The funding body for FE has warned that the number of colleges in financial difficulty could double "sooner than you may think".
Geoff Russell, chief executive of the Skills Funding Agency, told governors at a conference organised by the Learning and Skills Improvement Service that he also expected the number of colleges rated outstanding for their finances to halve as a result of the cuts.
"In the absence of some quite innovative changes in operating models for many of you, our view is that the number of colleges in outstanding financial health will drop by 50 per cent and the number in financial trouble will increase by 100 per cent, and sooner than you may think," he said.
"This means that you need to challenge your executive teams to demonstrate how they will survive a 25 per cent cut in real-terms funding over the next four years. The number of colleges that can improve, let alone protect the outcomes they deliver for learners, without some significant changes in models I believe to be small."
The latest figures from the SFA show 86 colleges are rated outstanding for financial health, while 15 are assessed as inadequate. Last year, 20 were given extra money because their rating was at risk of slumping from satisfactory as a result of the costs of the capital funding crisis.
A report by KPMG - Mr Russell's former employer - last year predicted that up to 50 colleges could disappear in mergers or other partnerships as FE adapts to cuts.
Mr Russell said FE was moving from a model where providers competed to meet government targets and win public funds to more of a real market economy, where fee-paying students would make or break a college.
He said: "Increasingly, it will be the market that does this job for us. It will be competition that will drive down cost, drive up quality, and eliminate the need for expensive micromanagement from the centre.
"And while of course our system has always been competitive, it has been a competition to attract public funding and to meet the demands of the bureaucracy, whereas, in future, it will be much more about a competition to attract and delight fee-paying customers."
But Mr Russell said FE was still perhaps better prepared than any other part of the public sector for the Coalition's reforms.
He said: "I believe that FE can lead the way in our country's public service reform. The sector is closer than any other public service to the Coalition's vision of a customer focused, locally accountable system whose strength is that it consists of competitive public and private businesses with a social mission. But we must go further."
Mr Russell said the funding agency was "relinquishing all the formal levers it holds" so colleges had responsibility to transform themselves. "I am completely confident that you will do just that," he said.