Balancing the Mission Checkbook

I have often said that my least favorite question is “What is the ideal target amount for a nonprofit to have in an operating reserve?” Because there is never a simple answer for the question, I wrote a post a while ago on The Cash Reserves Myth:

Every nonprofit should have a cash reserve equal to three months of expenses.” There’s some truth and some myth to this “best practice.” It is absolutely true that every nonprofit needs to have adequate cash balances available to support the timing of payroll and other expenses, as well as to pay for unanticipated costs or increases. It’s a myth, however, that a single standard applies for all nonprofits. I have two issues with the “three month reserve” standard. One is that different organizations need different amounts of cash on hand. The second is that building a reserve of three months of expenses is not a practical, or even desirable, goal for all nonprofits.

In an article I wrote a couple of years ago, The Yin and Yang of Nonprofit Reserves, I recommended different ranges depending on the stability of incoming cash flow, with reserves as low as one to two months of operating expenses. One reason for my caution about standard reserve ratios has been the business question of whether idle cash is an efficient use of capital.

I take it all back. Well, I take some of it back.

The Value of Cash Reserves

The past 18 months have been a lab test of the value of cash reserves. This isn’t a surprise, I suppose, but it has made me re-think my earlier questions about the focus on reserves. It is clear that nonprofits that have been able to build up a good cash cushion have had options and opportunities in the past year that enabled them to respond to reduced income and increased demand more strategically and carefully than those organizations with few extra dollars in the bank. You know what I mean whether you are affiliated with a nonprofit that has reserves or with one that does not.

In the survey that the Minnesota Council of Nonprofits conducted to prepare the most recent Current Conditions Report, several questions were included about operating reserves. MCN generously shared the survey data with me for an in-depth analysis of these questions. The responses illustrate the differences between nonprofits with and those without reserves.

• How much in reserves? For all respondents, 34% have one month or less, 18% have none, and 6% had a reserve fund but depleted it in 2009.
• Asked if they anticipated dipping into reserves in 2010, 24% of nonprofits replied that they do.
• Not surprisingly, 65% of nonprofits with minimal or no reserves experienced cash flow problems in 2009, and most of them anticipate prolonged cash flow problems in 2010. Nonprofits of all sizes fell into this group, most commonly in arts & culture and social services.

Why does it matter? I sliced the responses further and found that the nonprofits with minimal or no reserves were more likely to have cut budgets, eliminated staff positions, reduced wages and benefits. They were also less likely to have been able to increase services to respond to growing demand.

There’s a caveat that these results aren’t necessarily caused by the lack of reserves. It’s quite likely that other factors are at play, including the broader question of the governance and management practices and business model needed for nonprofits to build reserves over time through operating surpluses.

This survey and the practical cases that we talk with every day have taught me to truly appreciate – to love – operating reserves.

Build the Right Reserve for Your Organization

I still believe that the “right” target for reserves needs to be customized for each nonprofit based on their operating structure, cash flow, and ability to generate surpluses in the operating budget. Building reserves requires an intentional budget strategy and follow through to generate surplus funds. Whatever the target amount, reserves are most useful if there is clear agreement about their purpose and use codified in a written policy. Nonprofits Assistance Fund has developed a new resource, Operating Reserves Overview and Policy Example. If you are interested in a deeper dive on the issues, considerations, and structure for reserves, you’ll love the Nonprofit Operating Reserves Initiative Workgroup White Paper. They answer the “how much” question with a useful chart that sorts through the “it depends” factors.

The theme for the Carnival of Nonprofit Consultants this week is “What one thing should we do to improve the state of the sector?” My nomination is to declare 2008 the year that the program service-administrative cost ratio formula became irrelevant.

Yes, the good old 70%-30% ratio has been declared officially useless in identifying whether or not a nonprofit organization is effective in accomplishing its mission and helping the community. Most readers of these blogs have probably been beating their heads against the wall about this anyway. I read a lot of research reports and I have never read one that demonstrated that the expense ratio is a clear indicator of the quality of programs or management, or impact on the lives of people. One reason why we continue to chase this argument, though, is because the ratio is prominent, well known, and easily calculated.

We need a two-step retirement plan. First is to jointly stop using the ratio as a way to distinguish our organizations from others, in an unhealthy type of competition, as in “our administrative ratio only is 5%, so your donated dollar will go farther with us.” The second is to find a better way to convey the quality and effectiveness of the work that you do, which requires a real method of evaluating and communicating the programs and impact on clients.

So don’t be irrelevant – join the movement.

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.

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.

