Balancing the Mission Checkbook

How important are financial ratios? I’ve had several very lively discussions recently about the value of using financial measurements, specifically ratios, to assess the financial health of nonprofit organizations. The appeal of ratios is that they are so tangible and certain, which makes them seem very reliable – especially compared to attempts to evaluate management strength or program effectiveness.

I will confess that I’m a finance person and I love financial analysis the way other people love mystery novels – I can follow the clues and tell a story from the numbers. So I’m surprised that I find myself in these discussions taking the devil’s advocate role that ratios are valuable only at certain times and with a lot of conditions. Used as a generic measure, ratios can potentially even mislead. To prove my case, consider the value of the “program service ratio” in evaluating nonprofits. This is the percentage of total expenses that are spent on program services rather than general and administrative and fundraising. Whenever someone attempts to impose a standard ratio that all nonprofits should use, we all bray about how different organizations are depending on their size, years of operation, field of service, client base, etc, etc. I agree with all of those arguments against a single standard and use the same reasoning to argue that ratios are valuable only when used in the right context and with the right information.

The first law of quality financial analysis – always use the right comparative information. Financial information by itself is just a list of numbers on paper. The understanding comes when it is compared – to the budget, the previous year’s reports, a set of goals, a peer organization or industry averages. Ratio analysis follows the same law. Yes, you should calculate ratios to analyze financial information, but then the ratios must be used with the right comparative information. There is no single “current ratio” for all nonprofits, but there is probably a good one for your nonprofit. A small nonprofit with few bills can have a strong current ratio compared to a larger organization with a larger budget, but that doesn’t tell us that one organization is in better financial shape.

After making an argument about the shortcomings of ratios, let me switch sides and offer a resource for ratio calculations.  Analyzing Financial Information Using Ratios has just been posted on our website as part of our Financial Management Resources. It includes an overview of ratios, definitions and descriptions and an excel worksheet for the calculations.

When I argue that ratio analysis is not a complete and reliable method to assess financial health, I have to offer some alternatives. How can we assess nonprofit financial health? What IS financial health? In a word, financial health is stability – the confidence that the organization will be able to serve its community and clients in the future. I can think of only three universal signs of stability that can apply to all nonprofits: reliable revenue, managed expenses and adequate cash. Pretty simple, and even these have to be understood in the context of the organization. Measuring and assessing these three components can take the form of ratios, trend analysis, comparisons with peers, budgets, plans or history. They are the fundamental financial levers that build stable operations. If you are interested in going through an in-depth analysis of your organization’s financial picture, with an emphasis on the types and reliability of income, consider attending Minnesota Council of Nonprofits’ workshop: Planning for Financial Sustainability on May 8th.

I led a workshop this morning called “Monitoring Your Financial Health” that covers a variety of methods for interpreting and analyzing nonprofit financial reports. The group read and compared reports, calculated income, expense and balance sheet ratios, and reviewed key indicators. When we talked about how to communicate the financial analysis to management teams and boards of directors I distributed a few samples of executive summary and dashboard reports (download an example here). As always, several of the workshop evaluations listed these reports as a highlight of the materials. The idea of dashboard reports has been around for a long time in business and nonprofit management. (For a good introduction to the concept see these articles from CompassPoint’s Board Cafe and the October 12, 2006 issue of The Chronicle of Philanthropy.)

I think that the reasons that workshop participants respond so strongly to the reports are their clarity and simplicity. Ideally, a dashboard report conveys in one page the key indicators for the organization and relates those indicators to goals, historical information, or benchmarks. The people in my workshop today know that this type of report is one that every nonprofit board wants to have.

So why don’t we all have dashboard reports? We don’t because they are very hard to develop. The art to creating a good dashboard is identifying what information really matters. The dashboard in your car shows you the speed, fuel level, oil pressure, blinkers, and warning lights. Think of all the other information that could be displayed as well – but isn’t – because too much information is overload. To create a valuable summary or dashboard tool you have to cull through all the possibilities and select the five to eight key indicators that convey the most important measures for your nonprofit organization.

I use two example reports in the workshop. One of the examples is for an organization in the middle of turnaround after several years of financial problems, and the other is an organization that is healthier financially seeking to diversity its contributor base. These nonprofits have very different key indicators. One watches cash and payables closely while the other needs more information on development.

The other challenging task to developing good dashboards is selecting appropriate goals or benchmarks. These deserve some focus because the wrong goal can send you in the wrong direction. One well-intentioned but problematic benchmark that I’ve seen at many organizations is the goal of building a cash reserve equal to three to six months of operating expenses. It’s a terrific goal, of course, but it’s unrealistic for boards to expect a nonprofit to build that level of unrestricted cash balance in one year or less. Fieldstone Alliance published a good book last year on identifying appropriate and useful measures, Benchmarking for Nonprofits. Here’s a link to a free excerpt.

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.