Terry Melia warns of a "downward funding spiral" which requires "imaginative management." But it is clear from his report that many of the problems are outside the colleges' control, particularly where there is little scope for significant further student recruitment.
It stands as a sharp warning to ministers not to pull the plug on growth when the current expansion phase comes to an end next year. The warning is all the more significant given the exhortations from Education and Employment Secretary Gillian Shephard in her earlier leaked document for last week's strategy Cabinet meeting at Chequers.
Mrs Shephard warned that "stopping the growth of the dynamic FE sector would be difficult to defend, job insecurity and the fear of unemployment is holding back the feel-good factor and therefore the recovery."
Her document showed she believes further education is central to the Government's strategy for national competitiveness and education and training.
Dr Melia's report pulls no punches in pressing some colleges to remedy deficiencies in a wide range of areas including student record keeping, planning and marketing. Course completion rates and exam grades are still "unacceptably low" in some colleges.
While judging the sector to be in "good health", he calls on managers, particularly in the general further education colleges, to be more critical of their own performance.
The draft inspection report says colleges can be more imaginative in recruiting students other than traditional 16 to 19-year-old adults.
But prospects for expansion here depend on the ability of colleges to attract the unemployed - an area dogged by complex legislation and the 21-hour rule which limits the amount of time an unemployed person can study without losing benefits.
Future reforms and the introduction of new rules are tied to the legislation on the Job Seekers Allowance (JSA). Here Mrs Shephard, in her Cabinet document, has pleaded for sustained investment.
If colleges turn back in desperation to school-leavers, they will find themselves on an uneven playing field with schools. Labour further and higher education spokesman Bryan Davies predicts greater friction as schools look increasingly towards extending their range of vocational courses. He says: "Colleges feel adversely affected the market is distorted against them in all sorts of ways."