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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

 

 

 

 

 

 

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

 

 

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.

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.