Top Indicators of Nonprofit Financial Health
Nonprofit leaders have a difficult mandate to constantly balance money and mission, while collecting and sharing data on social and financial performance. With limited finance staff and multiple sources of financial information, it’s no wonder these leaders and their supporters often struggle to tell a clear, compelling financial story that makes sense of all the data. (This post focuses on financial health basics, for information and ideas on what it takes to manage to programmatic results, check out NFF’s publication and campaign, Invest in Results, a partnership with the Federal Reserve Bank of San Francisco.)
How can nonprofit executives, funders, and advisors identify what matters most when examining finances? What are some trends and indicators that can guide us through an abundance of data and help assess true financial health?
Not all financial indicators are created equal. Below, you’ll find a short list of financial health metrics based on NFF’s years of experience lending to and advising nonprofits. You can find the data for these metrics on historical-looking documents such as audited financial statements and Forms 990, as well as on forward-looking internal budgets and projections.
Business Model Indicators
The business model reflects how a nonprofit makes and spends money in service of its mission. It is reflected on the Income Statement (aka The Statement of Activities in nonprofit accounting)
- Revenue reliability: Rather than overly focusing on the ratio of earned to contributed revenue, we suggest evaluating revenue reliability – an organization’s track-record of bringing in recurring dollars on an unrestricted operating basis year after year. Reliable revenue doesn’t always come from the same sources providing the same amounts of money. Instead, it suggests an ongoing ability to earn or raise a level of income with a fair amount of certainty. While revenue reliability can be reflected in numbers via historical trends, it is more fully understood through a conversation with or among the organization’s leadership, and in the context of relevant market dynamics.
- Consistent surpluses: A healthy business model is one characterized by reliable revenue that covers operating expenses and contributes to surpluses – all in the service of mission. Nonprofit is a tax status, not a way of operating: Positive operating results (unrestricted revenue consistently exceeding expenses) are an indicator of strong financial management, and are necessary for organizational health and financial resilience. Simply aiming for breakeven results doesn’t allow for the breathing-room necessary when things don’t go according to plan. Nonetheless, since 2008 when NFF began measuring the percentage of nonprofits reporting a surplus for our State of the Sector Survey, this measure has never surpassed 40%.
Working Toward Full Cost Coverage
Why does NFF focus on consistent surpluses (above) as a key indicator of financial health? Because surpluses allow organizations to cover the additional cash needs that typically don’t show up on your income statement. Nonprofit leaders are encouraged to set revenue targets high enough to cover not just their direct and indirect operating expenses but also the “full costs” of doing business. These full costs over and above total operating expenses reside on the balance sheet and include covering working capital, reserves for an opportunity or rainy day, fixed asset or technology additions, and debt principal repayments. Though covering full costs every year is aspirational for most organizations, it is a worthy goal to work toward. Doing so can help ensure longer-term financial sustainability and vibrancy.
Balance Sheet Indicators
This financial statement provides a snapshot in time of all of an organization’s assets (what it owns), liabilities (what it owes), and net assets (what it truly owns after liabilities).
- Appropriate liquidity: This critical measure of financial health shows an organization’s financial ability to withstand risks and respond to new opportunities. NFF often measures liquidity in terms of the months of expenses that can be covered with available cash (or access to cash through a line of credit) and liquid unrestricted net assets (LUNA). Looking at months of available liquidity indicates available resources in proportion to operations by showing how long the organization could continue current operations without new revenue. Our prior State of the Sector Survey results indicated that 53% of respondents expected to have three months of cash or fewer in 2015. As a general guideline, fewer than three months of cash is often perilously tight for nonprofits, though the “right” amount of liquidity depends on several elements, including an organization’s strategic priorities, funding volatility, facility needs, and the general economic environment.
- Ability to manage debt: Debt is a critical financial tool that can help organizations manage the ebbs and flows of cash for operations, facility purchases and upgrades, and more. But as liabilities bump up against an organization’s ability to pay off those obligations, they can become a real problem. Measuring an organization’s liabilities as a percent of total assets can show the big picture view of how much an organization owes relative to what it owns. As this percentage creeps up near the 50% mark, it can call into question the organization’s ability to manage debt, which could jeopardize the delivery of programs and services.
- Ability to steward facilities: If owning property and equipment is necessary for an organization’s mission delivery, it has a responsibility to maintain and replace these assets over time. A best practice for organizations with substantial property and equipment is to create and sustain a reserve designated by the board of directors to fund facility improvements and replacements. Absent formal reserves, we can ask: Are there appropriate levels of liquidity to respond to issues such as replacing the hot water heater or complying with ADA regulations? To understand facility stewardship ability, accumulated depreciation can be a helpful accounting proxy for evaluating the remaining “usable” life of these fixed assets. However, keep in mind that the accounting value of an asset doesn’t reflect its market value. An engineer can help identify the true future costs of fixed asset repairs and replacements.
When conducting a financial analysis using health metrics like these, remember that numbers can tell us a lot about an organization’s finances, but they also have their limitations. At NFF we strongly believe that no analysis is complete without understanding the context behind the numbers. There is no “right” business model or balance sheet, other than the one that contributes to an organization’s ability to manage the unexpected, adapt to changing circumstances, and pursue mission imperatives.
Still, these indicators are a useful starting point. If you work at a nonprofit, use them to focus your staff and board on the big picture story. If you are a nonprofit supporter, consider streamlining your financial due diligence using these themes as your guide. Examining these key indicators of financial health can help replace belief with fact – ensuring decisions are driven by data that will support mission execution today and for years to come.