Stress Testing the Charitable Organization

Stress Testing the Charitable Organization

Article posted in Governance on 13 October 2015| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 14 October 2015
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Summary

There are more than 1 million nonprofits in the United States, and more than 70% of these entities receive annual support of less than $200,000.  Philanthropic advisors play an important role in guiding these volunteer-driven nonprofits in the performance of their vital community work.  Here's a tool to help them stay healthy and improve sustainability.

By Dennis Walsh, CPA

Should we be worried?

As financial leader of the organization, heads usually turn to the executive director when this concern is voiced at board and management meetings.

If the ED is equipped with good financial knowledge and proactive about identifying and addressing weaknesses in advance, the organization is in a stronger position to withstand financial challenges before they reach a crisis stage.

This 30 question self-evaluation is designed for assessing three key pillars of financial health:

  • Liquidity – The organization’s ability to meet current financial obligations as they arise
  • Sustainability – The likelihood that the organization can survive funding interruptions and other unexpected events
  • Financial leadership –The ability of management to navigate the organization through financial hardship

Evaluating the strength of these pillars requires a closer look at governance, management practices, and financial resources.

This exercise will help expose areas of weakness that can be prioritized for improvement.  It should provide some actionable insights about the executive director’s financial acumen and overall organization health, essential for mission effectiveness and sustainability. 

Access the questionnaire

Scoring guide

Number of “yes” answers:

  • 24 or more - The organization is demonstrating indications of good financial leadership, and is likely in a good current financial position with a favorable sustainability outlook.
  • At least 18 but less than 24 - The organization is probably doing many things very well, but has significant weaknesses that merit further evaluation and action. 
  • Less than 18 - The board should consider fundamental needs regarding financial leadership and potential for mission sustainability. 

Examine each “No” answer and look for common issues.  Some items can be addressed individually, while others may be a symptom of a wider problem.  Use good judgment in consultation with the board chair and other advisors as necessary to weigh the seriousness of each and then prioritize weaknesses for further analysis and action.  Take a close look at any “?” responses as well in order to determine what type of training or advisor explanations might be helpful.

While the implications and remedies for many of the “No” answers are obvious, refer to the following discussion to help inform the analysis and stimulate discussion.

Liquidity

In simple terms, liquidity means having enough cash available to operate, so that programs and other activities continue uninterrupted and that obligations are met on time.  Liquidity may be provided from sources other than donor support or program revenue, such as from cash reserves, the proceeds of borrowing, or from the sale of property.

It is common to draw from cash reserves or from a line of credit for temporary liquidity, but in most years the organization should sustain positive cash flow.  In other words, the organization should generate revenue and support from ongoing central activities sufficient to meet recurring needs over the annual operating cycle, so that it begins the next cycle in a similarly liquid position.

Current ratio

A key liquidity indicator, the current ratio, is found by dividing total current assets by total current liabilities.  Current assets are the sum of cash, temporary savings, amounts receivable from grants, pledges, or program services, and any other operating assets expected to be turned into cash within the next 12 months.  Current liabilities represent the sum of accounts payable, accrued expenses, and any other obligations due within the next 12 months.  Of course, this calculation assumes that the organization has reliable current financial statements available for reference.

There is no particular current ratio that is optimal.  This will vary based on multiple factors. But generally speaking, maintaining a current ratio above 1.5 means that the organization should have enough liquid assets to cover current obligations.  If the current ratio is below this level, it’s more likely that the organization has insufficient resources to meet operating costs or to smooth out fluctuations in cash flow.

A high current ratio may not be a good thing, either.  This can indicate poor cash management or under-utilization of resources and be of concern to donors and other stakeholders.  Remember also that like other financial ratios, the trend in the current ratio from period to period is as important as the ratio result itself.  Are things improving or declining?

Months cash reserve

Another important liquidity indicator is months of cash reserve.  This can be calculated by dividing total cash and cash equivalents (e.g. savings, money market funds, and similar liquid assets with a maturity of less than 90 days), by average monthly expenses.  Average monthly expenses can be approximated by dividing total annual expenses from the financial statements by 12.  This essentially tells how many months the organization can survive without any further cash inflow.  Again, the trend is important.

