proportion of income were Norwich University College of the Arts (10.7 per cent), Liverpool Institute for Performing Arts (9.4 per cent) and Swansea Metropolitan University (9.2 per cent). The only Russell Group institution in the top 10 was the LSE, with a surplus of 8.7 per cent.

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Cambridge recorded the largest deficit - ?16 million - but this represented only 1.4 per cent of its total income. As a proportion of income, Thames Valley University had the largest deficit, 12.3 per cent. The university's accounts show that it was in surplus in 2007-08 but sunk into the red after paying ?6.9 million back to Hefce for over-reporting its number of fundable students. The University of Wolverhampton, which listed a 9 per cent deficit, is talking to Hefce about a threatened clawback for the same reason. Bucks New University recorded a 7.3 per cent deficit, but this disappeared once exceptional items were factored in: the university sold a campus in June 2009.

Borrowing

Borrowing figures say little in themselves about an institution's financial health - the crucial factor is the ability to service debt - but loans as a proportion of total income can provide a rough indication of indebtedness. A university must seek permission from the funding councils to borrow more money once the cost of servicing its existing loans exceeds 4 per cent of its total income.

The sector's total borrowings increased by 28.6 per cent to ?4.85 billion in the two years ending July 2009. This meant an increase in the amount of borrowing as a percentage of income from 18.1 per cent to 19.5 per cent over that period.

The most highly geared institutions are Queen Margaret University (220.5 per cent of income), Ravensbourne College (171 per cent) and the University of Worcester (82.5 per cent). Queen Margaret University said it had a Barclays loan of ?21.49 million and that other borrowings were not "conventional loans" but were a result of accounting treatment. Other institutions among the top 10 include Surrey (63 per cent), Brunel University and the University of St Andrews (both 62 per cent).

Manchester recorded the largest total borrowings - ?206.7 million ( per cent of income), followed by King's College London with ?202.7 million (41.7 per cent of income).

Pay

Staff remain universities' biggest cost. Grant Thornton's analysis shows that the wage bill - including pension contributions and social security costs - has grown 16.7 per cent over the past two years, on top of an 18.5 per cent rise between 2005 and 2007. However, the typical university now spends 55.8 per cent of total income on its staff, down from 57.1 per cent in 2006-07.

UUK's Smith says: "The significant increase in staff costs is driven partly by the modernisation package that was introduced in 2008-09, which significantly improved pay and conditions.

"Although we are now in a different funding environment, we will need to continue to invest to compete effectively for the best academic staff internationally and to support expanded operations - for example, with respect to the provision of student bursaries and financial information to students."

Pension costs remain a serious worry for all universities (see box, above left).

The analysis shows large variations in the proportion of total income that individual institutions spend on their employees. Writtle College, Birkbeck, University of London and Thames Valley spent the most last year: 71.6 per cent, 69.8 per cent and 67.8 per cent of their incomes respectively.

Non-specialist institutions with the lowest proportional staff costs are the University of Bedfordshire at 41 per cent and UEL at 42.6 per cent.

Of the mission groups and representative bodies, the Russell Group spends the smallest proportion of its income on pay, 54.6 per cent. The University Alliance spends the most, 58.5 per cent.

OFF THE CHARTS: THE MISSING FIVE

Three institutions, London Metropolitan University, the University of Gloucestershire and the University of Cumbria, were not included in the analysis because Grant Thornton was unable to access their accounts. In addition, Edinburgh College of Art and University College Birmingham submitted data too late to be included.

London Met's board of governors had not signed off its accounts at the time of writing.

A spokeswoman said the university's surplus for 2008-09 was ?9.5 million: "This includes an exceptional profit from the sale of a hall of residence of ?22.7 million."

Outstanding balances due on mortgages, finance leases and capital loans totalled ?15.9 million against an income of ?157.8 million. Staff costs were ?101.4 million - 64 per cent of London Met's income.

