Balancing the Mission Checkbook

Call it what you want – surplus, positive change in net assets, or profit – nonprofit organizations really need to plan for, and embrace, the importance of building financial capacity by generating a cushion. We don’t have a common language for this, and many nonprofit leaders would be uncomfortable using a term like “profit” when describing their financial goals. The word is much less important than the practice of budgeting and managing to build surpluses. Read “Organizational Slack (or Goldilocks and the Three Budgets” by Woods Bowman, published in the Spring 2007 issue of The Nonprofit Quarterly, for a very helpful overview of the topic.

The definition of slack used by Bowman is “a cushion of potential resources which allow an organization to adapt to internal pressures for changes in policy, as well as to initiate changes in strategy with respect to the external environment.” The benefit of a cushion is probably clear to any nonprofit director. Money doesn’t just fall into your lap to build a reserve. Bowman makes it simple and direct: “Where does financial capacity come from? There can be only one place: annual surpluses.”

Planning for an annual surplus, specifically an unrestricted surplus, is a positive, important, beneficial, and necessary practice for all nonprofits. I emphasize the importance of viewing unrestricted operating results, rather than the total of all unrestricted and restricted funds, because of the volatility in results caused by the timing of project and multi-year grants.

One step that could encourage the practice is to add a measure or ratio that defines the annual addition to the reserve or cushion. In the for-profit world, this is communicated in a fundamental ratio:

Net Operating Income = Profitability Ratio
Total Sales, or Revenue

The comparable measure for a nonprofit could be a CINA (change in net assets) ratio:

Unrestricted Change in Net Assets = CINA Ratio
Total Unrestricted Income

Try calculating this ratio for your nonprofit organization for the past few years and you will start to see how well the ratio can communicate the building, or depleting, of financial capacity. How high should the ratio be? On this point a for-profit and nonprofit organization will differ. A for-profit company seeks the highest ratio possible. For a nonprofit the ideal amount of surplus depends on what they need – and that balancing act is complicated. Bowman’s article has a whole section on measuring the right amount of slack needed.

Continuing on this theme, how effective are nonprofits at making the case for unrestricted support? Rather than bemoaning the lack of unrestricted funds, what can we learn? An article in last Sunday’s New York Times, “Here’s My Check, Spend It All At Once”, connects the current financial challenges at the American Red Cross to their Donor Direct policy established in response to the fallout about the use of funds donated after the September 11 attacks. When the Red Cross commits to direct all of your donated funds wherever you choose, what donor wouldn’t take the opportunity to be the master of their own philanthropy? The long-term results, though, may be the kind of deficits that the American Red Cross is facing. Was the Donor Direct policy an extreme reaction – did the Red Cross go too far as a reaction to a communications and PR problem?Following the references in the Times article, I compared the online fundraising messages of the American Red Cross and of Doctors Without Borders. The choice of how to direct donations is the first question for a donor at the American Red Cross. While the option “Where the Need is Greatest” is the first choice offered, specific funds are immediately listed below. The FAQ section even offers more options:

I don’t see the fund that I wanted to donate to. What do I do?
Due to space limitations, we are limited in how many funds we can make available for online donations. If you would like to donate to a fund that is not listed, please contact Donor Services.

Contrast this with the Doctors Without Borders website, which provides a concise summary of how funding is used to carry out their programs. Note that the information doesn’t offer the donor a choice to designate their funds to a specific use. In the FAQ section, in fact, Doctors Without Borders makes the case for unrestricted gifts:

Can I earmark my donation for a certain area/project?
We appreciate your interest in supporting our programs. While it is possible to have your gift directed toward a specific program or country where we are currently working, we ask that you contribute unrestricted funding. By not restricting your contribution for a specific emergency or project, you will enable us to allocate our resources more efficiently and where the needs are greatest.

All of these appeals and messages rely on trust, of course, and donor trust is what the American Red Cross must rebuild. Every nonprofit should care about this, because the public’s perception and confidence in the Red Cross is a good indicator of confidence in all nonprofits.

