Recognizing, averting risk of financial failure

Financial failure is an increasing risk for all organizations — often due to a confluence of contributing factors. Any one or even several of these factors may not have a significant effect, but when they work in concert, it is very difficult to regain financial stability and keep from failing. Leaders finding themselves in this precarious position have been known to compromise strategic goals, reduce critical investments in infrastructure, cut the extent and quality of services, and make other spending and revenue choices that begin to significantly challenge their organization’s ability to achieve its mission.

NFP risk of failureIn this post-recession period, philanthropy has not rebounded to historic highs, and not-for-profit organizations have been called on like never before to provide services and meet the increasing demands of their constituents, many of whom are also suffering post-recession strains.

Monitor and respond to these 10 financial warning signals This list is not all-inclusive; instead, it highlights indicators that, if ignored, could lead to financial difficulties in the not too distant future. These signals are not new to not-for-profit organizations, but their impact and velocity have increased of late. In large part, the acceleration of these factors is due to the current economic climate, coupled with the inability of most organizations to differentiate themselves from their peers and adopt an operating model that is both financially sustainable and responsive to the evolving needs of their communities and constituents.

For the sake of those you serve and your organization, determine which of the following are signals of concern, and consider the solutions recommended:

1.    Challenges in hiring and retaining qualified leadership personnel: While the perception may be that not-for-profits typically have long-tenured employees, the reality is that not-for-profits in recent times are experiencing increased turnover.1 Nonprofits have many challenges in hiring and retaining qualified leadership, including little to no recruiting budgets and compensation structures that are often not as attractive as those offered by for-profit enterprises. The loss of talented personnel can be extraordinarily disruptive, with a significant cost to hire, train and acclimate credentialed replacements. Often, the principal reason for losing personnel is their frustration stemming from new hires being brought in to fill leadership positions, rather than promoting from within.2 Another factor is a sentiment among employees that the extent of personal and professional enrichment and advancement may not be as significant as in for-profit enterprises. Moreover, while many choose to work for nonprofits because they believe in the mission or are passionate about the cause, individuals may opt to leave if they no longer feel connected with the mission because it has either drifted or their daily job responsibilities do not align with or further the programmatic goals of the organization. In addition, when organizational financial strains become obvious, staff often explore new opportunities with more stable organizations.

To attract talent and thwart unwanted personnel turnover, ensure your mission and its actionable items cascade through all levels within the organization. As for compensation challenges, you might not have the resources to match for-profit compensation levels, but offering a salary near market coupled with stronger benefits can help in recruitment and retention. Also, identify ways to recognize performance and contributions through the use of nonfinancial recognition — while this is particularly important to millennial workers, nonfinancial recognition can go a long way with personnel of all generations. Consider creating or promoting personal development opportunities for your staff, including membership in key professional organizations, attendance at national conferences and funding for education germane to their job responsibilities. This will not only improve organization-wide capabilities, but will also lead to enhanced individual employee skills that will create promotion opportunities. While a strong sentiment and tendency exists for not-for-profits to devote a substantial portion of their resources to support programmatic operations, consideration needs to be given to ensuring that a properly credentialed staffing complement is maintained so that policies and procedures are well-defined and instituted, and resources are safeguarded. Without this consideration, challenges in hiring and retaining strongly credentialed staff could result in weakened internal controls or unqualified personnel tasked with essential operational and financial responsibilities, exposing the organization to risk. With periods of financial strain inevitable for most organizations, reassure your staff by conveying your plan to return to stability. Reach out to your employees with the same communications that you extend externally. See in this report “Enhancing stakeholder communications, transparency," by Katrina Gomez, Joseph Mulligan and Mark Oster.

2.    Absence of relevant KPIs and metrics: It is broadly accepted that entities manage what they measure, but what if an organization is measuring the wrong indicators? Monitoring relevant key performance indicators (KPIs) has become paramount for all entities, not-for-profit and for-profit alike. For larger organizations, the challenge is to distill the broad spectrum of KPIs to only the most meaningful ones, so that an organization focuses on the most relevant information to help make impactful decisions. The challenge for smaller nonprofits is ensuring that information systems have the functionality to supply operational and financial data critical to developing KPIs and, ultimately, evaluating them.

