Financial reports as a guiding light for your mission

This article features insights from Jim Croft, former CFO of The Field Museum and senior advisor to the Grant Thornton Not-for-profit and higher education practices. In this article, Croft shares insightful analyses and solutions with respect to effective financial reporting.

Imagine you are the executive director of the City Shelter in Anytown, USA, a nonprofit organization that provides on-site casework seven days a week, with 24-hour staffing. The shelter also offers access to food, clothing, hygiene items, and safe and secure emergency housing. Although you’ve always found the work both challenging and rewarding, with the economic pressure faced by nonprofits today, it is even more demanding, as described by Sara Herschander and Dan Parks of the Chronicle of Philanthropy.

The City Shelter is currently meeting its fundraising goals — but you worry that donors may begin losing faith that the economy will improve and will start cutting back on their contributions. Even if you can count on donations remaining at their current levels, you know the shelter will be paying more for operating expenses such as supplies, utilities and, of course, staff. As is true for most nonprofits, more than half of the shelter’s operating budget is dedicated to salaries and fringe benefits. Average hourly earnings have increased in recent months at annualized rates just over 5 percent — and although it has always been difficult to compete with for-profit companies’ salaries, it is even more difficult today. Therefore, you are faced with either increasing staff compensation to compete in the employee marketplace or risking the loss of valued staff members.

What would you do? The situation emphasizes just how important accurate and timely financial reports are for the leaders of a nonprofit organization. These reports are key to making sound financial decisions that will allow a nonprofit to continue to meet its programmatic mission. This is true at any time, of course, but especially during tough economic conditions. Plus, donors, charity rating services, and financial institutions will scrutinize an organization’s financial position to determine its support worthiness, so nonprofits must make certain that their internal reports use data that tells a story they can confidently share with supporters.

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Budget variance analysis can show early trouble

Given this starting point, let’s look at the first of these reports: the budget variance analysis. If prepared regularly, it can warn the organization early on that financial performance is not aligned with its operating budget. It can also help identify steps the institution could take to get back to its plan. Since a variance of any kind might indicate that a problem needs to be addressed, this report looks for both unfavorable and favorable variances from the budget. For example, if the analysis shows you’re spending less than what was budgeted for salary and wages, you may be having difficulty finding the staff needed to carry out the shelter’s service programs.

Ratios to determine solvency and liquidity

An analysis using ratios can also help to manage finances. There are many types of ratios; we’ll begin with a few that focus on liquidity. The current ratio measures an organization’s ability to pay its current obligations. It is calculated by dividing current assets (those that can be reasonably turned into cash or consumed within a year) by current liabilities (those obligations that need to be paid within the next year). A current ratio of one (1:1) says you have $1 of current assets available to pay $1 of current liability. That’s good news: it means you’ll be able to pay your bills on time. It would be better, though, to have a current ratio of more than $1 of current assets to cover $1 of current liabilities (2:1, for example), so that enough current assets or working capital is available for operating activities after paying the bills.

The cash ratio may provide a better way to determine the organization’s liquidity. This ratio considers only cash and cash equivalents (securities meant for short-term investing) that are available to pay current liabilities. The cash ratio divides cash and cash equivalents by current liabilities. As with the current ratio, a cash ratio of 1:1 signals that the organization has only enough cash to pay current liabilities — but does not have enough to cover operating activities. The cash ratio, then, should also exceed one.

As we’re seeing, managing cash is crucial for nonprofits. Even if an organization has a balanced operating budget, it has no guarantee of always having enough cash to fund its planned programs. The days of cash ratio allows an organization to estimate the number of days it would have cash available if all revenue was discontinued. To calculate this ratio, add current cash and cash equivalents, multiply that amount by 365 (days in the year) and divide that product by the organization’s estimated annual expenses less noncash items such as depreciation. The result tells management how many days of cash are available to continue funding operations. Ideally, the organization should have between 180 and 270 days (six to nine months) of cash available for operations.

COVID has made clear the importance of maintaining operating reserves. The operating reserve ratio can provide helpful information about an organization’s reserve position. To calculate this ratio, subtract the value of property and equipment from net assets without donor restrictions. Divide that number by the organization’s estimated annual operating expenses less noncash items. The result tells you how many years’ worth of operating reserves the organization has. Generally, this number should be between one and three. If an organization has less than one year of operating reserves, leadership and the board should commit to building those reserves to meet unforeseen circumstances such as a recession or pandemic.

Ratios that focus on operating efficiency

The ratios we’ve already mentioned focus on liquidity and solvency. But we can also use ratio analysis to determine an organization’s operating efficiency. Because this information is important in communicating with donors and charity rating services, the executive director should know and be able to talk about how much the nonprofit spends on programs, administration and fundraising.

Note: Readers interested in an extensive discussion of financial health and operating efficiency ratios should see Miller, Randolph, Richtermeyer and Greenlee’s informative discussion of key financial ratios used by nonprofits. The authors provide a series of benchmarks in various nonprofit sectors so that organizations can compare their ratios to those of others in their respective fields.

The organization’s program expense ratio (program expenses / total expense) reveals what percentage of an organization’s total spending is dedicated to programs; the administrative ratio (management and general expenses / total expenses) and fundraising expense ratio (fundraising expenses / total expenses) do the same for their respective functions. Even though these analyses may not portray the quality of an organization’s programs, donors and charity rating services focus on what percent of total expenses the institution allots to programs.

Finally, it’s helpful to know the cost of raising a dollar of contribution revenue. The fundraising efficiency ratio will give us that answer. It is calculated by dividing fundraising expenses by total contribution revenue. Ideally, nonprofits should have a ratio of 0.2 or less — which means they spend 20 cents or less to raise $1 of contribution revenue.

Using the information gained from these ratios, the shelter’s management will better understand how it is allocating its resources and whether those expenditures align with its approved operating budget. As Parks said, “Inflation is making it hard for nonprofits to serve client needs as costs for food, fuel and other staples spiral upward.” But, with the right information and tools like financial ratios, nonprofits like the City Shelter will be able to make financial decisions that allow them to fulfill their missions, even in very challenging times.