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Using Ratio Analysis to Manage Not-for-Profit Organizations

Thousands of CPAs work in the not-for-profit sector, and thousands more volunteer as members of the governing boards of not-for-profit organizations. There is little in the academic background or experience of many accountants, however, to prepare them to analyze and evaluate not-for-profits. University courses in not-for-profit accounting emphasize the recording of transactions and the preparation of financial statements, rather than the evaluation of financial and operational effectiveness. Board members without substantial accounting expertise are even less equipped to interpret not-for-profit financial reports.

Because not-for-profit organizations exist for purposes other than earning a return for equity investors, measures commonly used to evaluate commercial enterprises are not well suited for evaluating them. Furthermore, although they are commonly represented as a single class of organization, great variety exists in the mission and finances of not-for-profit organizations. While many not-for-profits rely heavily on contributions, others derive most of their revenues from the sale of services or membership dues. Because of varying missions and funding sources, there are no sector-wide norms to guide managers and board members.

It is often difficult for not-for-profit managers and governing boards to plan for the organization’s financial future because of a reliance on contributions and the lack of predictability of demand for their services. The future can be daunting if a not-for-profit does not have a strong grasp on its financial position. A not-for-profit can, however, help maintain its financial sustainability by following prudent financial management standards and monitoring financial ratios. Financial management standards help a not-for-profit monitor its budget, cash flow, resource utilization, and revenue sources. This article’s focus is on the use of financial ratios in trend analysis and benchmarking to improve the effectiveness of management and boards charged with monitoring not-for-profit organizations, specifically those not-for- profits that file Form 990. Financial ratios can help determine if a not-for-profit has sufficient resources and determine if it is using those resources efficiently to support its mission. Ratios are useful because they express underlying financial relationships as a single value, allowing comparisons across time and among entities of varying size.

Not-for-Profit Ratios

Investors, creditors, and analysts routinely use ratios to evaluate commercial enterprises. Because many of these ratios focus on profitability measures, their usefulness in guiding not-for-profit managers is limited. Historically, discussion of financial ratios among not-for-profits has focused on spending ratios: program, fundraising, and management expenses as percentages of total expenses. Donors in particular employ these measures to evaluate the extent to which their contributions support mission-related activities. There is ongoing discussion in the not-for-profit literature suggesting that being overly focused on spending measures can have unintended consequences. Sector leaders have called for greater attention to measuring operational effectiveness; others contend that measures of financial position are necessary to assess liquidity and sustainability. Responding to this demand, FASB standards now require greater disclosure related to liquidity.

The authors contend that not-for-profit managers and boards should actively measure and evaluate not just spending ratios, but also measures of liquidity and operational effectiveness. The selection of a set of ratios to monitor is challenging because not-for-profit missions vary extensively, as do their sizes and the industries in which they operate. The most accurate statement that may be made about the choice of ratios to monitor is that no single set of ratios is suitable for all not-for- profits. The management team of each not-for-profit should consider its needs and select a set of ratios to measure that address its particular concerns. Regardless of the specific ratios selected, two characteristics make ratio analysis more useful:

  • Trend Analysis. Within an organization, the value of ratio analysis lies in directing management’s attention to areas of changing conditions. Therefore, it is important to measure and report financial ratios across time. Once agreed upon, the selected ratios should be consistently measured and presented to the governing board within each financial report so that trends can be identified. The authors’ recommendation is that financial reports provided to the governing board contain five years of ratios.
  • Benchmarking. No generally accepted ideal or target levels exist for ratios. The desirable level for a given ratio is a matter of judgment and will vary according to the circumstances facing each organization. Ratios are generally evaluated against a benchmark rather than a theoretically optimal value; these benchmarks are typically calculated as an average value from a comparison group. Therefore, in addition to agreeing upon a set of ratios to measure and monitor, each not- for-profit should also agree on a comparison group of five to ten peer organizations. Ideally, this group would consist of well-managed not-for-profits of similar size and mission.

Because many ratios focus on profitability measures, their usefulness in guiding not-for-profit managers is limited.

For purposes of illustration, the authors present a set of eight ratios that are likely to be useful to a variety of not-for-profit organizations. The ratios represent the three broad areas of liquidity, operations, and spending. It also computes average values for these ratios for over 200,000 not-for- profits, divided into five categories by entity size, using information available from the IRS website.  Exhibit 1 describes the ratios, what they measure, and how they are calculated.

Ratio; Formula; Averages by Size of Not-for-Profit Liquidity Ratios Days cash on hand: Measures the number of days of expenses that can be covered from existing cash and cash equivalents. Generally, higher values indicate a stronger liquidity position, although there is both a benefit and an opportunity cost to holding cash reserves.; (Cash + cash equivalents) ÷ [(Total expenses – depreciation expense)/365 days]; Total assets Average value; $100,000 to $500,000 123 days $500,000 to $1,000,000 146 $1,000,000 to $10,000,000 99 $10,000,000 to $50,000,000 76 >$50,000,000 57 Months of spending: A less extreme measure of liquidity than days cash on hand since it assumes receivables can be collected to sustain operations. Generally, higher values indicate a stronger liquidity position.; (Current assets – current liabilities + temporarily restricted net assets) ÷ [(Total expenses – depreciation expense)/12 months]; Total assets Average value $100,000 to $500,000 4.22 months $500,000 to $1,000,000 5.24 $1,000,000 to $10,000,000 3.84 $10,000,000 to $50,000,000 3.35 >$50,000,000 2.42 Operating Ratios Savings indicator: Measures the net revenues that are retained by the organization as a percentage of expenses. Generally, not-for-profit organizations must maintain some surplus to replace existing facilities and extinguish debt. This ratio should be evaluated in the context of the anticipated needs of the organization.; (Revenues – expenses) ÷ Total expenses; Total assets Average value $100,000 to $500,000 4.5% $500,000 to $1,000,000 6.0% $1,000,000 to $10,000,000 4.3% $10,000,000 to $50,000,000 4.5% > $50,000,000 9.6% Contributions and grants: Measures the extent to which revenues are received from donors and grantors. Since this ratio measures the organization's dependence on voluntary support, high values indicate less diverse revenue sources and greater susceptibility to economic downturns.; Contributions & grants revenue ÷ Total revenue; Total assets Average value $100,000 to $500,000 59% $500,000 to $1,000,000 56% $1,000,000 to $10,000,000 47% $10,000,000 to $50,000,000 34% >$50,000,000 15% Fundraising efficiency: Indicates the amount of contributions raised for each dollar of fundraising cost. Higher values indicate greater fundraising efficiency.; Total contributions (other than government grants) ÷ Fundraising expenses; Total assets Average value $100,000 to $500,000 $16.94 $500,000 to $1,000,000 $16.47 $1,000,000 to $10,000,000 $11.45 $10,000,000 to $50,000,000 $11.93 >$50,000,000 $12.86 Spending Ratios Program service expense: Measures expenses incurred on mission-related programs as a percentage of total expenses. Donors generally view higher values as desirable since this represents resources that are being directed to mission-related programs.; Program services expenses ÷ Total expenses; Total assets Average value $100,000 to $500,000 85.3% $500,000 to $1,000,000 86.1% $1,000,000 to $10,000,000 85.2% $10,000,000 to $50,000,000 86.2% >$50,000,000 86.8% Management expense: Measures management and general costs as a percentage of total expenses. Donors generally view higher values as undesirable since this represents resources that are not being directed to mission-related programs.; Management and general expenses ÷ Total expenses; Total assets Average value $100,000 to $500,000 12.3% $500,000 to $1,000,000 11.7% $1,000,000 to $10,000,000 12.6% $10,000,000 to $50,000,000 12.3% >$50,000,000 12.4% Fundraising expense: Measures fundraising costs as a percentage of total expenses. Donors generally view higher values as undesirable because these represent resources that are not being directed to mission-related programs.; Fundraising expenses ÷ Total expenses; Total assets Average value $100,000 to $500,000 2.5% $500,000 to $1,000,000 2.2% $1,000,000 to $10,000,000 2.2% $10,000,000 to $50,000,000 1.6% >$50,000,000 0.8%

Because commercial businesses are reluctant to share detailed financial information with competitors, developing suitable benchmarks can be very challenging. In contrast, not-for-profits are aided in this process by the I RS’s requirement that tax-exempt organizations file a Form 990 and it be made publicly available. Many notfor-profits post their Form 990s to their websites or make them available through organizations such as Guidestar. In addition, the I RS website provides annual extracts of Form 990 data; users may download financial information for all tax-exempt organization filings in a given year. Form 990 contains much more detailed financial information than is typically available in corporate financial statements and includes a wealth of nonfinancial information, including information about organizational governance and employee compensation. A list of potential ratios and the lines on the Form 990 where the information can be found appears in the article, “Why So Many Measures of Nonprofit Financial Performance? Analyzing and Improving the Use of Financial Measures in Nonprofit Research” (Christopher Prentice, Nonprofit and Voluntary Sector Quarterly, August 2016, http://bit.ly/2GlwUHX (http://bit.ly/2GlwUHX)).

Liquidity ratios.

The “days cash on hand” ratio measures the number of days of expenses that could be paid from existing cash and cash equivalents. Depreciation is removed from total expenses (denominator) since it does not require a cash outlay. Higher values indicate a stronger liquidity position. The “months of spending” ratio represents a longer planning horizon since it assumes receivables can be collected to sustain operations. Because the ratio removes current liabilities and donor-restricted resources from the numerator, it closely parallels the liquidity management disclosures that are now required of not for-profit organizations.