The production of accurate and relevant KPIs is predicated on the availability of data — both qualitative and quantitative. For example, a KPI for a social service organization could be the cost of providing a counseling session to one individual; that cost would then be trended over a defined period of time and regularly analyzed to understand cost fluctuations compared to individuals counseled.

Select and develop KPIs that align with your strategic goals and support your operating model. When selecting KPIs, be collaborative, and create a cross-functional team spanning the board, senior management and programmatic personnel. This multidisciplined approach ensures that indicators of significance will be identified and perspectives at all levels within the organization considered. Do not focus solely on financial metrics; operational metrics are of equal importance. Financial KPIs may track and report on accounts receivable and accounts payable turnover, approval rate of purchase orders, debt to equity, expendable net assets, etc. Operational or programmatic KPIs may include, for example, the number of new or strengthened pollution laws, progress toward the eradication of a disease, or the proportion of repeat offenders. For further direction, see in this report “Utilizing data analytics to improve performance," by Mary Foster, Anthony Pember and Matt Unterman.

3.    Lack of clarity in strategic goals: Critical to every strategy is having a well-defined business plan that outlines actionable items to achieve those strategies; without such a plan, the organization will not know how to reach its goals.3 Business plans should give focus and direction to organizational efforts, and be adaptive to changes in the organization’s economic and social environment.4 If all levels of your organization do not understand the actions to take to support the business plan, and if the plan is not regularly reviewed and updated, strategic goals cannot be achieved. Further, many strategic plans contemplate lofty and aspirational goals that cannot be fulfilled with existing resources.

Collaboration across all levels within an organization and analysis are required to define and estimate the cost of meeting your strategic goals, and the extent of execution risk. Through this process, you can gain a realistic grasp of the financial and personnel resources necessary to execute your business plan, comparing resources required to resources available. Not-for-profit organizations sometimes become distracted and drift from their principal mission due to ancillary projects embraced by board members or members of senior management that are not integral to their strategy. These peripheral projects, in certain instances, have served to weaken the strategic focus of organizations, dilute the strength of their brand, and divert precious resources — both financial and personnel — in ways inconsistent with overall mission.

Clients, find more about specific financial and operational signals of financial strains, ways to communicate them to your board, and how the information can shape strategic initiatives.
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4.    Services not differentiated from peers: Organizations may not have a clear and complete understanding of how they are viewed vis-à-vis other similarly focused organizations. If organizations have on “competitive blinders,”5 they may not appreciate that other entities are more effective in providing services or attracting the attention of donors or constituents. The competitive nature of the marketplace suggests that it is counterproductive to espouse a mission statement that is unduly broad and intended to serve a wide array of constituent needs. Specialization and providing focused services continues to be an effective way to reach and serve a desired constituency, and to build brand. Over the past decade, a trend has been afoot wherein many not-for-profits have become introspective and have refined their mission to focus more narrowly on their strengths (i.e., to exploit their greatest programmatic offering). Unless a nonprofit has truly positioned itself as the premier provider of a particular service, growth opportunities are generally limited. Competition among nonprofits centers on revenue and service, with funders (e.g., federal/state/local agencies, corporations, foundations and individual donors) focusing their giving on organizations demonstrating sustained success and programmatic offerings tuned to respond to the evolving landscape. Begin to focus resources on a refined and narrowly defined set of programmatic imperatives. Modify your strategic plan as necessary to accomplish this sharpened objective. In parallel, research the marketplace to find out what your brand represents to the public, and to determine how your services suit current needs so that you can hone them accordingly. Study the competition, and position your organization as best-in-class provider of your chosen service(s). Herald your differences via marketing channels to communicate benefits and outcomes.

