Best Practices for Nonprofit Financial Health, Part One: Top 3 Measures of Financial Health
At NFF, we frequently get asked by nonprofit leaders, “Where do I start with finance?” In a three-part series on “Best Practices for Nonprofit Financial Health,” Alice Antonelli, Director for Advisory Services at Nonprofit Finance Fund (NFF), explores answers to some of the most commonly asked questions about nonprofit finance and shares best practices for financial health in the social sector. In this first installment, Alice shares her “Top 3 Measures of Financial Health.”
What do you believe are the three most important financial indicators that leadership should look at when analyzing financial health?
There are three general measures that I look at when analyzing the financial health of an organization, and that I think are very important for executive leadership and the board to review on a consistent basis.
1. Is the organization producing consistent surpluses? We look to the income statement to find out whether an organization is generating surpluses – annual revenue in excess of expenses. If the organization is not producing surpluses, it will have a difficult time building balance sheet strength (i.e., reserves). Ideally, leaders should look at whether the organization is generating unrestricted surpluses, and ask if unrestricted revenue covers operating expenses.
Unrestricted revenue typically comes from earned revenue such as fee-for-service, ticket sales, or membership income; it can also come from general operating support or temporarily restricted revenue in which the restrictions have been satisfied. This last point is important. Some leaders will include temporarily restricted revenue when thinking about total revenue for the year. However, for planning purposes, you really only want to focus on the revenue that the organization is likely to spend that year (unrestricted and/or temporarily restricted revenue released) – not on future commitments.
2. Does the organization have positive net worth? The balance sheet is where you can find net worth. Essentially you add up all the assets (e.g., cash, receivables, fixed assets) and then subtract the liabilities (e.g., payables, debt) to arrive at the organization’s net worth – or net assets (I like to think of net assets as assets net of, or subtracting out, liabilities). In some cases, the organization’s net worth or net assets will include permanently restricted net assets, such as an endowment (the corpus of which cannot be used at all), and/or temporarily restricted net assets, the balance of which is restricted for a specific purpose or time frame, and therefore should not be touched until the restrictions have been satisfied.
Unrestricted net assets are the numbers to focus on. Why? Because they give leaders a quick appreciation for the net worth available to tap into in case of emergency or to smooth out cash-flow issues. Are they positive? Hopefully. If not, this means that the organization owes more than it owns on an unrestricted basis, which is not an ideal situation to be in. Ideally, you want to focus on liquid unrestricted net assets – these are the resources that are immediately available if needed (more on that further in this blog).
3. Next, how liquid is the organization? In a very simple sense, how much cash does the organization have on hand to support operations? Again, cash is found on the balance sheet (and of course in your checking or savings account). Knowing how much cash an organization has on hand is critical. Organizations need cash to survive, and I will take it one step further: unrestricted cash is best. Why? We need unencumbered cash to be able to pay the utilities bills, payroll, and other expenses without having to worry about what is restricted for use. You don’t want to be spending money on utility bills when it’s meant to be spent on art materials.
So now, let’s go a little deeper into the question, what are the most important measures that leadership should look at to determine financial health? At NFF, we examine financials from organizations from all geographies and sectors. A lot of our inquiry is based more on trend analysis than ratio analysis. Having said that, there are two ratios that I believe are very important for nonprofit leaders to track – and both have to do with liquidity.
1. The first is the months of cash ratio. How many months of cash does an organization have on hand to pay bills during both good times and bad? You may know from best practice in personal finance that many suggest having six months of expenses on hand in cash – just in case your income situation changes dramatically. Six months provides a nice cushion. The nonprofit sector is no different; however, some organizations just aren’t there yet. For example, I have worked with very small organizations that may be operating at one or two weeks’ worth of expenses in cash on hand. Instead of suggesting that they save six months’ worth of expenses in cash from the outset, I will meet them where they are, suggesting short-term goals of reaching one or two months of cash for starters.
To calculate, simply take total expense for the year and divide by 12 to get a monthly expense number. Then, take total cash (or for a more conservative approach, use total unrestricted cash if you know it) and divide by the monthly expense number. To illustrate this and other concepts throughout this blog series, I will be using the example of a small performing arts theatre (let’s call it the Drama Queen (DQ) Theatre). DQ Theatre has a $600,000 expense budget, which means that it has about $50,000 in monthly expenses. If this theatre had $100,000 of unrestricted cash on hand, it would have just two months of cash available to support operations.
Steps to Calculate Months of Cash Ratio
Example: Drama Queen Theatre
Step 1. Calculate monthly expense number:
Step 2. Divide total cash by monthly expense:
$600,000 total expenses / 12 months = $50,000 monthly expense
$100,000 unrestricted cash / $50,000 monthly expense = 2 months of cash
2. The second ratio that I like to look at is months of liquid unrestricted net assets (LUNA). The idea is to understand how much in liquid, unrestricted net assets is available to support operations – or is available to pay the bills. This number may be greater than, the same as, or less than months of cash. If it is larger, most likely it means that the organization has unrestricted receivables (perhaps grant pledges) that may be available for conversion to cash in the near future. If the number is less it may mean that some of the cash is restricted or spoken for. It is a similar calculation to months of cash. First you take the unrestricted net assets and subtract the equity of any fixed assets (property and equipment minus debt owed). It’s important to subtract out the equity of fixed assets because unless you sell your equipment, property or building, you can’t pay bills with a fixed asset. Then you divide this figure by the monthly expense number.
Leadership may want to track both numbers, or just the more conservative of the two, to monitor progress of liquidity. In the case of DQ Theatre, the amount of their unrestricted net worth, or net assets, is $175,000. The theatre owns sound and lighting equipment and a van, all purchased for $200,000 with approximately $100,000 in outstanding debt; therefore, the equity in its fixed assets equals about $100,000 ($200,000-$100,000). For DQ Theatre, their LUNA equals $75,000 ($175,000 unrestricted net assets less $100,000 equity in fixed assets). If we divide this by the monthly expense, which is $50,000, we can see that it has 1½ months of liquidity. Since they have slightly more cash on hand than LUNA, it may be that some of the cash is restricted, or spoken for. In any event, months of LUNA may be the metric to follow as it is the more conservative measure of the two.
Steps to Calculate LUNA and months of liquidity
Example: ABC Theatre
Step 1. Calculate LUNA:
Step 2. Divide LUNA by monthly expense
$175,000 unrestricted net assets - $100,000 fixed assets = $75,000
$75,000 LUNA / $50,000 monthly expense = 1.5 months of liquidity
Ultimately, the financial story for every organization is different. These measures of financial health are meant to serve as touchpoints for leadership and the board to discuss in considering the best path forward for the organization.
Next up is Part Two: Smart Nonprofit Business Models