Both ratios indicate whether the not-for-profit has a sufficient “cushion” of cash and near-cash resources (often described as liquid resources—assets that can be quickly converted into cash) to meet organizational expenses as they come due. Many organizations have a policy of maintaining cash reserves equal to two or three months of expenses; higher values indicate a stronger liquidity position, suggesting that the not for-profit is better prepared to address periodic declines in revenues or unexpected expenses. Several factors influence the desired level of financial liquidity. Larger organizations and those with more predictable expenses and more diverse revenue sources may maintain lower levels. In addition, organizations relying on donated goods, such as food banks, can operate with lower levels of liquidity since those goods (rather than cash) are the source of the bulk of their average monthly expenses. As is the case with many financial ratios, maximizing either of these ratios comes at a cost. While reserves in the form or cash or short-term investments may make the organization financially secure, these resources could also be used in programs that further the organization’s mission.

Operating ratios.

The “savings indicator” ratio expresses the annual surplus (or deficit) of revenues over expenses and should be evaluated in combination with the liquid funds indicators. Improving liquidity ratios requires an organization to increase its annual savings; similarly, a governing board that is comfortable with its liquidity may spend a greater proportion of its resources, driving the savings rate to zero, or even a negative value, for a short period. A common misunderstanding about not-for- profits is that operating surpluses (i.e., savings) are undesirable. In most not-for-profits, accounting surpluses are necessary if equipment and facilities are to be enhanced, debt retired, or liquidity maintained.

The “contributions & grants” ratio indicates the organization’s reliance on external support. Very high values indicate the absence of a diverse revenue stream and a funding model that depends upon donations and grants. This ratio is particularly tied to the not-for-profit’s industry; religious and public broadcasting charities rely heavily on donations, while many larger organizations have multiple sources of revenue, including program revenues, charges for services, and member dues. For example, hospitals receive most of their revenue from patient services, and professional associations rely on membership dues. These not-for-profits typically report low values for this ratio.

Many organizations have a policy of maintaining cash reserves equal to two or three months of expenses; higher values indicate a stronger liquidity position.

“Fundraising efficiency” is the average dollar amount of contributions raised for each dollar expended on fundraising. Values less than $1.00 indicate the cost of fundraising exceeds its benefits. Charity Watch advises a minimum level of $2.85 for most charities. As with most ratios, care must be exercised in its interpretation. Fundraising capacity may take several years to develop, with the result that fundraising appears more expensive as an organization is building capacity. For this reason, studies find that smaller organizations dedicate higher proportions of their budget to fundraising than larger entities (e.g., Patrick Rooney, Mark Hager, and Thomas Pollak, “Research about Fundraising and Administrative Costs,” Giving USA Update,2003, http://bit.ly/2G2qQCw (http://bit.ly/2G2qQCw)). It is also important to recognize that the ratio is an average and not a marginal return. This distinction becomes important if development activities are evaluated on the basis of this ratio. In such a situation, notfor-profits may forego productive fundraising efforts for the purpose of keeping the ratio artificially high, thereby leaving money on the table that could have been used to further the organization’s mission. Fundraising opportunities should not be rejected merely because the expected pay-back is less than the current average.

Spending ratios.

The next three ratios all measure a given category of expense as a percentage of total expenses. Conventional wisdom is that expenses incurred for program services are good, while expenses incurred for management and fundraising are undesirable. Because accounting standards require expenses to be classified with the categories of program, fundraising, and management and general, the three ratios must sum to 100% for any given organization.

Because these ratios are relatively easy for non-experts to interpret (e.g., how much of each dollar is spent on programs), they are widely reported by the media, not- for-profit watchdog organizations, and not-for-profits themselves. Ample evidence exists that these ratios are widely used by governing boards, granting agencies, and donors. While these ratios are industry standards, they are also often misused. Because of the prevailing perceptions, incentives exist to shift costs to the program category and thereby improve the desirable ratio while decreasing the other two. To address abuse, accounting rulemaking bodies provide standards for the allocation of joint costs.

The “program service expense” ratio is the proportion of expenses incurred for purposes of the organization’s mission. It does not measure program effectiveness, only the extent to which available resources are directed toward the organization’s mission. The Better Business Bureau’s Wise Giving Alliance recommends a minimum threshold of 65% for this measure. Charity Watch uses a grading system ranging from A+ (> 90%) to F (<35%), with 60% or greater required for a satisfactory rating.

“Management expense” may be the most commonly misinterpreted ratio. Sometimes called “administrative expense,” it includes expenditures for training, planning, internal controls, and organizational governance. Training employees and volunteers, safeguarding assets, and assuring responsible governance are all desirable things, but the conventional view of this ratio is that higher values are undesirable. In addition, the costs associated with securing government grants and complying with grant requirements are classified as management and general expenses and can significantly affect this ratio, particularly among smaller not-for-profits. As organizations grow in size, they require more layers of management for institutional control. Yet while the amount spent on administration increases with notfor-profit size, management expense as a percentage of total expenses may remain constant or even decline, depending upon economies of scale.

“Fundraising expense” is the proportion of total expenses devoted to development activities, and together with management and general expense is commonly described as “overhead costs.” Substantial empirical evidence exists that investments in overhead vary with the size and nature of organizations (Rooney et al 2003), but that increased overhead spending contributes to organizational performance. For example, a study by the Urban Institute’s Center on Nonprofits and Philanthropy (Getting What We Pay For: Low Overhead Limits Nonprofit Effectiveness, 2004, https://urbn.is/2X8svNX (https://urbn.is/2X8svNX)) found charities that spend too little on overhead are less effective. In response to these and similar findings, the chief executives of the Wise Giving Alliance, Guidestar, and Charity Navigator jointly authored a letter to donors alerting them to the “overhead myth” and encouraging greater attention to not-for-profit performance, transparency, and governance.

Curtis Klotz proposed adoption of a new reporting model for not-for-profit expenses to overcome the inherent limitations of current reporting (“A Graphic Re- visioning of Nonprofit Overhead,” Nonprofit Quarterly, Aug. 16, 2016, http://bit.ly/2FeaZ3x (http://bit.ly/2FeaZ3x)). Until accounting standards or the format of Form 990 are changed, however, the existing expense categories and reporting will persist. Because of the visibility of these spending ratios and their importance to donors, management and governing boards should continue to monitor them. But it is important to recognize their inherent shortcomings and not base strategic decisions exclusively on the ratios.

Use of Ratios to Evaluate a Not-for-Profit

In this section, the authors calculate the eight ratios for an example not-for-profit organization for purposes of illustrating how ratios may be used in both trend and benchmarking analyses. The organization chosen was a Young Men’s Christian Association (YMCA) from a moderatesized U.S. city. YMCAs are easily comparable because each community’s YMCA is separately incorporated—and thus prepares its own Form 990—and they have relatively uniform missions, organization, and activities. The information necessary to calculate the ratios presented here took less than two hours to collect using the free section of Guidestar’s website; this suggests that once a not-for-profit selects a set of peer organizations, the annual investment necessary to obtain relevant benchmarking data is not significant.

Exhibit 2 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T2) presents ratios for the selected YMCA over a five-year period. Longitudinal analysis permits the identification of trends and highlights aberrations. During the past four years, the selected YMCA has consistently maintained a cash balance of approximately 2½ months of spending and an overall liquid net asset balance of approximately 3½ months.

Ratio; Current Year; Year 4; Year 3; Year 2; Year 1 Liquidity Ratios Days cash on hand; 67 days; 70 days; 81 days; 69 days; 128 days Months of spending; 3.3 months; 3.3 months; 3.9 months; 3.5 months; 5.7 months Operating Ratios Savings indicator; 8.6%; 3.9%; −0.9%; 2.8%; 1.3% Contributions and grants; 18.6%; 12.0%; 8.6%; 10.4%; 10.9% Fundraising efficiency; $7.00; $4.30; $2.70; $3.30; $2.10 Spending Ratios Program service; 87.6%; 87.5%; 86.6%; 86.7%; 85.5% Management and general 9.5%; 9.6%; 10.2%; 10.1%; 9.0% Fundraising 2.9%; 2.9%; 3.2%; 3.2%; 5.3%

One benefit of trend analysis is that it identifies deviations in the ratios, such as the unusually high liquidity values in Year 1. A 46% decline in cash from Year 1 to Year 2 would almost certainly merit investigation. In this case, the organization had undertaken a capital campaign in Year 1, resulting in high cash balances, which were expended for long-term assets in Year 2. The presentation of five years of ratios provides a context for unusual amounts; presentation of only two years of ratios (Years 1 and 2) would likely leave the governing board uncertain about which year was abnormal.

Among the operating ratios, the savings indicator exhibits the greatest year-to-year fluctuation. Although negative savings (deficits) are not sustainable in the long run, not-for-profits may experience occasional deficits. In this case, the YMCA held expenses constant over a three-year period (Year 2 to Year 4), and the deficit reported  in Year 3 was attributable to a 20% decline in contributions that year. Because the savings indicator returned to positive in the subsequent year, the one-year deficit should not be of particular concern to the governing board.