I find it interesting that I’ve read and heard quite a lot lately about foundation leaders discussing the relative merits and challenges of moving some of their grantmaking from program and project grants to general operating support. The New York Times recently published a re-framing piece on this by Denise Caruso, “Can Foundations Take the Long View Again?” The members of GEO (Grantmakers for Effective Organizations) have been engaged in a long discussion and analysis on this topic. They have published several thoughtful guides (free registration is required to view them). What I don’t think I’ve heard is a comparable discussion from nonprofit leaders about how much impact and long-term value their clients and communities would gain from more general operating support. If you are the director of a nonprofit, you may think that is an obvious statement – but I don’t think that connection is made very well. There are several issues involved, including different terminology and understanding of budgets.

What is a general operating grant? Is it a grant to pay for overhead expenses, or is it funding to provide comprehensive support for the organization’s mission and activities? Too frequently, the term is used as in this excerpt from an article, “General operating money is certainly one of the more difficult categories of funding to secure, mostly because it’s a lot less appealing to the funder. Let’s face it, paying rent is not nearly as sexy as helping people fulfill their potential as human beings.” STOP saying that. This is the kind of thinking and woe-is-me mentality that can’t make the case for general operating support. There is an implicit choice in this article: We have $10,000. Should we spend it on rent, or should we spend it to help people fulfill their potential as human beings? How about this instead: Let’s spend it on rent, salaries, benefits, supplies, and phones to operate our effective, innovative programs that help people fulfill their potential.

Do we need some new terminology to cut through this mess?

• General Operating Grant: Apparently, this is a grant to pay for distracting, hard to justify, and uninteresting expenses (like rent and phones).

• Program Grant: A grant that is restricted for a defined set of activities and outcomes that fit with the organization’s mission. All expenses included in the program budget, including salaries, rent, and supplies, are needed to carry out the program’s goals.

• Core Mission Grant: A grant provided to an effective organization to use as their leaders direct in order to support and achieve their mission. Some of the funds may be spent on immediate program and organizational needs and some on long-term investments, such as program development, staff training, and technology.

According to Caruso’s article, “The majority of foundation leaders polled in the studies acknowledged that unrestricted operating funds were better and more effective for grantees. But they continue to focus their grantmaking on project support, they said, because they prefer its clear-cut results.” Flexibility is the key value of core, or operating, support. Think about how you can make the case that flexibility will enable your nonprofit to be more responsive to community, better prepared for the future, and more effective in all of your programs and activities - that’s results.

Reading the headlines reflecting concerns and jitters about the direction of the economy is causing leaders of nonprofits to ask how it will affect their organizations. For some people, a state of worry has set in. I can see why. Today, the StarTribune posted this article on their website, “Chairman Bernanke says Fed ready to cut interest rates again as needed.” The article predicts further cuts to key interest rates “to rescue a weakening economy.” Factors cited included the unemployment rate, weak real estate, tightening credit, and high energy prices. What’s a nonprofit leader to do? Anyone who has worked for a nonprofit for more than three years has experience with a tough economy, so many directors and managers will be well prepared to respond to lean times. But how worried should you be right now and what are your concerns? I think it’s worth a review of the causes and effects that may have a direct impact on your nonprofit organization.

The key is to understand your income mix. There are essentially five distinct sources of nonprofit income and each income source expands or contracts depending on different factors in the economy. If you understand the sources of income that are most important to your organization, then you can focus on following movements and trends that will matter. One overall trend to keep in mind is that the “nonprofit economy” tends to lag the general economy by about a year. Here are some ideas for trend watching the economy.

Program service revenue, or payment for directly providing services, is the largest total source of income for nonprofits. Income from contracts for service, especially from government agencies, is determined based on tax receipts and state and local budgets. We know how many reductions occurred a few years ago and most of these sources haven’t rebounded. If this is your primary income source, the keys are the reports from the state and the budget process. You can track these through the Minnesota Budget Project. To survive with contracts, it’s important to understand the true costs of delivering the services (which is probably not the amount you are paid for delivering the services) and having your eyes open about the need for additional subsidy - and where to get it.

Program service revenue that is paid directly by the user of the service - like tuition, memberships, tickets, and fees – is a lot like business income and reacts to market downturns depending on the buying power of your customer. If your service is considered discretionary, like entertainment, then consumer spending is worth tracking by reading the business section of the paper.

