Nonprofit organizations are misunderstood for many reasons. one of which is inherent to their predominant label: “nonprofit.” The word simply refers to an organization without profits, which is not entirely accurate. A clearer general term for a member of this sector would be “tax exempt organization,” since the organization would be exempt from paying income taxes. Therein lies the real distinction. For-profit companies must pay income taxes on their profits while nonprofit companies do not. Of course, that doesn’t then preclude nonprofits from generating profits. It gets confusing and sounds wrong, but it’s not. From a fiscal perspective, well run nonprofit organizations function as any other business enterprises do, and yes, they should strive to generate profits. Understanding the nuances of nonprofit finances is essential to leading, managing, and assessing the effectiveness and viability of any organization. From the profit conundrum to liquidity, and from solvency to mission, stakeholders of nonprofit organizations are often left scratching their heads when reading nonprofit financial reports, statements, and tax filings. What positive benchmarks should you look for? What are donors focusing on? Does anybody really care? These are some of the many questions that we hope to answer by shining a light on the subjects that should matter most to readers of nonprofit financial information.
Standard nonprofit financial reports
The accounting gods force us to apply different terminology to nonprofits than we do other business enterprises, adding to the pile of confusion that the users of nonprofit financial statement already face. For-profit companies report their asset and liability balances at points in time in balance sheets. Nonprofits call them statements of financial position. For-profits hold shareholder’s equity for the part of assets that are not obligated. Nonprofit equity is called net assets. For-profit companies report their income, expenses, and net income (profits) on income or profit and loss statements. Nonprofits use statements of activities. Nonprofits also include a statement that for-profits do not; statements of functional expenses, which present costs between programmatic and other supporting categories. Statements of cash flows are the same, as are notes to financial statements, of course considering the unique quirks of individual businesses and industries. Tax returns for nonprofits (IRS Form 990 and related state filings) are more voluminous in nature, requiring significant programmatic, governance, and other supplemental information that for-profit tax filings do not require.
To profit or not to profit?
There are two major schools of thought that differ in their views of what financial pictures nonprofits should aim to present to the outside world. To some, nonprofits should appear to need funds, not too financially sound, and with breakeven or worse operating results (no profits). While these are certainly valid considerations, they do not factor in all the practical considerations that are important to nonprofits. Nonprofits are businesses too. While their missions are altruistic, without positive financial results and positioning, nonprofits’ abilities to serve their constituents will be severely hampered. It’s difficult to deliver quality services, meet demands, scale, and evolve without adequate financial resources. It’s also challenging to convince donors, government agencies, and foundations to invest in nonprofit missions if the nonprofits themselves lack infrastructure and support. Nonprofits should not shy away from positive operating results, reserves, cash flow, and dare we say it, profits.
Liquidity and Solvency
Liquidity measures an organization’s ability to meet its financial obligations as they come due in the next year of operations. There are many different calculations used to measure this, including working capital, current ratio, quick ratio, and days in cash. All these benchmarks intend to quickly judge an organization’s short-term solvency. Calculations and standard benchmarks are shown below:
- Working capital – current assets minus current liabilities. Value should be positive. The higher, the better.
- Current ratio – current assets divided by current liabilities. Value should be at least 1.50. The higher, the better.
- Quick ratio – current assets convertible to cash within ninety days divided by current liabilities. Value should be at least 1.0. The higher, the better.
- Days in cash – The number of days the organization can operate with its cash balance as of a specific date based on an assumed daily cash “burn rate.” The higher, the better, but 60-90 days is healthy minimum.
The word “current” refers to assets that can be liquidated or expected to convert to cash within one year (cash, receivables, investments, prepaid expenses, et al) and/or liabilities that are required to be paid within one year (vendor payables, employee payables, debts maturing within one year, lease obligations, et al).
Poor liquidity measures may cause organizations to delay payments to vendors, struggle to meet payroll obligations, constrain program activity, seek new debt financing, delay capital expenditures, and prevent investment in expansion, none of which help to serve underlying missions.
To consider overall solvency, liquidity certainly plays a role, but noncurrent assets and liabilities need to be factored in as well. Remember that net assets are akin to equity. Positive net assets are an essential financial metric for any solvent nonprofit organization. This bluntly reports that an organization’s assets exceed its liabilities. Special attention must be placed on the underlying nature of net assets though. Nonprofits with significant donor restrictions may appear fiscally sound on the surface, but they may be hamstrung in reality. Nonprofits thus need to ensure that their net assets without donor restrictions balances are always positive. Negative balances are red flags. Similarly, net asset balances that are composed of illiquid assets, such as property and equipment, are less useful than more liquid assets. That should be contemplated when forming any conclusions on nonprofits’ solvencies.
Financial and Program Performance
Nonprofits generate revenue from so many sources – donations, government support, events, programs, investments, and more. They spend money in so many ways as well – payroll, occupancy, technology, marketing, and many others. Statements of activities compare all revenue and all expenses to arrive at organizations’ changes in net assets (this is net income for for-profit companies). This is where profit comes into play. The higher the change in net assets, the better. Trends over time should also be positive. Wild fluctuations from one year to the next are common for nonprofits, but not ideal. Smooth, consistent growth in total revenue and total expenses, along with changes in net assets, are signs of well-managed and successful organizations. Another way to assess an organization’s ongoing financial performance is to normalize its revenue by removing nonoperating items, such as loan forgiveness, investment gains, and other one-time items. If an organization can pay its total expenses with its normal program revenue and support, then it’s well-structured and fiscally sound. Programmatically, an organization’s program service percentage continues to be an important metric used almost universally. This represent the portion of total expenses that are on program services. Benchmarks vary depending on the type of organization and funding sources, but most tend to fall in the 70-90% range. A figure much below that, without reasonable explanation, should give reason to pause. Generally speaking, the higher this ratio is, the better it is viewed by third parties, such as donors.
One must remember that all nonprofits cannot be painted with the same brush. There are different subsectors within the nonprofit world that will showcase different financial characteristics. The information above is meant to be generic and to start conversations/analyses, not necessarily finish them. There are countless other matters, facts, and figures that can and should be weighed when assessing any nonprofit’s financial wherewithal and execution. Being well armed with proper context, expectations, and background is essential for nonprofit leaders. We will soon be hosting a series of webinars to explore this subject more fully with nonprofit stakeholders. Stay tuned and stay connected to us.
Matthew Burke, CPA, CFE
Matt specializes in providing Cerini and Associates’ diverse array of midsized business clientele and nonprofit organizations with valuable consulting and assurance services. He prides himself on value-added, responsive, and innovative service to his clients; with a focus on forward-thinking and creative solutions. Matt joined the firm in 2002 and has years of experience with many types of complex accounting, auditing, compliance, and general business matters that impact entrepreneurial, established, and nonprofit businesses.