Exhibit 2 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T2) also highlights the interrelationships among financial ratios. The decline in contribution revenue in Year 3 caused the deficit reported for the savings indicator as well as a decline in the contributions and grants and fundraising efficiency ratios. Conversely, contribution revenue increased nearly 70% in the current year, causing all three operating ratios to increase.

The purpose of a benchmarking analysis is to evaluate the current position of a notfor-profit with respect to similar organizations and to identify areas for improvement. The value of benchmarks as an evaluation tool is dependent upon the selection of an appropriate peer group. Not-for-profits vary widely in mission, activities, and funding sources, and benchmarks developed from disparate organizations are likely to be of marginal value. In many instances, not-for-profit managers will be able to identify organizations with similar missions. Trade associations and networking opportunities provided by industry conferences and meetings may also be useful in identifying peers.

Exhibit 3 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T3) presents the current year financial ratios of the selected YMCA and average values for a sample of 10 peer YMCAs. To ensure comparability, the peer YMCAs are from similarly sized cities within the same geographic region; geographic proximity contributes to comparability since real estate, utilities, and other costs vary across regions. Ratios were calculated for the peer institutions using information from their Form 990s. Exhibit 3 (https://www.nysscpa.org/news/publications/the-cpa-journal/article-detail?ArticleID=12842#T3) presents both average values and ranges of values for the peer group.

 Ratio; Example Not-for-Profit; Average for Peer Group; Range of Peer Group Liquidity Ratios Days cash on hand; 67 days; 51 days; 11 to 71 days Months of spending; 3.3 months; 3.1 months; 0 to 9 months Operating Ratios Savings indicator; 8.6%; 3.6%; −3.3 to 14.3% Contributions & grants; 18.6%; 15.9%; 3.7 to 40.8% Fundraising efficiency; $7.00; $12.00; $3.10 to $44.50 Spending Ratios Program service; 87.6%; 84.6%; 74.8% to 94.7% Management and general; 9.5%; 13.4%; 3.9% to 22.1% Fundraising; 2.9%; 2.0%; 0 to 5.4%

With regard to liquidity, the selected YMCA is very close to the peer group average for the months of spending ratio and has a cash position near the top of the peer group distribution. The operating ratios are also close to the peer averages. Although the selected YMCA has a higher-than-average contributions and grants ratio, it is not high in an absolute sense, with most revenues continuing to come from program fees and membership dues. The fundraising efficiency ratio is less than the peer group average, but well above the minimum recommended by charity watchdog groups. Finally, the spending ratios are close to peer averages. Overall, both the trend and benchmarking analyses suggest nothing is out of the ordinary in this year’s liquidity, operating, or spending ratios. Accordingly, the governing board could better use its members’ time discussing strategic matters affecting the future of the organization rather than past financial results.

Using Benchmarks and Ratios to Their Fullest

The requirement that all tax-exempt organizations complete and make available their Form 990s provides access to a wealth of financial information about peer organizations at minimal cost. In some cases, it may be desirable to develop multiple benchmarks. For example, colleges and universities commonly develop benchmarks for both peer and aspirant institutions. Doing so enables organizations to evaluate how well they are doing and what is required to move up to the next level.

Financial ratios can be useful tools for those in charge of monitoring a not-for-profit’s financial position and operations. Ratios are not a goal in themselves, however, and care should be taken in their interpretation. Conventional wisdom regarding desirable levels for some ratios may be unsupported by empirical data. For example, not-for-profits often feel pressured to lower overhead ratios, even though research shows that investment in overhead is often critical to overall not-for-profit mission success.

Each not-for-profit faces unique circumstances, and pursuit of a given strategy may improve one ratio while worsening another. It is also important for boards to understand that resource providers monitor the organization’s ratios. Management should anticipate and be prepared to address the concerns of donors and grantor agencies regarding the organization’s financial position.

CPA Journal, May 2019 Issue

By Kaitlin Cashwell, Paul Copley, PhD, CPA and Michael Dugan, DBA

 

 

 

 

 

 

2019 Review of Non Profit Accounting Systems

CPA Practice Advisor, Mary Girsch-Bock, April 16, 2019

According to the National Center for Charitable Statistics (NCCS), there are currently more than 1.5 million nonprofit organizations registered in the U.S. While the vast majority of these organizations are registered as public charities, the number also includes private foundations, chambers of commerce, and civic leagues.

While their missions may vary greatly, one thing these organizations share is the need to manage funds properly. This can include everything from applying for and managing grant funding, to tracking both donors and donations adequately. Membership driven organizations need to be able to track members, invoice members when membership fees are due, and maintain an accurate member list. Those that run programs regularly need to be able to handle event registration and keep track of everyone who has registered.

If that isn’t enough, these same organizations also have to be able to do the things that for-profit organizations do such as process journal entries, pay vendors, record payments, send out invoices, pay employees, and reconcile bank statements.

Many smaller nonprofit organizations make the mistake of thinking that regular accounting software is adequate. And while it’s possible to make it work, the more a nonprofit grows, the greater the need for a system that is designed to track the information that needs to be tracked.

Of course, finding the nonprofit software that is best for your client’s organization can take some time. If the organization has a large number of donors, they’d likely want that capability in any product that they choose. Likewise, if their organizational funding source is primarily from grants, they should be looking for a program that includes the ability to manage multiple grants.

Another issue to look at is deployment options. While some nonprofit software applications can be accessed from anywhere, others are designed to be installed on a desktop or network system. . Of course, cost can also be an issue, particularly for smaller nonprofit organizations with a limited budget.

All of these issues will need to be considered when looking for a software product that will work best for your client’s needs. And the best place to start is by taking a look at the nonprofit reviews that are included in this issue:

Abila MIP Advance

 AccuFund for Nonprofits

 Aplos Fund Accounting

 Araize Fast Fund

Blackbaud Financial Edge NXT

 Cougar Mountain Denali FUND

Fund E-Z Nonprofit Accounting  

GMS Grants Management Systems

QuickBooks for Nonprofits

Serenic Navigator

Tangicloud for Nonprofits & Government

 Xero Nonprofit Accounting

The reviewed products vary widely in both cost and functionality, with some of the products best suited for smaller nonprofits that have less stringent needs, while others provide just about every feature and functionality possible.

To make it easier, we looked at specific features and functionality in each of the products listed above, including chart of accounts structure and customization, grant management capability, fundraising and donor management capability, and even whether a mobile app was available. A Features chart accompanies the reviews, allows you to quickly view which features and functionality are found in each product. We also advise readers if a free demo is available, since trying out the product can be extremely useful when in the market for a new software system. Finally, pricing considerations come into play for most nonprofit organizations, since many have a limited budget available, so we’ve made every effort to include product costs in the review.

The bottom line is that nonprofit software can help an organization work more efficiently while they continue their mission to make this world a better place. We hope that the reviews included in this issue help in some way towards finding your client’s organization the product that works best for them.

Financial Technologies & Management provides our software evaluation to help you select the best nonprofit accounting system for you.  Also, we sell and implement the industry leading solutions which include MIP Fund Accounting, MIP Advance, AccuFund,  and Araize.  I would suggest you review our article “why your Nonprofit should consider using Nonprofit Accounting Software?” to start your review.  Please contact us before you contact any software vendors for us to best serve your review of Nonprofit Accounting Systems and Software.

12 Characteristics of Financially Healthy Nonprofits

12 Characteristics of Financially Healthy Nonprofits

Every director and board member of a nonprofit would like to have a large endowment, reserve cash in the bank, and a surplus at the end of every year. Unfortunately, most of us know that this might be a dream instead of reality. Without these tangible signs of financial strength, how can you know if your organization is financially healthy?

Financial health is about more than just reserves and endowment balances. Having a large budget or complex accounting system doesn’t always result in good management and longterm success. Just as our personal health depends on our behavior, so the financial health of a nonprofit depends on management behavior – policies and practices.

Even though there may be occasional deficits, or periods of tight cash flow, the following character- istics are good signs that your organization will be financially healthy over the long-term.

  1. Board of directors and management hold themselves responsible for long-term stability in both programs and financial performance.
  2. Board members understand their roles and responsibilities in financial matters.
  3. A realistic and well-considered budget is prepared and approved by the board.
  4. Budgets are prepared in tandem with planning for programs and operating needs.
  5. Management and board are committed to managing with the goal of an operating surplus each year.
  6. Consistent, accurate, and timely financial reports are prepared and analyzed by qualified individuals.
  7. Management and board monitor financial results as compared to the budget and modify programs and activities in response to variances.
  8. Management realistically plans and monitors cash flow so as to be able to meet obligations.
  9. Financial policies are in place that establish, or have specific plans to establish, an operating reserve to finance cash shortfalls and program growth.
  10. Policies are established for major financial decisions and adequate and appropriate internal controls.
  11. Management is committed to compliance with all required legal and funder reporting.
  12. The board and management regularly review short-term and long-term plans and develop goals and strategies for the future.

It is important that you strive to achieve each of these characteristics to insure your organization’s financial health and long-term sustainability.

Please let us know if we can help you improve in any of these areas.

Is Diversification of Revenue Good for Nonprofit Financial Health?

By MARK A. HAGER AND CHIAKO HUNG

This article comes from the spring 2019 edition of the Nonprofit Quarterly.

As in any field, nonprofit management has its little truisms: Boards make policy and staff members carry it out. Hire an independent facilitator for strategic planning. Always thank your volunteers. One of the most often-quoted truisms is that nonprofits should seek as much diversity in their revenue streams as possible. Turns out that some truisms are truer than others, and anybody handing out absolute rules is probably trying to sell you something. There’s no substitute for understanding the ins and outs of an issue and then smartly applying them to your own situation. What blossoms in one situation might crater in the next.