For the majority of nonprofits, obtaining a bank line of credit is very difficult if not impossible.  This makes it even more important to have a cash reserve covering at least 90 days of expenses.  Without this the organization may have more difficulty coping with slow grant or pledge collections or other unexpected changes in the timing of cash inflows and disbursements.

This is particularly true if net cash flow fluctuates significantly throughout the year, such as from seasonal fundraising, or from program expenditures required in advance of collections for services to be performed.  If the organization is unable to budget for a cash reserve from year to year, this may be indicative of more serious sustainability problems. 

Collection time

Depending on the nature of support and number of program constituents to whom the organization may extend credit, it is important to monitor the trend in the average age of amounts receivable.  If collections are taking longer, it’s time to ask questions like whether credit policies and billing procedures are being adhered to, whether credit standards have become too loose, if collections are falling into the wrong pocket, and so on.  Prompt action is vital to avoid bigger problems.  Don’t wait until payments are substantially behind to make inquiries. 

Tax payments

There are few things that can get an organization into serious trouble more quickly than late tax remittances.  In addition to stiff penalties and interest, bank accounts and other assets may be seized, and persons responsible for authorizing disbursements can be held personally liable for the payment of delinquent taxes withheld from wages or sales taxes collected from the public.

Meeting such obligations on time may not always be a liquidity issue, however.  Be sure the organization has procedures and personnel assignments in place to assure timely remittance of payroll related responsibilities.  The use of an independent payroll service may be a cost effective option for an organization without accounting staff.

Sustainability

Nonprofit sustainability has been a hot button issue for more than a decade, and like many terms can mean different things to different people.  From a financial standpoint, the most conservative definition of a sustainability problem is described as a “going concern” issue.

As a result of a change in generally accepted accounting principles (GAAP), for reporting periods ending after December 15, 2016, management must make an assessment of whether it is probable that the organization will be unable to meet its obligations for the 12-month period beginning with the date the financial statements are issued. 

If a going concern problem “exists, then certain information about this condition must be included in the financial statements, a potential funding death blow to the nonprofit. 

For this discussion, a sustainable organization is assumed to be one that has sufficient financial strength to go forward into the foreseeable future, and has an adequate blend of governance and management to continue the mission in a manner that will maintain or improve its financial position from year to year.

For those familiar with financial statements, the balance sheet is a numerical representation of financial sustainability.  In simple terms, the balance sheet is the value of what the organization owns, less what it owes, resulting in either positive net assets, or insolvency, i.e. debts are greater than assets.  In general, the greater the value of assets, both in absolute amount and relative to liabilities, the stronger will be the organization’s sustainability outlook.

And the statement of activities, traditionally referred to as an income statement, indicates whether financial sustainability is improving or declining as a result of current year activities.

An absence of significant financial support from individual board members can be a telling indicator of their commitment to financial leadership and another threat to mission sustainability.  If the board doesn’t have significant skin in the game, it’s less likely they will be strong community advocates for the mission.  The executive director plays a key role, through interaction with the board chair, to challenge the board to fully embrace its duty to assure adequate resources are available to sustain the mission.

A board with member ages concentrated within a generational range may be a precursor to sustainability issues, including the organization aging out.  Age concentration often results from the nature of the mission and trends in culture, and can be difficult to avoid.  But if the mission is to be sustainable, board members should be proactive about seeking out and mentoring candidates across a wide age range.  Here again, the executive director plays an important leadership role by recommending such prospects from among high-performing volunteers and other stakeholders.

Restricted support

As a general rule, the greater the presence of donor-restricted support the greater the potential threat to financial sustainability.  Managers will have less flexibility to fund and modify programs or provide for management and fundraising needs not falling within permitted uses.  And to the extent the organization accepts restricted support, the more control it gives to donors, increasing the likelihood of mission drift and lessening the board’s ability to strategically lead the organization.

There is no unacceptable threshold of restricted support.  As a starting point, however, a gift acceptance policy will help define conditions under which the organization is willing to accept gifts with strings attached and will provide an objective basis for turning away gifts that are not in its strategic interest.