If foundation grants are an important component of your income, watch the stock market. Because endowment payouts are calculated in a way that evens out big increases and decreases, there is no reason to expect a big decrease in 2008. However, pay attention to the excellent surveys and analysis from Minnesota Council on Foundation including Grantmaking Outlook and Giving in Minnesota. If the market performs poorly over time, some reductions in grants could develop. Keep in mind, though, that even with the poor market performance several years ago, grants from Minnesota foundations have increased total dollars almost every year (more details in the MCF reports). If your endowment is an important source of income, the same market trends described above apply.

For nonprofits that rely on individual donors it’s a mixed bag of economic news. This recent online discussion about the Outlook for 2008 hosted by the Chronicle of Philanthropy highlights some opportunities for planned giving and large gifts that transcend the economy, and emphasize the importance of relationships and communications in maintaining a building a donor base.

So don’t assume the worst or start a chorus of woe about the poor economy. Yes, there will be challenges, but you can understand how economic trends will affect your nonprofit. Knowledge is power and will help you anticipate and plan for any changes.

We’re more than halfway through the year – how’s your budget holding up?

It’s pretty common to review the financial reports for the first six months of the year and notice some clear trends when you compare the actual results for income and expense lines to the budget. Differences between the plan and the results are to be expected, but if the variances are really large, it might be reason to consider a mid-year budget modification. At the very least, big variances are a signal that your process for developing the budget might need some improvement.

Variances from budget are normal, of course, since it’s unlikely that the staff or board of a nonprofit will know with certainty and within a few dollars what each income and expense item will be. Expenses are easier to predict since they are under management’s control (more or less). Income, on the other hand, is harder to predict since there are many different types of income and so many external factors. That is precisely why a good budget process is crucial.

Mid-way through the year is a good test of the reliability and value of the budget process that you use. Signs that you have problems with budgeting are: widespread and inconsistent variances; ignored or excused materials variances; accounting problems that don’t allow you to monitor actual compared to budget; or flawed significant assumptions.

One budget problem that can rear its head at this point in the year is when budgets for either grants or contributions were plugged in when the budget was created. It feels good in December when a balanced budget is approved, but it really hurts in July when you see that balanced budget evaporate because the numbers were made up.

If you look at the mid-year financial report and see big differences between budget and actual and you want to avoid repeating this problem next year, start thinking about how to get everyone committed to having a reliable, useful budget. Some of the reasons budgets fail are:

• Lack of support for the budget development
• Weak or undeveloped assumptions, especially for income items
• Lack of oversight of initial decisions and priorities
• No buy-in from program staff who will be responsible for the budget
• No input from development staff about realistic fundraising goals
• Starting at the last minute and rushing to get the budget completed
• Emphasis on minor details rather than macro factors (good numbers for telephone expense but no attention to changes in funder guidelines or contract terms)
• Lack of accountability

How do I develop a good budget? Just do the opposite of everything on the above list. Another resource is an article we wrote in the style of the troubleshooting guide at the back of your DVD manual – Troubleshooting Your Budget.

At the beginning of the annual budget season, which for many nonprofits is in the fall, listen carefully and you will hear the wails of anxiety about what grants, contributions and contracts to include in the budget for next year. A frequently heard wail is: “Why can’t we be one of those nonprofits with grants that they can count on every year, and deep-pocket individual donors who always write big checks, and … if only we could be one of them, we’d be financially stable.”

I’ve heard this over and over. The truth is that this is a myth – and too many nonprofit directors and board members believe it. It’s an unusual nonprofit that has completely reliable and recurring sources of income year after year. Income, both contributed and earned, has to be continually researched, requested, proved, and unearthed by small, mid-sized, and large organizations. What makes a nonprofit financially stable is having the kinds of systems, plans, and people in place to do all of this consistently enough to get results they can count on. This means that we have to change our definition of the mythical financial stability.

The myth is that a nonprofit can find foundations and donors once and turn them into a never-ending stream. The truth is that nonprofits have to create a solid infrastructure for prospecting, requesting, completing, and maintaining grant and donor relationships. This is one of those bad news/good news realities. The bad news is that there isn’t an easy one-time fix for income budgets. The good news is that every nonprofit has the ability to create and build systems to bring in income consistently – if only they keep working at it.

For consistently interesting ideas and research about the financial reality of leading a nonprofit, read the Nonprofit Quarterly. Their most recent e-newsletter included a preview of an article profiling six income models for financial stability - Financial Independence: Six Approaches.