The basic principle sounds good: depending on one primary source of income can be risky, especially if that source begins to head south, so it makes sense to hedge your bets—right? Indeed, the decree that more types of revenue—or more revenue streams—is always good has been around for a long time. Each revenue type (and source) comes with its own levels of reliability, constraints, and costs, and all may not align appropriately with the organization or its stakeholders or other revenue sources. Many types of revenue streams may need a runway where they may cost more than they bring in for a period of time. Some need a different kind of organizational capacity than what exists. Some may draw you off course or create reputational issues. Some revenue streams might soften with the economy, while others do not.

Examples of this kind of complexity are everywhere. Picture a thrift shop that lives and dies purely on individual contributions, which we might call a concentrated portfolio. In contrast, the homeless shelter across the street may also rely substantially on individual contributions but also benefit from a foundation grant, county government sponsorship, and earnings from a social enterprise (a café staffed by shelter residents). We might say that the shelter has a diversified portfolio. And that’s always good, right?

Not always, no. Perhaps the government grant does not pay full costs of the service required to fulfill it, and therefore requires otherwise precious unrestricted money to supplement a specific contract. And perhaps the social enterprise demands more than its fair share of staff attention— producing more angst than cash. The fact is that every revenue source requires some transaction costs: money, time, and attention. Every revenue source has its own level of restriction, from complete to none at all, and this affects autonomy and adaptability. The thrift store can do what it wishes with the money it makes within the confines of the nondistribution constraint—unless, of course, it loses money or operates on a very thin margin. Its revenue is not likely to decline with the economy—in fact, the opposite is true. All of these details about the nature and behavior of various revenue streams matter to the health of the overall operation, complicating the question of whether or not diversification is needed.

The decision to pursue additional revenue streams is a vital question of strategy for any nonprofit. So, you might not be surprised to learn that dozens of university faculty members who study nonprofit organizations have been studying the value of revenue diversification for decades. But how useful has this been for practitioners? We reviewed all this research for a paper recently published in Nonprofit and Voluntary Sector Quarterly, and you might not be surprised to learn that the findings are messy and conflicting.1 When we say that revenue diversification matters, what exactly are we saying it matters for? “Financial health” might mean revenues, or revenue growth, or volatility. It might mean assets, or asset growth. It might mean operating margin, or fundraising spending, or program spending, or even survival. Different researchers study different outcomes among different types of nonprofits in different places with different research methods, and *boom* they get different results and draw different conclusions. Sometimes revenue diversification is helpful to financial health, sometimes it makes no difference, and sometimes it is harmful. Given these conflicting results, it falls to you to figure out your situation for yourself.

Luckily, this rich thread of research has spawned a number of arguments about why revenue diversification might be helpful or harmful. That’s what we want to present for you here, so that you have what you need to make your own strategic decisions in your nonprofit organization. An important starting point is to dispel the notion that revenue diversification is uniformly (always, every time) a good thing. Sometimes it’s not. Turns out the pros and cons are about even on the revenue diversification question. Let’s dig in.

Pro: Flexibility

If you know anything about the revenue diversification arguments, you might call this the standard textbook declaration on the pro side. Maybe the future is going to be stable and predictable, and your one revenue stream will provide the resources you need to pursue your mission. But the
future is unknown! Two kinds of uncertainty threaten to upset the applecart at any time. One is large-scale environmental change: a hurricane, or a recession, or civil unrest could radically shift what you need or what you have coming in. The other is more personal: your revenue line could just dry up. Shifts in tax policy make people think twice about their charitable gifts, foundations change their giving priorities, governments move their contracts to your competitors, and social enterprises fail. We know these things happen, and it’s not hard to imagine them happening to us.

The argument, then, is that more (and ideally unrelated) revenue streams give us the flexibility to weather shifts of all kinds. If you get all your money from government contracts and that contract is terminated, you may be sunk. If you get half your money from government contracts and half from private grants, loss of the contracts is serious but not necessarily fatal. Revenue diversification can give you options when the ground shifts beneath you. We say it allows you to “hedge against uncertainty.”

Con: Risk and Vulnerability

Hager saves a little money each month: It grows in his savings account—not much, but it grows. Hung saves a little money each month: He invests it in mutual funds—sometimes the market produces big returns, and sometimes it cuts into his principal. Maybe Hung will end up with more savings than Hager after a few years, but Hager sleeps better at night.

Modern portfolio theory helps us think about how to balance our tolerance for risk with our desire for greater returns. The investment choices with the greatest potential for gains are the same ones with the greatest potential for loss. These same ideas apply pretty well when making decisions about whether to pursue new revenue streams or not. Some revenue streams are more volatile or harder to maintain than others. Every time we pursue a new revenue option, we increase the complexity of our portfolio. We introduce risks that might cost us money in the long run—or at least a few nights of sleep.

Single-revenue streams, especially when the future is going to look much like the past, are safe and stable, just like savings accounts. However, the future is looking less and less like the past. Most of us now understand that we have to be prepared to adapt. Many read reliance on one revenue source as vulnerability, and, therefore, risk, and that makes good sense. But adding revenue streams adds complexity and new risks—ones that we often cannot fully calculate or appreciate as we enter into them.

Thus, diversifying requires at the very least a sober look at all the pros and cons of that particular income stream, including assessments of start-up costs, capital needs, and risks and consequences of worst possible scenarios. You may also need a special dashboard—or additions to your dashboard—so that the board can measure the costs-versus-benefits proposition. Without this forethought, you might end up in a worse financial position than if you chose not to diversify. The competence of your management team plays a big role here, and only you can gauge the likelihood that you will end up ahead.

Pro: Autonomy

The great advantage here is the freedom to call your own shots. Having money above what is needed for subsistence provides a lot of freedom, and needing money is a source of “constraint.” You have certainly seen examples of this: Private foundations do what they want, while their grantees have to toe the line.

Read any of the scholarship on revenue diversification, and there’s a fair chance you will see references to “resource dependence,” which means that money (or the ways to procure it) influences how organizations behave. Nonprofits that get all their money from government contracts—say, to provide mental health services for some part of their state—do not have much autonomy. The American Civil Liberties Union, with its recent huge influx of donor dollars, has a great deal of autonomy. The difference, again, is in the type of restrictions written into the type of revenue.

Revenue diversification has the potential to provide autonomy and all the advantages that come with that, since the nonprofit is not beholden to a single master. Whether many masters is better than one master is an open question, but diversification can provide freedom when one or another revenue stream places constraints on operations. The ability to call your own shots is essential; otherwise, nonprofits just vend services for the people holding the purse strings, and might stop representing their missions, boards, and broader stakeholder communities.

Con: Crowd-out of Private Donations

Crowd-out is one of those unanticipated problems that might come with—or might complicate—diversification of income streams. Put simply, crowd-out means that donors or purchasers might adjust their decisions due to their views on your other resource acquisition efforts. An example is the art museum attendee who declines to respond to a fundraising appeal because he believes his support obligation was met when he purchased the coffee-table book as he passed through the gift shop. Consequence: the museum cleared $15 profit on the book purchase, but lost out on a $150 donation.

Most of the research on crowd-out focuses on the statistical relationship between government contracts and private donations. A mental health agency might strategize that a public fundraising campaign would provide it more latitude and autonomy, and even the ability to innovate.
However, people may not be willing to contribute because they perceive the agency to be amply funded (by the government contracts) and therefore not in need of their contribution. Right or wrong, you can’t blame the donor for making that leap.

Blind revenue diversification carries these kinds of unanticipated problems. Because the revenue streams are part of a portfolio, they can interact with and influence each other. In isolation, a given revenue stream has a certain potential for revenue gains. Taken together, those potentials may be lowered. If they are lowered enough, they may well not be worth pursuing or will need to be pursued in a more limited, experimental way.

Pro: Community Embeddedness

Community embeddedness refers to your street credibility. Do potential clients or patrons know about you? Do they see you as legitimate? Do potential collaborators think about you when opportunities arise? Embeddedness is one part visibility, one part credibility, and one part networking. Some people call it social capital—the more that key stakeholders see you as a player, the more embedded you are in the community. Not every nonprofit needs this kind of embeddedness in order to serve its mission, but many crave it nonetheless.

One important way that organizations interface with community is through their efforts to acquire resources. An organization with a prominent fundraising campaign might be well known among the part of the public that cares about its mission but invisible to foundations, other nonprofits, government, local businesses, or the more general public. While diversifying revenue streams can have unanticipated downsides, a potential “extra” upside is exposure to new dimensions of the community. An organization well known to local grant makers might gain unique connections and increased reputation through the development of a social enterprise. Community connectedness might increase your penetration of mission, but community embeddedness might pay other benefits as well. For one, nonprofits with greater community embeddedness tend to live longer than more isolated nonprofits. Social capital pays, and revenue diversification can be a pathway to such embeddedness.

Con: Increased Administrative Costs

We mention risk and the potentials for crowd-out above, but the costs associated with (and capital required for) competently pursuing new revenue streams is too often overlooked by decision makers. If your organization has put time and effort into really good fundraising, that doesn’t instantly translate into expertise in grantwriting, or investments, or sales. Expertise is one thing, but sunk and ongoing administrative costs in management systems are another. Contracting often carries the highest such costs, with administrative time required for application, monitoring, and reporting. A good fundraising program requires pricey software and a sustained effort. Earned-income ventures require products and physical spaces and bear the risk of market failure.

