Use Nonprofit Financials as a Strategic Decision-Making Tool
Program managers dream of a funder making an unsolicited offer to support program replication in another location. This type of validation is exciting, but it raises questions about whether your organization can afford to expand.
If you received an expansion offer, would you know how to determine whether you could afford to accept? You can find answers in your financial statements.
One key to making informed, strategic decisions is financial ratio analysis. It’s the same type of analysis that bankers perform when you apply for a loan and that Charity Navigator uses to determine part of your score.
Bankers often focus on your balance sheet statement, which is typically divided into current and long-term assets and liabilities. (If yours isn’t, ask your auditor to present your balance sheet this way.) In this case, current refers to less than a year into the future from the statement date, and long-term refers to periods that are more than a year from the statement date.
The first important ratio to know is your current ratio, which is your current assets (usually cash and accounts receivable and sometimes inventory) divided by your current liabilities. There is no bright line ratio that separates financial ease and financial trouble, but a current ratio of one is a helpful demarcation. If your current assets are greater than your current liabilities, your current ratio will be greater than one and your short-term financial outlook is sunny. The more your current ratio exceeds one, the stronger your organization.
On the other hand, if your current liabilities are greater than your current assets, the ratio will be less than one and your short-term financial outlook is cloudy. The further below one that this ratio drops, the weaker your organization (at least from a financial standpoint). A low current ratio means that your organization will probably have trouble meeting its obligations sometime within the next year if you don’t reduce your expenditures, find new sources of revenue, or collect your receivables faster. If it drops below one half, it means you are probably already having trouble executing your programs.
Most nonprofits get into financial trouble when they run out of cash, so you also need a financial ratio that focuses exclusively on this asset. That ratio is called the quick ratio and is your cash divided by your current liabilities. When calculating the quick ratio, include only cash that is readily available, such as checking, savings, and money market accounts. Do not include certificates of deposit unless you are willing to pay the early withdrawal penalty. Also leave out endowments and any other funds designated for a specific purpose, such as restricted grant proceeds.
As with the current ratio, the line between sleeping well at night and lying awake worrying about your organization’s financial health is a ratio of one. If your quick ratio is greater than one, your nonprofit has enough cash to pay all the expected liabilities that will become due in the next year. If it’s less than one, you will likely experience difficulty paying your bills sometime in the next year unless you find new sources of cash, such as contributions, a loan, or a line of credit. If the ratio is less than one half, you are probably already spending time fielding calls from vendors seeking payment.
The life of a nonprofit is not always rosy. We often have to respond to funding reductions rather than windfalls from generous benefactors. The Trump administration has proposed reducing funding for a wide variety of social programs, which should lead you to wonder how much of a funding reduction your organization could withstand. This answer, too, can be in a ratio derived from your financial statements.
Working capital is a useful metric for thinking about funding reductions. Think of working capital as your unencumbered resources. It is defined as unrestricted net assets minus fixed assets; both of these numbers are found on your balance sheet. Working capital is available for use in response to an unanticipated need or change in plans. If your working capital is greater than zero, your organization has some resiliency to respond to unanticipated events like a decrease in funding.
The largest amount of funding reduction you could safely absorb is the amount that would reduce your working capital to zero. You can perform this calculation by assuming that your unrestricted net assets will be reduced by the amount of the funding reduction. For example, if you currently have unrestricted net assets of $1 million and fixed assets of $750,000, the largest funding reduction you could absorb is $250,000.
Ratios help determine credit risk
If your current ratio is low, it’s too late to talk to a bank loan officer, at least for the moment. Most banks would consider your nonprofit too risky for a loan. You may still be able to get a loan from a community development financial institution such as the Nonprofit Finance Fund. Even so, you will get the most favorable loan terms by planning ahead, continually monitoring your current ratio, and borrowing just as it dips below one.
Expansion typically involves borrowing. While the funder we talked about earlier may be offering to pay the direct costs of the new program location, there may also be indirect costs such as leasing or buying a new site, and adding new human resources, information technology, and accounting support to meet the administrative needs of the new program staff. Eventually you will want to cover these indirect costs by raising more unrestricted funds, but you will need time to build fundraising capacity and demonstrate programmatic results in the new location. Borrowing will help keep the new site running while fundraising ramps up. If your quick ratio and current ratio would give a lender pause, you should think twice about expanding to a new location.
How we can help
These three fundamental financial ratios are just the beginning; much more should go into any recommendations of decisions that your financial team makes. CLA’s nonprofit professionals can use technology tools and personal experience to help you to calculate and analyze these and other ratios, and work with you to employ them as you plan for an impactful and sustainable future.