Nonprofit Sector

When Funders Don't Know Finance

January 9, 2023
Headshot of Kristine Alvarez, smiling and wearing a dark green shirt

This post originally appeared on Philanthropy News Digest on January 3, 2023.

I’ve lost count of the times I’ve fielded calls from nonprofit leaders worried about how their financial information will be interpreted by potential funders: Will a grantmaker penalize them for not having a bigger safety net? Or, conversely, disqualify them if they have some savings? Will they understand that restricted cash or restricted revenue may distort their financial picture?

Sharing financial details can make nonprofits feel quite vulnerable, especially if they don’t have a sense of why the information is needed or how it may be interpreted.

Some foundations are leading the way with proven approaches of multiyear general operating support, unrestricted funds, and flexible grantmaking. But too many are still requiring a level of compliance and control in ways that are at odds with trust-based philanthropy.

What’s worse, sometimes grantmakers require financial statements but don’t know what matters the most or what to look for in the data. Unprecedented levels of giving by foundations and the public sector in 2020 and 2021 spurred by the COVID-19 pandemic and its economic fallout has added further confusion: Some grantmakers may misread this moment of relative financial health as a signal that the need is less urgent, even as communities continue to face acute challenges—including but not limited to inflation, staffing shortages, and an uncertain fundraising outlook for 2023.

This is not the time for funders to let up on support or to back away from doing the homework to understand organizations’ financial realities. Ultimately, nonprofits and their supporters are on the same team. If a foundation cares about an organization’s work and the people it benefits, supporting its financial well-being is essential to creating positive impact.

For those well-meaning grantmakers who think they are doing due diligence but are actually undermining their relationship with nonprofits delivering community impact, here are a few basic considerations—which even experts in for-profit finance may not know.

First, grantmakers should understand the organization’s safety net: Does it exist, and to what extent can it sufficiently provide cover to the organization?

If COVID-19 has taught us anything, it’s that savings is not “the S-word” of the nonprofit sector. Nonprofits that had the opportunity to save some money in the bank were much more likely to survive the crisis. Cash reserves were what separated those that could weather the storm and those who got washed away permanently. Even organizations that had some safety-net cash struggled through the storm, but they still fared better than those without.

In personal finance, we advise our friends and family to save up at least six months’ worth of living expenses in case of an emergency—yet the concept of savings in the nonprofit sector is still regarded by some as either a frivolous luxury conceived of textbook finance or simply not a top priority in grantmaking. If a nonprofit’s savings are little or non-existent, then you’re looking at an organization that is out there doing the work without adequate protection from storms like the pandemic.

Grantmakers need to prioritize funding cash reserves and safety nets so that nonprofits are no longer under a perpetual existential threat and can focus on advancing mission goals in service of communities.

Where to look and an important caveat: If you want to determine how much safety net an organization has, one starting point is to compare its existing cash balance (from the balance sheet) with its average monthly expenses (from the income statement). This will give you a preliminary proxy for months of cash on hand. But be careful: “cash on hand” will likely include restricted cash earmarked for specific purposes—meaning that the organization is operating with a much smaller safety net than is actually needed to cover unanticipated needs or emergencies.

Grantmakers should understand how well a nonprofit is able to cover its expenses with incoming revenue.

Comparing total unrestricted revenue with total expenses (on an income statement) can give you an initial sense of how an organization is faring financially. Many grants ignore the myriad non-program costs required to do business well, leaving nonprofits scrambling to supplement inadequate compensation.

If an organization is suffering from consecutive deficits or is at risk of not being able to cover expenses, foundations can provide immediate, unrestricted funding to address the imbalance. They can also provide a financial coach that the nonprofit trusts to help make necessary adjustments. Foundations should give the organization’s leaders decision rights when providing financial coaching, so that they feel comfortable sharing and working through the intimate details of their financials.

Funders don’t need to require audited financial statements in order to understand an organization’s financial needs and financial story.

It is not an automatic red flag if a nonprofit is unable to produce audited financial statements. Audit reports are expensive, and an organization that can’t afford one still has a financial story to share. A supportive grantmaker can find other ways to understand a nonprofit’s financial situation—such as simply asking the organization to share their financial story, goals, and needs in this moment.

Funders should ask the organization: What “full cost” needs are not being met?

Spoiler alert: If an organization is showing a surplus or cash savings, that does not automatically mean that they’re sailing through with no problems. At minimum, there’s a good chance that the total expense number showing up on the financial reports is grossly understated—and that’s because we have set a misguided norm that community leaders operate with unfunded expenses by doing things like donating sweat equity (i.e., not paying themselves enough or at all so that mission work can continue).

Bottom line, the surplus you’re seeing on paper may in reality be much smaller or nonexistent.

To get a clearer picture of how the organization’s full cost needs are being met, funders have an opportunity to ask questions and explore with grantees: How fairly is staff compensated? What kind of working capital is available for day-to-day needs? Is there a sufficient safety net to pursue opportunities to improve outcomes through one-time investments in things like technology or space to deliver programming? What debt obligations do they have, if any? Do they have “change capital” that provides space to adapt, grow, and expand?

Grantmakers should understand how much of an organization’s money is flexible and how much is restricted.

In the nonprofit sector, cash isn’t always liquid. Funds are often designated for a specific use and can’t be redirected if community needs shift. Unrestricted funding is critical for most nonprofits, as it enables them to decide how to spend their funds to best support their work.  While many foundations and governments lifted restrictions during the early months of COVID-19, we’re seeing practices starting to revert back to pre-pandemic norms.

Funders should consider racial equity when reviewing financial information.

Black, Indigenous, and people of color (BIPOC)-led and -serving nonprofits often do not have the same access to financial resources as white-led organizations. Nonprofit Finance Fund’s most recent survey affirms that they are more likely than their white-led peers to have leadership with relevant lived experience (57 percent vs. 18 percent)–making them uniquely positioned to create impact in their communities. Systemic racism leaves BIPOC-led groups without the same access to wealth and traditional funding networks and institutions.  In that funding gap, funders should see an opportunity to meet grantees where they are and invest in racial equity.

Oh, and please don’t use the overhead ratio as a measure of anything meaningful.

If you’re still doing this, just stop. There’s no excuse for continuing this habit, which has sown so much confusion, inequity, and devastation.

Well-informed grantmakers can be powerful allies for underfunded nonprofits and the communities they serve. Diving into financials can help funders who operate with trust and transparency better understand an organization’s true needs, structure financial support in a way that is most advantageous to the grantee, and set the stage for long-term partnerships toward advancing shared goals. But if they are going to ask for financials, they should be prepared to do the work and understand how the numbers connect with impact, challenges, and opportunities.

Kristine Alvarez is a director at Nonprofit Finance Fund.

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