It is reasonable to assume that the majority of charitable nonprofits need to spend, on average, at least 25% of their support on management and fundraising needs in order to be sustainable.  It follows that the organization should, at a minimum, maintain at least the same proportion of unrestricted support for discretionary program uses.  Thus, in the author’s opinion, restricted support should not exceed one-half of annual support, and preferably a good deal less than this level.

Additionally, without adequate resources for executive salaries, technology, operating reserves, and other management and fund development needs, the deeper the organization will go into what is commonly referred to as the nonprofit starvation cycle.  It is difficult for many nonprofits to adequately budget for infrastructure and other supporting services.  This is compounded by the presence of donor restricted support and pressure to maximize program expenditures to the detriment of organization health.

Financial leadership

More expectations and demands fall on the executive director than any other position in the organization.  The ED may need to ask for help from the board or independent consultants in key management areas while she acquires any necessary financial leadership skills, as indicated by relevant “No” or “Don’t Know” answers.

The ED and other managers will simply be unable to provide an adequate level of financial leadership if they don’t take care of themselves physically and emotionally, and have someone ready to step in their place during periods of absence.  Before dismissing this point, are managers tied to their mobile devices outside of work hours or on days off?

An often underestimated threat to sustainability is a poorly compensated executive director.  The board has a fundamental duty to promote financial sustainability through adequate management compensation.

Governance versus management

If the executive director is a voting board member, then the board is not independent.  While this practice would seem unthinkable for an organization of size, it is not unheard of among grassroots charities. 

Although generally permissible under state laws for the ED or other employee to hold a voting board seat, it is best practice that the ED is nonvoting.  There is no escaping the conflict of interest between governance and the self-interest of employed management.  Additionally, the payment of compensation to a board member may result in loss of charitable immunity protection under applicable laws.

Without clear separation between governance and management, it is less likely that the organization will be adequately transparent, accountable to stakeholders, and able to sustain broad public support over the long term.  And whether the board is independent must be disclosed on the IRS Form 990.

Financial reporting

The ability to compare accurate results with the operating budget as the organization moves through the fiscal year is one of its most powerful internal controls and indicators of mission sustainability.  The executive director cannot achieve maximum mission performance from historical financial data alone.  It’s like trying to drive while looking in the rear view mirror.  Past results provide important insights, but a budget informed by annual strategic objectives through meaningful staff and board input is the organization’s road map to mission effectiveness.

Cost assignment

Good nonprofit financial reporting also requires fair and consistent allocation of shared costs, i.e. costs that benefit more than one of the functional categories of programs, management, fundraising, and member development (if a membership organization).  Managers will never know what it really costs to operate programs, raise funds, and sustain a healthy organization without good cost allocation practices.

Management must avoid misallocating expenses to the program category for fear of looking bad as a result of reporting significant overhead costs.  Savvy funders appreciate that it costs money to operate the organization and sustain support, and recognize how percentages are easily distorted by fluctuations in income and the timing of expenditures. 

Tracking restricted support

An organization that lacks systems to keep up with the use of donor-restricted support has a serious accountability problem.  Developing understandable procedures in this area is a challenge for many organizations (and their independent accountants, too).  But it’s vital that managers know whether they may have inadvertently invaded restricted support and that they can provide accurate and up to date reports to donors of how their funds are applied.

Not only are there donor accountability issues to consider, but there may also be legal implications for borrowing from restricted funds.  There are appropriate accounting reasons for cash being less than restricted net assets in certain instances, so if this situation arises, questions need to be asked to determine if this is the case or if it is a red flag.  There may also be errors in classification, accounting for the release of restricted support has fallen behind, etc.

IRS Form 990

Issues surrounding Form 990 reporting may also indicate a financial leadership problem.  If the Form 990 is consistently filed after the initial due date, contains errors, or does not accurately portray program activities and finances, some questions to ask include:

  • Do we lack the personnel or systems to summarize and transmit accurate data to the Form 990 preparer on a timely basis?
  • Are we receiving second-class accounting service, either internally or from an independent accountant?
  • From the board down, do we appreciate that the Form 990 is publicly available and likely tells stakeholders more about us than any other document? 
  • Are management needs such as accounting systems and financial training starving as a result of budget priorities or support restrictions?

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