5.    Ineffective connection with donor base: Competition for donors remains pronounced. Accordingly, increased effort and investment in development activities are crucial. Research shows that the old methods of communicating and connecting with donors through mailed brochures and letters are no longer the most effective approaches. Over the past decade, donors have become far more knowledgeable in and focused on assessing a not-for-profit’s effectiveness and achievement of mission. Information about a charity’s financial position and performance, and the extent of its service offerings and progress toward achievement of mission is now more readily available and more easily accessed. The IRS Form 990, coupled with other public disclosures, provides a fairly granular level of transparency into an entity’s governance and operating characteristics. When organizations cannot attract and retain donors, they risk losing their ability to fulfill their mission.  

First, no matter how well you think you know your donors and potential donors, find out who they really are. Study and analyze the market to understand demographics, and at the same time, to gauge the strength of your brand with your target audience. Reach your audience via social media and events; share testimonials and communicate your outcomes. With household balance sheets the strongest in decades, now is the time for organizations to double-down on their donor acquisition and cultivation activities. See in this report “Telling your story transparently: Putting disclosures to work," by Kimberly Schrant and Dan Romano.

6.    Concentrations of revenues and receivables: Organizations that are principally dependent on one source of revenue place their organizations at significant risk. A singular revenue source that has long been dependable may gradually or suddenly vanish. This type of financial vulnerability is a pressing concern to organizational management and board members, leading them to reduce further programmatic investments or enhancements, or curtail or limit existing services.

Moreover, for those whose principal revenue stems from federal, state or local funding agencies, the resultant margin available to support infrastructure is typically inconsequential. Government grants provide little to no margin because they are generally paid out after expenses have been incurred, or provide reimbursement based on a fee for the delivery of a service at defined rates. Government grants can be important, but federal/state budget shortfalls are leading to overall grant reductions. A factor in the demise of the historic Hull House was reliance on government contracts for over 85% of its funding.6 Grants can help an organization fulfill its mission, but usually do not provide seed money to develop new programs to respond to a changing economic and social landscape.

When an organization has a singular concentration of revenue, regardless of source, a reasonable risk exists that an aging of the receivables associated with such revenue can have daunting negative implications. Specifically, readers of the financial statements can lose confidence in the long-term viability of the entity. Additionally, when receivables become severely aged, they can significantly strain cash flow, which, in the extreme, can lead to insolvency and financial failure.

Diversifying revenue sources will help your organization become more financially stable. However, be mindful that the development of new revenue sources takes time and may also have inherent costs and risks, requiring additional programmatic and personnel investments.

7.    Shrinking investment portfolios: Endowments have been weakened over the past several years due to poor market performance, resulting in losses or lower-than-anticipated returns. Of greater concern is strong evidence that the financial woes being experienced worldwide will likely persist. This financial downdraft, combined with an increasing demand imposed on not-for-profits to do more for the benefit of their constituents, have, in certain instances, yielded perilous consequences. With an inability to expand and/or grow current revenue streams (and cash flows), investment portfolios have been called upon like never before to assist in propelling missions and satiating demands, but also to provide for operations and strategic investments. With declining margins caused by decreasing contributions and increasing operating costs, many organizations have supplemented their board-approved spending policies with additional board appropriations to fund unbudgeted operating costs, underwrite capital campaigns, pay for voluntary retirement plans to aid in aligning personnel costs with refined strategies, or service debt obligations. For some not-for-profits, there may be no alternative to increasing the spending draw from their endowments. However, they must do so with an acknowledgment that additional endowment appropriations, beyond the normalized annual spending policy, can lead to a reduction in the purchasing power of the endowment and an erosion of principal. Combined with lackluster market performance, the endowment could be significantly diminished.

