Service Children's Education has been found to have serious weaknesses in leadership, support for schools, special needs provision and the delegation of funds to its 45-plus primary, middle and secondary schools worldwide.
The findings by the Office for Standards in Education are contained in a draft report that has been shown to the agency. A final report is expected next month.
Revelations about problems with service schools will cause concern at a time when many servicemen and women are in action in Iraq and Afghanistan.
The German-based SCE is responsible for schools in Belize, Brunei, Cyprus, Denmark, Falkland Islands, Gibraltar, Italy, Belgium, Holland and Germany, educating tens of thousands of five to 16-year-olds.
One of its roles is to ensure the smooth transition between schools of children moving overseas from the UK and those returning.
The agency's schools follow the national curriculum and provide the same pattern of education as that given in the UK. They are also expected to adopt and abide by UK legisation on aspects of schooling such as special needs.
Teachers must have recognised UK professional qualifications and about 80 per cent are recruited directly from the UK. The rest are hired locally but they must have the same training.
The agency's website states that it is "dedicated to providing a first-class system of schools and educational support overseas".
It also boasts of a distinguished place within the UK education system.
David Wadsworth,the agency's chief executive, claims on the website: "Our examination and assessment results place us among the leading local education authorities in the UK.
"Reports by the Office for Standards in Education, which provides an independent inspection service for our schools have, over a number of years, been consistently good and compare very favourably with those made on UK schools.
"The work of schools is backed by our own Inspection Advisory Service, which provides challenge (sic), and extensive and varied in-service training facilities to ensure that our schools are conversant with developments in the UK."
A spokesperson for the agency said the latest Ofsted report was the subject of "ongoing debate" and that the agency was seeking clarification on a number of points. "SCE is anxious that Ofsted understands fully the differences between our services and those of local education authorities," he said.
Service children often moved schools every two or three years, which created disruption, he said, adding that Ofsted had been invited to examine the quality of education in service schools.
The SCE said that "nobody is perfect" and the spokesperson said, it was committed to learning from the process.
The Ministry of Defence annual report for 20023 showed the agency missed more than half of its key targets, up from 40 per cent in 20012.