A nonprofit with a concentrated revenue portfolio can streamline its spending and maximize the resources it passes to programs. In contrast, diversification requires specializations and different administrative apparatuses across the various approaches. If administrative costs stray onto the sensibilities of donors, those donors might even reduce their commitments to the organization. The increase in administrative outlays and the signals this may send to stakeholders are complexities that board members and other top managers do not always fully appreciate. Don’t get us wrong: we think nonprofits should spend more on vital administration, including information technology, human resource management, and resource development. But the problem is that your patrons may not agree with that. As always, nonprofits have to balance their progress with the demands of those who hold the purse strings.

Can decades of academic research tell you whether you should diversify your revenue streams or not? Sadly, no: the results are mixed and difficult to sort out. However, what it can do is outline the issues you and your board should consider when the question arises. Strategy, expertise, history, commitment, cause, and revenue mix differ from case to case, with a million different permutations. It depends. Study your own case, think through the ramifications, talk to everyone involved, and make your best calls without paying undue attention to an overly simplified prescription. Hopefully, flexibility, autonomy, and community embeddedness are around the corner.
Note

1. ChiaKo Hung and Mark A. Hager, “The Impact of Revenue Diversification on Nonprofit Financial Health: A Meta-analysis,” Nonprofit and Voluntary Sector Quarterly 48, no. 1 (February 2019).

“Is Diversification of Revenue Good for Nonprofit Financial Health?” draws on the NVSQ article, with permission

 

 

MIP Fund Accounting 2019.2 Product Release

The MIP product release is ready for download!!  Please feel free to contact Abila support or us to help with upgrade and software installation.
Please be advised that future releases of MIP will no longer be supported on Windows Server 2008 or 2008R2 and SQL 2008R2.  Let us know if we can help to upgrade you to a more current copy of SQL like 2012, 2014, or 2016. This release contains quality updates, as well as several customer-driven improvements.

  • Application improvements:
    • Upgraded budget worksheet to allow saving of in-progress work at any point
    • Additional filtering options to including payee, receipient, and name on Cash, Revenues, and Expense Journals which is typically used to proof 1099 information
    • Vendor activity reporting – additional report highlighting vendors with no recent activity
    • Form 1099 updates for 2019
    • Financial Statement List Report – addition of Account Type column and filter to see what account types have been assigned to report
    • Added feature to Payroll, so the ACH file can be regenerated and resent as needed in case of error.  You now have option to reset direct deposit to regenerate direct deposit file.
  • Quality improvements across MIP

MIP CLIENT PROMOTION

Get 10% off one module or 20% off two or more modules when you add to your MIP solution by June 30, 2019. Please contact us to get the special pricing or see a demo?  Offer does not include Microix or DrillPoint.

READY TO CHECK OUT THE NEW MIP CLOUD?

Even if you haven’t joined the group of cloud adopters, you’ve probably considered it, researched it, or discussed it with your peers. If your organization is ready for a deep dive, now is a good time to check out the newly improved MIP Cloud – request a presentation by contacting us

SUPPORT AND TRAINING TRENDING TOPICS:

Budgeting must be more flexible in uncertain times

By Jim Simpson, CPA and Director, Financial Technologies & Management

A strong budget is an essential element for any nonprofit organization to achieve financial leadership. Superior budgets, though, have written plans about the core activities to include strategic, organizational, and program goals and how they will be financed.  A superior budget must be monitored and managed in light of the political and economic realities and the increased uncertainties we are all facing.

Most financial leaders focus too much time on budget variance analysis and not enough time on anticipating or planning for the future. By anticipating or planning, organizations can focus on what’s upcoming regardless of its budget cycle or fiscal year-end. A budget can be complemented with rolling forecasts to better anticipate upcoming financial results.

Budgets also need to include cash flow projections, which maybe outside of the finance departments capacity or capabilities. Financial leaders must have a direct role in developing useful cash flow projections and assumptions with frequent, detailed analysis.

Financial sustainability can only be achieved with a well-prepared and continuously monitored budget. Conversely, a poorly developed budget can diminish mission focused activities opportunities and threaten long-term success.

It is important that each of the following budget process practices is used to develop the budget.

  • Draft revenue and expense budget to attain strategic, organizational and program goals. It is important to break expenses into variable expenses, fixed expenses, incremental expenses and indirect expenses for administration and facilities.  It is important that any new initiatives are approved and deadlines established before they are undertaken.
  • Modify budget with budget team input to ensure everyone understands and approves the revised draft budget.
  • Implement budget to communicate budget, assign management responsibilities, implement in accounting system, monitor and respond to changes to the budget. It is important that you document budget decisions including writing down all budget assumptions.
  • A budget should be implemented with monthly distributions to anticipate the changes to monthly revenues and expenses based on timing and seasonal program activities.
  • A budget may need to be broken out for donors without restrictions and donors with restrictions to insure that there are sufficient resources to actually fulfill the donor restrictions.
  • A budget should add a contingency or cushion to take into consideration the unknown.   The less predictable your budget it, the more contingency you may need to have.    A contingency of 5% of your non-personnel costs is typical and may need to increase if your funding or costs are not predictable.

Any unfavorable budget deficits need to be evaluated to determine if it is just a timing difference or an actual deficit. Shortfalls created by deficits need to be solved by budget adjustments or strategic choices to absorb a shortfall. An organization can determine timing or actual deficits by reviewing the budget to see if it had planned for or not.

Your budget deficits should consider what funding may become available, whether to utilize reserves, utilize unrestricted funding, or reduce expenses.  If funding is disappearing, can we replace the funding, should we reduce or eliminate an ineffective program, or can we reinvest into more effective or sustainable programs.  You should create various budget scenarios so you have various options about how to meet budget deficits.

In contrast to traditional budgets, a flexible budget may include a range of scenarios or a shorter time frame, or both. Three scenarios at a minimum should be prepared: best, worst and expected cases.

A bare bones worst-case budget will show you exactly which expenses are crucial to your organization.  Prepare your flexible budget in shorter or longer time increments from the annual budget cycle.

It is important the you strike the right balance in your development of flexible budgets.

  1. Worst-case budget – It will include realistic income and your core expenses.  The realistic income is committed funds and conservative fundraising estimates.  The core expenses would include essential expenses with no expansion of services.
  2. Expected-case budget – It will include optimistic income and incremental expenses.  The optimistic income will include uncertain funding estimates.   The incremental expenses would be the additional expenses to be incurred if new funds are secured.
  3. Best-case budget – It will include the fundraising goal revenue and projected expenses.  The fundraising goal revenue includes the combination of the realistic and optimistic income.  The projected expenses includes the combination of he core and incremental expenses.

It is important that an accompanying cash flow projection be developed to accompany the accrual based budget.  A cash flow projection will help to foresee cash flow problems a plan for solutions even if an organization has a balanced or surplus budget.

Flexible budgets and Cash Flow Projections will provide you with additional tools to help ensure your organization remains financial stable despite an uncertain future.

Key Goals for Financial Stability

  • Diversify Revenue so you are no too dependent on any one funding source and look for ways to accelerate cash flows
  • Allocate indirect costs to programs to insure all program costs are covered
  • Develop Staff versatility and adaptability to work in different program areas
  • Develop and maintain an Endowment to support financial operations
  • Maintain one to three months reserves to allow for program growth and cover short-term deficits
  • Keep track of financial results and how you are doing to keep organization financially stable
  • Monitor cash flow projection at least monthly to determine how long the organization can survive without additional funding

Let us know how we can help your organization develop the financial tools it needs to grow and remain financially stable.

Beyond the Debits and Credits: A Management and Governance Checklist for Implementing FASB ASU 2016-14

Beyond the Debits and Credits: A Management and Governance Checklist for Implementing FASB ASU 2016-14

 The time has come to dive into the details of how to implement FASB Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities. For that purpose, you can’t beat a good checklist. While there are several checklists available online to assist you with the financial-statement-presentation aspects of ASU 2016-14 implementation, this checklist addresses the governance side of implementation. What needs to be considered from a process perspective; what needs to be communicated and to whom?

The checklist is divided into the five key areas:

  • Classifying net assets
  • Reporting investment returns
  • Reporting expenses by function and nature
  • Preparing the statement of cash flows
  • Preparing disclosures about liquidity and availability of financial assets

Each section contains a high-level overview of the requirements, followed by questions that management should consider when implementing the standard as well as steps that may be taken to ensure that your board understands the implications.

Net Asset Classification

ASU 2016-14 replaces the three classes of net assets – permanently restricted, temporarily restricted and unrestricted –with two classes – net assets with donor-imposed restrictions and net assets without donor restrictions. To ensure that there is no loss of information, the standard requires not-for-profits to provide information about the nature and amounts of donor restrictions on net assets, as well as the amounts and purposes of net assets that have been designated by the governing board.

Amounts by which endowment funds are underwater will now be reported within net assets with donor restrictions rather than in unrestricted net assets. In addition, organizations will be required to disclose their policy for spending from underwater endowments and the aggregate original gift amounts of underwater funds, along with the fair value of those funds.