Like London Met, Gloucestershire and Cumbria, universities known to be in financial difficulties, said their accounts would not be approved by their boards until later in the year.

As of July 2009, Cumbria's trading deficit was ?8.4 million; Gloucestershire's topped ?6 million.

Gloucestershire is also servicing loans of about ?36 million on a net income of some ?65 million.

PENSION PAINS: THE TIME BOMB TICKS

Pension deficits represent a serious risk to the finances of most universities.

Employers are negotiating with the University and College Union on changes to the Universities Superannuation Scheme - the principal pension provider to the sector.

The USS' fund was valued at ?26.8 billion at 30 September 2009. With ?31.8 billion of benefits promised to members, this left it with a ?5 billion deficit on the "technical provisions" basis.

To tackle the deficit, options under discussion include replacing the final-salary scheme with a career-average scheme, increasing the pension age to 65 and an arrangement whereby future increases in contribution rates would be shared.

Universities cannot pull out of the scheme without having to pay their share of the total scheme deficiency, which would be unaffordable.

If no agreement has been reached by 2011, the pensions regulator will impose a change. Any change would be likely to involve increased employer contributions.

Post-1992 universities are members of the Teachers' Pensions Scheme, which is due to be revalued next month.

LIFE ON THE EDGE: HOW TO SURVIVE THE COMING FAMINE

For many years, the ÖйúAƬ sector was not required to make too many tough decisions because it operated in an era of comparative prosperity. Now, in a time of turbulence, difficult choices can no longer be avoided.

This may be stating the obvious, but we have to ask if the leaders of our universities are confident that they can manage the troubled times ahead.

The sector enjoyed some good years until July 2009. The situation today is very different because of the recession and the consequent cuts being imposed by the government. The landscape over the next few years is inevitably going to be extremely challenging for institutions.

Some 12 months ago, we raised concerns about a number of issues that individually could probably be absorbed by institutions, but if faced collectively, could lead to severe and critical consequences. Our message was that management should not be complacent and should recognise the need for proper risk assessment.

We also highlighted the importance of ensuring that robust management information was available so that strategic decisions could be made swiftly. Unreliable information can hinder the ability to take corrective action within an appropriate time frame.

Our research did not find all universities to be poorly managed or failing to take appropriate action. It did, however, identify that the steps taken in the sector had not always been consistent and in some cases were inadequate. The institutions found to be struggling severely may find it difficult to survive as autonomous entities in the future.

Looking ahead to some of the tough issues facing the sector, severe reductions in public spending obviously top the list.

In addition to the cuts recently announced by the ÖйúAƬ Funding Council for England, we predict that over the next few years there will be further year-on-year reductions.

There has been an additional, albeit small, pay rise in the current year, but there will be pressure on further increases in future years.

The restrictions on overseas students entering the country have become more stringent and are set to increase further, as is competition from universities abroad. Non-government sources of income (endowment funds, sponsorship, research funds and commercially generated income) have decreased significantly and may decline further. We also expect that there will be a requirement to increase pension contributions, which will help reduce the sector's future pension liabilities.

The ability to remain financially sustainable will therefore be an increasing challenge in the future. As a minimum, there is a need to ensure that sound financial information is available to senior management. This will help to ensure that performance down to the faculty level can be assessed properly and fairly.

The need to take sensible strategic decisions on where to focus, while maintaining quality and student satisfaction, will become ever more critical; in this respect, we believe that the need to consider cross-institutional collaboration may be a sensible way forward.

Finally, those universities that are able to survive in the future will require experienced and robust governing bodies to ensure that the various committees take responsibility for the decisions made and respond in a timely and effective manner as required.

After years of plenty, we are heading into a period of famine. Some institutions are already on the edge, and others are approaching it. The changes required to ensure sustainability in the future must be at the forefront of universities' decision-making.

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David Barnes is a partner and head of education, Grant Thornton UK.