Rather than reacting immediately to the current need, analyze the long-term implications of supplementing board-approved endowment spending policies with additional appropriations. Determine if a better decision would be to suspend endowment appropriations until the investment markets rebound. This may be a sensible solution to preserve the value of your organization’s endowment if you have cash reserves or an ability to generate strong cash flows from operations. For those that have neither, an analysis of all noncore operating costs must be performed with a view toward cutting or significantly reducing them to weather the financial strains. Analysts believe that the market will continue to yield lower interest rates and returns, and experience continued volatility. Organizations should remain introspective in evaluating and tuning the mix of their portfolios to achieve the optimal configuration to navigate these turbulent times.

8.    Increasing cost of compliance: As scrutiny from watchdog agencies and regulators has heightened, compliance requirements have been ratcheted up. Laws are changing quickly, and the development of responsive and compliant policies has been costly. Nonprofits rarely have the budgetary capacity to accommodate the compensation costs associated with installing or expanding the complement of compliance officers, ombudsmen and legal staff, exposing them to potential noncompliance, reputational loss and financial penalties. Organizations are sometimes surprised by the cost of compliance and need to dramatically update or develop responsive policies; for example, the extent to which the Affordable Care Act has caused organizations to change their policies and reporting processes, and the effort and cost required to become compliant have been significantly more than some expected.

There is no alternative to regularly monitoring the legislative and compliance landscape to ensure your policies remain current with evolving business and regulatory practices. Consider ways to re-engineer your practices and policies to quickly adapt to a dynamic regulatory and competitive environment. Is your ERM program sufficiently designed to assess and anticipate the impact that legislative changes will have on your organization? Who within your organization is tasked with routinely monitoring the regulatory environment in which you operate?  

9.    Inability to fulfill financial covenants: Temporary downturns in philanthropy, combined with stagnant or declining revenues from core operating activities, may cause organizations to experience difficulties in meeting loan covenants. Even with little or no debt, organizations that are contemplating accessing the debt markets may be dismayed to learn that debt financing is not available to them until the state of their financial affairs improves. Failing creditor-imposed financial covenants tied to debt obligations can have costly implications, including substantial fees charged by financial institutions to provide covenant waivers.

When your organization enters into a financing arrangement with a financial institution, it is critical that you first model and stress-test all significant financial covenants; nonadherence can lead to default, an increase in interest and fees, or an acceleration of principal and interest payments. Work closely with your financial adviser and accountants to understand the mechanics of all financial and nonfinancial covenants to ensure they are tenable on an ongoing basis.

10.    Monetizing assets to provide liquidity or strategic pivot: When organizations owning properties or other valuable assets find themselves in the throes of financial strains, an approach to consider is monetizing nonessential properties that don’t align with your strategy. However, this is a gambit not often carefully thought out. The sale of intrinsically valuable assets will likely result in an infusion of cash or a reduction of debt, but if the core operating and business challenges are not understood and remedied, the proceeds of asset sales will be depleted quickly, as the underlying problems continue to drain organizational resources.

Align these asset sales with a refined strategy or mission pivot with the goal of improving financial performance and stability. A word of caution — property sales need to be evaluated in the context of your new/refined strategy, with due consideration for the effect on personnel, including associated relocation and severance costs — and, perhaps most importantly, the impact on your mission-related service offerings.

1 Nonprofit HR. 2015 Nonprofit Employment Practices Survey Results, March 4, 2015.
2 Landles-Cobb, Libbie; Kramer, Kirk; and Milway, Katie Smith. “The Nonprofit Leadership Development Deficit,” Stanford Social Innovation Review, Oct. 22, 2015.
3 National Council of Nonprofits. “Business Planning for Nonprofits.”
4 O’Donovan, Dana and Flower, Noah Rimland. “The Strategic Plan is Dead. Long Live the Strategy,” Stanford Social Innovation Review, Jan. 10, 2013.
5 Jewell, Jim. “7 Reasons Nonprofits Flounder or Fail,” The Valcort Group, April 3, 2013.
6 Cohen, Rick. “Death of the Hull House: A Nonprofit Coroner’s Inquest,” Nonprofit Quarterly, Aug. 2, 2012.

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The State of the Not-for-Profit Sector in 2016
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