The policy option to imply a time restriction that expires over the useful life of donated long- lived assets will no longer be available. Instead, absent specific donor stipulations, restrictions on capital assets will be released when the asset is placed in service.

 

Considerations Yes/No Actions Required
1. Should current classifications be reviewed to ensure accuracy?    
a) Are processes in place to ensure that donor restrictions have been released appropriately?    
b) Are there unidentified balances in temporarily restricted net assets that should be examined?    
2. Does the organization have board designated net assets?    
a) Are the purposes for which the net assets are designated still appropriate?    
b) Has the board’s approval of designated amounts been adequately documented?    
3. Does the organization have endowment funds that are underwater?    
a) Are systems and processes in place that enable identification of underwater funds?    
b) Will the transfer to net assets with donor restrictions adversely affect ratios or covenants?    
c) Is the organization’s policy for spending from underwater endowments still appropriate and adequately documented?    
4. Does the organization have a policy to imply a time restriction that expires over the useful life of donated long-lived assets?    
a) What is the potential effect of releasing from restriction net assets to which that policy has been applied?    
5. Does the organization’s chart of accounts need revisions to support the net asset changes?    
Considerations for Board Communication
1. Explain the new net asset categories.    
a) Review terminology changes.    
b) Illustrate how the changes will affect statement presentation.    
2. Describe any impact of underwater endowments on net asset balances.    
3. Describe any impact on net asset balances if policy to imply a time restriction on donated long-lived assets is currently being used.    
4. Reaffirm prior board decisions.    
a) Review existing board designations.    

 

b) Ensure policy for spending from underwater endowments is still appropriate.    
5. Discuss additional costs associated with changes.    
a) Additional audit fees    
b) Necessary system and/or process changes    

Reporting Investment Returns

Under ASU 2016-14, investment returns will be presented net of external and direct internal expenses in the statement of activities. The current requirement to disclose the amount of netted investment expenses has been eliminated. In addition, NFPs will no longer be required to display the investment return components (income earned and net realized and unrealized gains or losses) in the rollforward of endowment net assets.

 

Considerations Yes/No Actions Required
1. Identify the costs, if any, that are being netted today.    
a) Do costs currently being netted meet the definition in the standard?    
b) Will any additional costs need to be netted?    
2. Consider how to communicate any significant changes in net investment revenue reported in the financial statements.    
a) Who needs to communicated with?    
b) What is the best means of communicating (i.e., in person, by email, other)?    
3. Will a change in net investment return have any adverse consequences that should be addressed prior to implementation?    
a) Debt covenants    
b) Regulatory requirements    
c) Other    
4. Does the organization produce other reports that should be revised to provide consistent information?    
Considerations for Board Communication
1. Explain the new requirement for netting investment expenses.    
2. Identify any changes to the current amounts, if any, being netted.    
3. Describe any impact on net investment return to be reported in the financial statements and any adverse consequences of the change.    

Reporting Expenses by Function and Nature

ASU 2016-14 requires an analysis of total expenses by both their function and nature in a single location either on the face of the statement of activities, as a schedule in the notes to financial statements, or in a separate financial statement. To the extent that expenses are reported by other than their natural classification (such as salaries included in cost of goods sold or facility rental costs of special events reported as direct benefits to donors), they must be reported by their natural classification in the functional expense analysis. For example, salaries, wages, and fringe benefits that are included as part of the cost of goods sold on the statement of activities should be included with other salaries, wages, and fringe benefits in the expense analysis. External and direct internal investment expenses that have been netted against investment return may not be included in the functional expense analysis. Enhanced disclosures about how costs are allocated among functions are also required.

 

Considerations Yes/No Actions Required
1. Determine the best format for presenting the expense analysis:    
a) On the face of the statement of activities?    
b) In the notes to the financial statements?    
c) As a separate statement (i.e., a statement of functional expenses)?    
2. Are the current functional expense classifications still appropriate?    
a) Are there too many?    
b) Are there too few?    
c) Is any renaming necessary to accurately depict what is included in a specific function?    
3. Ensure functional classifications are being accurately captured in the financial statements.    
a) What processes are in place to ensure that expenses are properly classified?    
b) Is a review of the classification necessary to ensure accuracy?    
4. Are expenses by natural classification being properly captured?    
a) What processes are in place to ensure expenses are properly recorded?    
b) Are employee reimbursements in accordance with the organization’s policy?    
5. Are the current natural expense classifications still appropriate?    
a) Are there too many?    
b) Are there too few?    

 

6. Are current allocation methodologies appropriate?    
7. If comparative years are presented, should the expense analysis be presented for the current year only or for all years presented? (Note: NFPs that previously were required to present a statement of functional expenses do not have the option to omit prior-period information.)    
Considerations for Board Communication
1. Discuss how this analysis may differ from the similar analysis required on the IRS Form 990.    
2. Identify any additional costs anticipated in preparing the disclosure (i.e., costs to review existing functional expenses).    

Statement of Cash Flows

ASU 2016-14 allows an organization to present cash flows from operating activities using either the direct or indirect method. If the direct method is chosen, the indirect reconciliation is not required, but may still be provided if desired.

Considerations Yes/No Actions Required
1. Determine which presentation method is best for the organization.    
2. If contemplating a change:    
a) Consider recasting current statement into the new format.    
b) Identify any system changes needed to support the new format.    
c) Determine if any process changes will be necessary.    
d) Decide whether to include the indirect reconciliation in the financial statements.    
Considerations for Board Communication
1. Discuss the pros and cons of each format and get input on the board’s preference.    
2. Consider preparing statements in each format and highlight differences.    
3. Identify any additional costs associated with making a change.    

Disclosures about Liquidity and Availability of Financial Assets

The new standard requires not-for-profits to disclose both qualitative and quantitative information about liquidity and availability of resources as follows:

  • Qualitative information that communicates how the organization manages its liquid resources available to meet cash needs for general expenditures within one year of the balance sheet
  • Quantitative information that communicates the availability of the organization’s financial assets at the balance sheet date to meet cash needs for general expenditures within one year of the balance sheet The availability of a financial asset may be affected by its nature; external limits imposed by donors, laws, and contracts with others; and internal limits imposed by governing boards.

These disclosures can take many forms depending on the relative liquidity of an organization’s resources, donor-imposed restrictions on those resources, internal board designation of resources, and so on.

Considerations Yes/No Actions Required
1. What is the message the organization wants to convey?    
a) Does the organization have ample resources to fund activities over the next 12 months?    
b) Are there significant restrictions or internal designations limiting the use of resources?    
c) What additional sources of liquidity are available?    
2. Identify the best way to present the message:    
a) Text only?    
b) Tables and text?    
3. Identify current procedures around board designations.    
a) Are procedures formally documented?    
b) Does the board delegate authority for designation of net assets?    
i.   Is the delegation documented?    
ii. Are the levels of delegation still appropriate?    
4. Review current policies.    
a) Will any new policies be required?    
i.   Net asset designation policy?    
ii. Operating reserve policy?    
b) Do existing policies need updating or formalizing?    
5. Are system changes needed to easily capture information for disclosure?    
6. Does the organization’s chart of accounts need revisions to support the disclosure?    

 

7. Do current processes need to be modified?    
8. Are any new processes necessary?    
9. If comparative years are presented, should the liquidity disclosures be presented for the current year only or for all years presented?    
Considerations for Board Communication
1. Explain the disclosure requirements.    
2. Discuss the best presentation for achieving desired transparency.    
3. Recommend any policy changes or additions.    
4. Discuss any additional costs anticipated for preparing the disclosures.    

Source: “Beyond the Debits and Credits: A Management and Governance Checklist for Implementing FASB ASU 2016-14,” American Institute of Certified Public Accountants, Not-for-Profit Section.

Nonprofit Cash Flow Management: Day-to-Day Liquidity

In recent years, the concept of the “business model” has gained a great deal of currency within the nonprofit sector, with nonprofit leaders as well as grantmakers and other stakeholders focused on understanding and improving the business and financial underpinnings of how organizations deliver on their missions. Discussions of the nonprofit business model often include considerations of things like cost to deliver services, mix of sources of funding, and key drivers of financial results.  Discussions of financial stability and sustainability often focus on the overall health of the balance sheet and (accrual-based) operating results. While these are all essential elements to understanding an organization’s finances and business model, such conversations sometimes miss one critical component of any business—namely, day-to-day liquidity. This article will discuss ways in which cash flow impacts—and is impacted by—the way a nonprofit organization does its business.

Cash flow is simply the mix—and timing—of cash receipts into and cash payments out of an organization’s accounts. It is where the numbers on budget spreadsheets and financial reports translate into the reality of money changing hands. And as such, it is a very specific lens on the reality of a business model—one that takes into account not just what an organization’s revenues and expenses look like, but when they come and go.

Managing cash flow, therefore, is primarily a question of when—when we pay our staff, when this bill is due, when the grant payment will come in. And as there are many varieties of nonprofit business models, each one has a particular bearing on many of those whens.

Nonprofit business models have two main components: what kinds of programs and services nonprofits deliver, and how they are funded.  For nonprofits, the latter component is a bit more complicated than for our colleagues in the for-profit world, for whom the answer is (nearly) always “by selling them to customers.” Of course, this isn’t to say that cash flow is perfectly smooth or friction less even in the for-profit sector, only that the range and variety of funding models for nonprofits (including not just “customers” but also third-party funders such as foundations, governments, and even individual donors) adds additional complexity.

