5 Things Funders Consider When Evaluating Nonprofit Financial Statements
Nonprofit organizations invest significant resources in their fundraising efforts. Despite an organization’s mission driven achievements and qualifications, a nonprofit’s poor financial condition may be a potential road block to funding. Potential funders (i.e. government agencies, foundations, corporate sponsors, individual donors, banks/lenders, etc.) have financial criteria, whether formal or informal, that nonprofit organizations must meet to qualify for their particular grant, sponsorship, contribution, or loan.
| Posted in Management on Jan 27, 2012 by
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Five key things funders consider when evaluating a nonprofit’s financial condition:
- Liquidity - A balance sheet, or statement of financial condition, is considered “strong” or “solid”, among other things, when the organization’s current assets sufficiently exceed their current liabilities. What’s a good current ratio (current assets divided by current liabilities)? Every organization is different, and metrics vary, but current ratios typically should be at least 1.5 or higher. Less than 1.0 (current liabilities exceed current assets) signals liquidity problems on the horizon. Even better, having a cash ratio (cash divided by current liabilities) well in excess of 1.0 tells the funder they have adequate cash to meet obligations as they come due in the short term.
- Sufficiency of Reserves - This is related to liquidity. Look at the organization’s total net assets (total assets less total liabilities). How much of these net assets are unrestricted and not permanently or temporarily donor restricted? How much of these unrestricted net assets are undesignated (i.e. not designated by the Board of Directors for another purpose, such as an endowment or a building fund)? Now compare the unrestricted, undesignated net assets to your annual expenses? Is unrestricted, undesignated net assets at least 25% of your annual expenditures?
Said in another way, look at the organization’s total cash, short-term investments, accounts receivable and other assets readily convertible to cash in 30 days or less. Would these amounts cover operating expenses for at least 3 months?
The United Way has several standards that organizations must meet to be a qualified recipient agency. One of their financial standards is their financial reserve policy. The United Way generally recommends their participating nonprofit agencies retain funds (generally cash and funds/assets readily convertible to cash within 30 days) to cover operating expenses for a period of three to nine months. Also note that accounts receivable may not qualify to be classified as part of “reserve funds” because they may not be routinely collected in 30 days or less.
On the other hand, you can have too much of a good thing. The Better Business Bureau, which maintains several standards for charity accountability, says charitable organizations should avoid accumulating funds that could be used for current program activities. Their rule of thumb: an organization’s unrestricted net assets available for use should not be more than three times the size its total annual expenses.
- Balance between program, managerial, and fundraising expenses - A nonprofit’s income statement, or statement of activities, is unique, among other things, because expenses are required to be grouped, allocated, and reported according to three classifications: program, management & general, and fundraising. For example, an executive director’s salary is allocated to programs, managerial, and fundraising categories depending on how the ED typically spends his or her time. A sign of a well-run and efficient nonprofit is one that spends the majority of funding on programs (i.e. the services and mission related activities of the organization), but also maintains the proper oversight (managerial) and invests in replenishing the organization’s contributions and revenue streams (fundraising).
What’s the proper balance? Again, nonprofits vary from organization to organization, but the United Way Standards require program expenses to be 75% or more of total expenses (i.e. management & general and fundraising expenses are 25% or less of total expenses). The Better Business Bureau says charitable organizations should spend at least 65% of its total expenses on program activities. Neither the United Way nor the Better Business Bureau suggests a cap. However, if an organization reports more than 90% of its total expenses on program activities, I tend to wonder: 1) Does the organization have enough infrastructure in place to effectively monitor and control against fraud or mismanagement? 2) Is the organization investing enough in fundraising and donor development for future sustainability? 3) Are the organizations “natural” expense line items (i.e. salaries, rent, utilities, office supplies, etc.) allocated according to its “functional” expense classification (program, management & general, & fundraising) correctly? Again, organizations may vary, but it’s possible for organizations to spend too much on the mission/programs and not enough on their infrastructure and future sustainability.
- Sustainability of Revenue Streams - Are their trends in the operating revenues that indicate a decline in revenue streams? Does the organization require more contribution revenue every year to make up for declines in program service fees? Are fundraising event revenues declining because the organization’s fundraising events (for example, golf outing, trivia night, auction, gala, etc.) are getting stale? Does the organization count on a certain amount of investment income to cover operating losses every year? Does the Board and/or Management have a plan for addressing these issues now and in the future?
- Consistency - Perhaps the most important consideration of all is consistency of operating results year over year. If there are wide fluctuations in the change in net assets (a nonprofit’s net income or loss), revenues, or expenses, potential funders want to understand why, whether good or bad.
- Were there unusual, one-time or unexpected events: for example, a capital campaign, a large bequest, a government program was terminated, etc.?
- How did the organization perform against the budget?
- Are there wild fluctuations in the organization’s financial metrics, such as the ones discussed above: liquidity ratios, cash reserves, program expenses as a percent of total expenses and revenue trends.
The more consistent the operating results, the more confidence the funder has in the organization’s future operations. That’s why potential funders generally ask for at least two years of financial information: financial statements, IRS Form 990’s etc.
An underlying assumption with all these considerations is that the financial information is accurate, meaning financial statements are prepared in accordance with generally accepted accounting principles and/or the Form 990 is completed fully and in accordance with the instructions. That’s why funders will often ask for a financial statement audited by an independent CPA firm as well as a certification from management and/or the Board of Directors to their accuracy. The Better Business Bureau Standards for Charity Accountability require a financial statement audit if gross income exceeds $250,000 annually. The United Way requires audited financial statements from their participating nonprofit agencies annually.
Nonprofit Finance Fundraising IRS Form 990 Jim Rose Purk & Associates PC
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