I’ve had several discussions lately with board members of nonprofits on financial management topics that had an odd, disconnected feel to them that I couldn’t pinpoint at the time. One was about operating reserves and how much was the ideal amount to have in reserve – 3 months, 6 months, or a full year’s expenses? Another was about how to determine the best mix of income sources for a nonprofit that has grants, government contracts, and fee income. In both conversations I asked the board members my favorite question: Why? This is a set up, of course, since I think that reasonable reserves are valuable to have, and that understanding the sources of income is a key to financial health. The “Why” question has to be asked when financial matters are considered without any connection to the nonprofits’ mission – that’s the disconnect. The purpose of these particular queries had more to do with creating a financial model and satisfying the board members’ perception of their role than with improving the nonprofit’s ability to serve its community. Finding the balance is very hard, though, and we have few guides.

Nonprofit Quarterly has been one of those guides recently with their spring issue titled “Revenue is Destiny”. I enjoyed reading a preview of the summer 2007 issue, especially this excerpt from an interview with Richard Brewster, executive director of the National Center on Nonprofit Enterprise. NCNE “helps nonprofits make wise economic decisions”.

NPQ: What should boards focus on if they are concerned about long-term sustainability?

RB: This may be counterintuitive, but the central question is the quality of the program. In other words, the worst threat to nonprofit sustainability is if your program is crap. A nonprofit’s only reason for keeping going is to change people’s lives, communities, the environment, and so on for the better. If a nonprofit is not making the biggest difference it can with the resources available, it is being wasteful. From an economist’s perspective, it is not putting its resources to best use and is inefficient. I’d find it odd to apply the word sustainable in any really meaningful way to such an organization.

I love the directness of this comment. Why should nonprofit directors and board members be concerned about their financial and economic condition? As a tool to deliver good programs to change communities and lives, both today and in the future.

But what if your nonprofit doesn’t have audited financial reports? Does this item listed in the grant proposal form mean that you should rush out and hire an audit firm – or that without an audit you’ll never get a grant? Probably not – but you should understand what an audit is, why the foundation includes this on the checklist, and what alternatives you have. I’ve been asked this question many times by both nonprofit directors and foundation program officers. The short answer is this – no, you don’t have to have an audit for the majority of grant applications. Most foundations do not want to require a small nonprofit to spend $5,000 or more for an audit just to apply for a grant. In some cases, the cost of the audit would actually exceed the amount of the grant! Requirements for nonprofit audits depend on how funds are raised and various state and federal grant requirements, but the threshold for most nonprofits defined by the Attorney General in Minnesota is $750,000 $350,000 in income. What the foundation really wants – and needs – is financial information that they can rely on. An audit is the ideal, but there are alternatives.

It’s helpful to first understand what a financial audit is – and what it isn’t. An audit report is a financial report prepared according to accounting standards and an accompanying opinion of a CPA that they have reviewed and tested the information and determined that it is accurate. This is called a “clean” opinion. The reason that funders like to see audits is because of this opinion about the accuracy of financial reports. It’s important to understand that the audit is completed using the financial reports prepared by the organization, not by the auditor. (In fact, the auditor cannot prepare the financial reports and then turn around and issue an opinion letter about them.) An audit is not an assessment by a CPA that the nonprofit is in a good financial position. Making that assessment is up to the organization’s staff and board and any outside users of the financial reports.

So without an audit, how can you provide accurate and reliable financial information that is acceptable to a current or potential funder? Go back to the description of what an audit is: a financial report prepared according to accounting standards. Without an audit you won’t have an opinion letter, but you can provide an accurate year end financial report including an income statement and a balance sheet. In order to do this, the financial manager or treasurer will have to prepare a “final” financial report for the year and have it available in a standard accounting format. It’s great if you create a PDF version that can serve as the definitive version. Along with this report, send your IRS 990 form to demonstrate that you have complied with the requirements for reporting and accountability. The 990 should be accurate, the information reported should agree with the financial report, and it should be timely. The executive director and development staff person or volunteer should be able to read and discuss both of these reports at a site visit or phone call.

I recommend an article in the current issue of Nonprofit Quarterly, “Absent the Audit: How Small Nonprofits Can Demonstrate Accountability Without One”, by Jeanne Bell and Steve Zimmerman. The authors suggest that there are three key functions of an audit for a small nonprofit: generating donor and constituent confidence, ensure compliance with accounting standards, and prevent or catch fraud. They propose a number of ways that small nonprofits can fulfill these same functions with a printed annual report, open communication of a summary version of year end results and the annual budget, and a timely, correctly prepared IRS 990. The article also includes some good advice about using a board treasurer or volunteer to help assure accurate reports and the importance of internal controls for any sized nonprofit.