Each component of the nonprofit business model—the delivery model and the funding model—has implications for organizational cash flow that should be understood for effective financial planning. We’ll look at each one in turn before discussing some strategies for addressing the almost inevitable occasions when the cash flowing in doesn’t match the cash flowing out.

What Do We Do?

 “What do we do?”—what kinds of programs and services an organization delivers (and how it delivers them)—is really a more high-minded way of asking, “What do we spend our money on?” (Granted, some services may be delivered by volunteers or use donated goods, but money is still necessary to pay managers and fund operations.) Really understanding “what we spend money on” will also generally give us a good idea of “when we spend it.” For example, a performing arts company that does four productions a year will have a fairly steady base of ongoing expenses, with spikes during the periods when productions are being prepared and staged. An emergency relief organization may have its baseline of operating expenses, with sudden (and unpredictable) surges of cash needs in response to a local hardship or disaster. A social service organization may have very predictable and consistent monthly cash outlays: payroll every two weeks, rent on the first of the month, invoices on the fifteenth and thirtieth. In each case, the cash flow demands are inherent in the business model.

Job one for cash flow management, then, is to understand the timing of cash needs—the magnitude and due dates of an organization’s bills.    Again, the “what do we do” side of the business model is the guide. If what you do is relatively stable, consistent, and predictable (as in the social service organization example), your cash needs likely will be as well. If what you do is predictable but not consistent (as in the performing arts company with productions at various points throughout the year), you know to plan for the surge in cash needs when the programming picks up. If what you do is unpredictable (as in the disaster relief agency), you will need cash available to deploy at a moment’s notice.

The examples above only take into account normal operations—businesses also need cash at certain points for longer-term investments like moving to a new space or buying a building. And while a major investment like that wouldn’t happen without a solid plan, there are also the occasional random but significant expenses like facility repairs. Again, the business model tells the story of the cash needs: while the social service organization may not be making capital purchases beyond a new set of computers, a housing development organization may need enough cash for major real estate purchases or construction of buildings. However large or small the investment, at the end of the day it means cash flowing out of your account.

How Are We Funded?

 Wouldn’t it be nice if the biggest task were simply thinking through one’s program delivery model to identify when the cash will be needed, and then turning on the tap to make it flow? Unfortunately, cash doesn’t work like a tap (and in fact, we have to have cash to keep water flowing). While the ideal case scenario is that cash comes into an organization at a similar volume and velocity to how it goes out, in reality nonprofit funding streams very often don’t work like that. In fact, an organization with a balanced (or even surplus) budget can still end up running out of cash due to timing mismatches. Looking at the “how are we funded” side of the business model can give us a better sense of what to expect in terms of cash inflows and of what to do if they don’t line up with the “what do we do” side. Each type of income stream tends to have particular implications and challenges for cash flow, so a business model built primarily around one type of funding will need to understand and plan for those implications and challenges.

A revenue-side business model that we see posing one of the biggest challenges for cash flow management is funding from government (particularly state and local) sources. In general, contracts with government entities pay for services only after the services are delivered, forcing the service-providing nonprofit to cover the initial outlay of cash to deliver those services. This is actually fairly typical of any business (for example, a retailer has to front the cash for inventory before generating income from sales; a professional services firm delivers services to clients prior to invoicing and collecting cash), but it is often compounded in the case of government funding by bureaucratic delays in registering contracts or processing invoices and payments. In some extreme cases, we have seen gaps of several months or more between an organization’s disbursement of cash to deliver contract services and collection of cash under the terms of the contract. In the absence of other revenue streams or other ways of accessing cash (about which more later), nonprofits in situations like this can face true cash flow crises.

Earned income from nongovernment sources—for instance, ticket sales for a performing arts organization—brings some of the same challenges, although (ideally) without the additional bureaucratic delays sometimes inherent in working with government. Even so, cash outlays typically happen in advance of cash collection—performances are rehearsed and sets are built before the audience buys tickets. This means that an organization needs cash to finance those costs that will later generate revenue back into the organization. (Any sort of prepayment on earned income—for example, advance ticket sales for performances or advance payments or retainers for service delivery—can help to fund the initial cash outlays.)

Cash from contributions and donations doesn’t come with the bureaucratic delays of government funding or the up-front outlays required to generate earned income. But organizations whose revenue model is primarily driven by voluntary contributions often face another reality of managing cash, which is that cash inflow can be very concentrated at a particular point (or points) within the year. For example, an organization that generates a significant portion of its income from an annual gala-type fundraiser may have an event in spring whose receipts may have to carry it much of the way until the next spring. Another may see much of its cash come in from an annual campaign timed to take advantage of end- of-year holiday (and tax write-off) giving. Nonprofits with highly concentrated cash inflow can exist in something of a “feast or famine” mode— flush when the money is rolling in but concerned that it will have to carry all the way until next year, or at least the next campaign.

Support from foundations and institutional philanthropy has its own implications for cash flow. On the positive side, grants are generally paid at the start of a funding period rather than following the delivery (and costs) of programs and services. On the negative side, grantmaking calendars can vary considerably from a nonprofit’s own programming calendar, so there can still be periods when ongoing program or operating costs have to be financed from other sources. Another relatively common characteristic of foundation support (and a cash flow consideration unique to the nonprofit sector) is its restriction to particular programs or activities, meaning that a condition of a grant is that its funds be used only for a specified purpose. So, what may look like readily available cash to meet current needs could technically be a set-aside for expenses weeks or months down the road.

Each side of the nonprofit business model—what and how we deliver, and how we fund it—helps set expectations about the timing of cash into and out of the organization’s accounts. But, particularly given the fact of nonprofit life that our “customers” and “payers” are often different entities, there’s only so much we can do to line up that timing to smooth out cash flow. If it does happen to line up perfectly, it’s probably due more to coincidence (or miracle) than conscious effort. So, once we establish solid expectations for what our business model means in terms of the timing of cash going out and coming in, the task is how to manage the many and inevitable instances when the timing doesn’t line up.

Balancing Cash In and Out

Regardless of the nature of our business model, or of how well we plan, there will inevitably be periods in which more cash is going out of an organization than is coming into it. This is most obvious during a start-up phase, when the initial investments made in (or loans made to) a new organization are essential to meeting cash needs before income generation kicks in. But even for an established organization in a relatively steady state, “you have to spend money to make money” (and generally in that order) is a rule of business. So, how do we meet our cash needs in those times when there is not enough coming in from operations?

Before discussing that question, one critical point: It’s true that in almost any business, there will be times when cash coming in doesn’t cover the full need for cash going out. That may be because of certain timing issues inherent in the organization’s business model—slow payments for services delivered under a government contract, say. But it may also be because there’s simply not enough revenue in the business model to cover the expenses of operating the business. If the issue is a temporary cash shortage, then an organization’s leaders will know (or have a reasonable sense of) when the situation will be back in balance, with sufficient cash coming in to cover expenses. If the issue is a more permanent imbalance, what may be presenting as a cash flow problem (i.e., a matter of timing) is in reality a broader business model problem—not just a disconnect between when money is coming in versus going out, but between how much money is coming in versus going out. If an organization’s overall business model is in deficit and out of balance, cash flow problems will certainly exist, but not ones that can be resolved by the methods discussed further down. In those cases, cash flow problems are just a symptom of the bigger challenge of overall revenues not being enough to cover expenses; treating that situation as a matter of cash flow timing will only delay and intensify the necessity to address the deeper need to increase revenues and/or decrease expenses.

On the flip side, an apparently healthy cash balance doesn’t necessarily translate to cash fluidity. For instance, particularly in organizations that have multiple streams of funding for individual programs (where, as alluded to earlier, some money is restricted to certain activities), it is easy to lose track of the purposes for which each stream may be used. You may have enough money to run the program, but the money may end up being spent in ways other than what each funder requires. To make a bad situation worse, such mistakes can be punishable by a requirement to repay, making future cash even harder to come by. Thus, in nonprofit finance, cash is not fungible like it is in most for-profits: you cannot necessarily take it from one overfunded function and devote it to another that is underfunded. This can be confusing to boards—and also, too often, to unschooled executives. Such mistakes with government contracts and other forms of restricted funding can have serious high-profile repercussions for your long-term financial health and cash flow.

With that major caveat out of the way, let’s turn back to the question of how to address timing issues when last month’s collections are lower than this month’s bills. The most basic (and important) solution is drawing on an organization’s own cash reserves, which supply the working capital to keep current on payroll, rent, and other expenses. Having a cushion of a few months’ worth of expenses built up in the bank account provides the liquidity necessary to avoid being at the mercy of each day’s cash receipts to determine which bills to pay. Cash reserves are a good indicator of a nonprofit’s overall financial health and sustainability, but from an even more practical perspective they are an essential resource for managing cash flow and payment schedules.

Unfortunately, development of a robust cash reserve can be a significant challenge for many organizations. While financial surpluses and accumulations of reserves should always be a goal of budgeting and financial management, some organizations’ business models make this particularly challenging. For instance, heavily government-funded social service providers face a Catch-22, in that expense reimbursement contracts cannot by definition operate at a surplus, yet the typically slow pace of cash receipts makes it particularly important to maintain a significant cash reserve. What options exist in such cases?

For any business unable to meet cash needs with its own resources, it must meet them by borrowing from someone else’s resources (that is, taking on debt). To meet operating cash needs in the absence of adequate cash reserves, a nonprofit can turn to a line of credit as a “floatation device” to meet the temporary imbalance between available cash and expenses due. We stress the word temporary here to echo the important point made a few paragraphs back: that lines of credit should be used only to address a timing discrepancy between payment of expenses and receipt of cash.

Without a reasonable and relatively specific understanding of when the cash will be available to repay the line of credit, an organization is at risk of using credit to fund an operating deficit—and, of course, exacerbating the deficit with the interest expense associated with the debt!

That said, credit lines used responsibly can be a useful and vital tool for cash flow management, particularly for those organizations whose business models entail slow collection of major receivables or long gaps between cash infusions. We typically recommend that organizations in those situations secure a credit line at least as a safety net, since using credit is generally a better course of action than delaying payment of expenses that are critical to the functioning of the organization. And, as a general rule, it’s much easier to secure a line of credit before it’s needed than it will be when and if the situation becomes urgent. Of course, credit doesn’t come free, and organizations using lines of credit must also plan and budget for interest expenses and any other transaction costs associated with taking on debt.

If neither reserves nor credit are options in a cash crunch, nonprofits may be forced to resort to less appealing means of riding out the storm. These may include measures such as approaching funders for accelerated or advanced payments (here again, it would be critical to show that the problem is only one of timing mismatch in order to avoid raising a huge red flag to a funder) or delaying payment of certain noncritical vendors. An even less appealing option would be a loan from a staff or board member, which could raise conflict-of-interest concerns. Probably the worst-case scenario is delaying payroll for some or all staff, which could jeopardize the organization’s programs as well as potentially raise legal issues. Far better to understand your business model and budget, and plan in such a way as to establish a solid cash cushion for the lean times.

Cash Management across an Organization

The challenges and consequences nonprofit organizations face with respect to cash flow are to a large extent inherent in the business models those organizations operate with—what kinds of programs and services they deliver and the way(s) they are funded. But this isn’t to say that nonprofit leaders are purely at the mercy of the business model; understanding the way the model impacts cash flow is the first step toward planning for and managing it. While it may be impossible to ensure that cash is coming into the organization exactly on time and on target to keep things on automatic pilot, it is certainly possible to plan for those times when it isn’t, and to take advance measures to be sure that bills (and staff) are paid on time.

In this effort, it helps to take a team approach. While one person or department (finance) will be in charge of the central cash flow projection tool, effectively planning and managing cash requires input from across an organization. Program and human resources staff have the most insight into the timing of expenses. The fundraising team knows the most about timing of grant payments and donor gifts. Contract managers can set expectations about reimbursement schedules. Team members working on earned income projects can estimate billing and collections. Ultimately, all of this information should flow to the CFO to project and plan for any potential shortfalls (or, in the happy event of significantly more cash than necessary, to park it in safe short-term investments). Staff across the organization may also be asked to help manage challenges as well—perhaps by rethinking timing of certain expenses or working on accelerating collection of cash from donors or customers. Being informed, strategic, and collaborative in cash flow management can help to ensure that a nonprofit’s long-term strategy isn’t derailed by avoidable—if inevitable—short- term obstacles.

Source: Cash Flow in the Nonprofit Business Model: A Question of Whats and Whens by Hilda H Polanco and John Summers, Nonprofit Quarterly, February 13, 2019

5 Tips for Nonprofit Internal Financial Reports

When it comes time to present internal reports to the board, more likely than not we have grown to expect a few yawns, complimented by blank stares. This article has the ability to engage, enhance, and provide useful information to the board during these internal report presentations.

A not-for-profit should consider the following best practices to ensure that internal financial reports prepared for its board of directors and other governance committees are accurate, timely, and decision-useful.

The following 5 Tips are provided to make your Nonprofit Internal Financial Reports more effective and useful.

Make it easy to read. Internal financial statements that include management’s discussion and analysis of the results presented can be helpful to board members as they carry out their oversight responsibilities. A brief overview of the period presented and highlights of the results that are meaningful to the organization will assist the governing bodies in their decision-making processes. The analysis should be easy to read, avoiding overly technical language while conveying the organization’s financial story. In addition, the accompanying financial statements should include, at a minimum, comparative statements of financial position (balance sheet), statements of activities (income statement), and budget-to-actual report.

Describe profit and loss by program. Not-for-profits operating multiple programs (especially those relying on governmental funding) should also consider, as a best practice, producing a profit and loss statement for each program on at least a quarterly basis. The surplus or loss on each program should be compared with the surplus or loss of the corresponding period in the previous year with significant variances explained. As an additional best practice, on an annual basis, a reconciliation should be prepared between the budgeted surplus (or loss) to the surplus (or loss) from the audited financial statements. If a program is regularly operating at a loss, management and the board can evaluate whether the organization should continue to subsidize the program.

Use ratio analysis. Ratio analysis is an effective tool for assessing an organization’s financial viability. When produced on at least a semiannual basis, internal reports on key ratios can help organizations monitor their liquidity, performance, activity, and leverage. The ratios can also be used for benchmarking purposes. Each organization should identify which key ratios and metrics are the most meaningful to their business model.

Present cash flow and liquidity data. Periodically throughout the year, organizations should assess their liquidity and availability of resources to meet their cash flow needs for a specified time. These assessments should be shared with the board on a quarterly or semiannual basis. For organizations struggling with cash flow or liquidity issues, reporting may need to be more frequent.

Keep it simple. Avoid lengthy reporting and choose a format that is easy to follow. Provide training to board and senior staff members on how to read and understand the reports so they can ask appropriate questions and make effective decisions. In some cases, dashboard reporting, using visuals to highlight key metrics and indicators, is very effective. Having accounting software that can produce internal financial statements with minimal edits outside of the system is important, providing data integrity while maximizing efficiency.

Source: “Tips for NFP Internal Reports”. Journal of Accountancy. November 2018.

7 steps to planning a successful not-for-profit audit

Year-end financial statement audits serve a valuable purpose in helping maintain the financial integrity of not-for-profit organizations so they can successfully complete their missions. These audits can be more effective and less challenging with a little bit of preparation and planning on the part of the not-for-profit management and finance team.

This preparation starts with your accounting system, because everything you do on a monthly basis will pay dividends as you gear up for your year-end close and the audit. Chances are your accounting system is very good for everyday things, such as processing customer/donor billings, receiving payments, paying bills, and making payroll. And you probably do other things every month in the normal course of your monthly closing cycle, such as review and reconcile various accounts.

Having these processes in place provides a good start in preparation for your year-end audit.  There are 7 planning steps to help your year-end audit be successful:

Analyze, review, and reconcile significant balance sheet accounts. Use a roll forward schedule to capture all the account activity. You and your auditor can agree as to the exact form and layout of the schedules to ensure they serve the dual purposes of the year-end close worksheet and audit schedule:

Beginning balance + additions – reductions +/- adjustments = Ending balance

Completing the schedule ensures that the account balances roll forward from the prior year end to the current year end, which provides assurance that the income statement effects of the changes have been properly recorded.

The following balance sheet accounts (and related income statement accounts) that you will want to reconcile and roll forward. Be sure to add other accounts to meet your organization’s unique needs.

Balance Sheet to reconcile and roll forward include Cash, Investments, Account Receivable, Pledge Receivable, Prepaids, Property and Equipment and related accumulated depreciation, Accounts Payable, Accrued Expenses, Deferred Revenue, Debt including capital lease obligations, and Net Assets.

Meet with your auditor to confirm the audit plan and timeline. Be sure you both come away with a clear understanding of the who, what, when, where, how, and why for each step of the audit process all the way to delivery of the final reports. The result of these efforts will be a matrix of roles, responsibilities, and dates that you both agree to uphold. Review all the audit confirmations, schedules to be prepared, documents to be pulled, and other support functions your organization will provide to the auditor. Ask for items that can help reduce your work in preparing for the audit.

Talk to your internal accounting team. Discuss the expectations, concessions, adjustments, and accommodations needed to make the year-end closing plan work. Build some contingency time into your planning, as the unexpected has an uncanny way of sneaking into even the best of plans.

Inform others in your organization about what to expect. Share your plan outside of the accounting department. Talk about what to expect from your team and the auditors when they arrive on-site. Now is a good time to reserve space for the auditors and ensure that adequate electrical outlets, internet service, photocopying/scanning, and other resources needed by the audit team will be ready and waiting when they arrive.

Finish recording all the activity for the year. Before closing your fiscal year, post the accruals and adjustments necessary to put your books fully on GAAP basis of accounting. The objective at the finish is to have a closed general ledger that will need no adjustments by your auditor. As part of the closing process, you will be completing all the roll forward schedules and account reconciliations, adjusting depreciation, recording all payables and receivables, adjusting bad debt allowances, and so on. Be sure to perform a final check of roll forward schedules to be sure they agree with final general ledger balances.

Have everything ready for the audit team when they arrive on-site. If possible, try providing items as they are completed, which will give your auditor a chance to review them in advance, potentially saving time for you and your auditor.

Don’t forget to communicate. Kindness and communication throughout the year-end closing process will produce the best results, minimize stress, and make life more pleasant for all. Be sure to build in breaks and a little downtime to help everyone maintain a healthy balance and perspective as you work together through what can be a bit overwhelming at times

Source: “7 steps to planning a successful not-for-profit audit”  AICPA CPA Insider, April 24, 2017, Tim McCutcheon, CPA