Balancing the Mission Checkbook

Nonprofits Assistance Fund is sometimes called in to help nonprofits when they have financial problems that have been building for a long time. Fortunately, financial turnarounds are possible and we’ve seen some incredible work at nonprofits that resulted in financial recovery. Whether the outcome is positive or negative, though, in every case the situation would have been more manageable if it had been identified and addressed sooner. At some point, the question comes up: why didn’t someone, including board members, see the red flags and call attention to them sooner?

There are hundreds of reasons, of course, including disengaged boards, weak fiscal controls, misunderstanding of roles and responsibilities, and lack of timely information. I’ll offer one technical reason: boards miss the red flags because they don’t know where to find them.

But red flags should be obvious on the financial reports, right? Not really.

Some background: there are two standard financial reports that should be provided to the board of directors regularly, the income statement and balance sheet. From all the training workshops we’ve delivered over the years we know that the income statement makes sense to most people, especially when the report includes a comparison to the budget for the same period. With some basic training board members can get comfortable reviewing how much income is coming in, what the expenses have been, and where the actual performance varies from budget. Balance sheets, on the other hand, are not easy to read or interpret. They are based on accounting terminology and standards that require more training and experience to make them useful. Nonprofit accounting rules for restricted funds make balance sheets complex even for experienced finance professionals from the business sector. It’s hard for board members to get a handle on what’s important on the balance sheet or feel comfortable asking questions.

So, why do board members miss the financial red flags?

Boards pay too much attention to income statements and budgets.
The periodic income statement is useful for tracking progress and expense controls, but this report is very limited because it is covers such a short time period. Big variances are useful to alert boards to questions. Deficits are cautionary signs that deserve analysis. A surplus or a deficit in one month, or even one year, is usually not the sign boards need. What matters is the cumulative financial condition over time, signs that indicate a big problem that threatens a nonprofit’s future.

Boards don’t pay enough attention to balance sheets.
Many (most?) board members pass over the balance sheet or skim it, at best. That’s too bad, because the balance sheet is the key for seeing the problems. The balance sheet reports the cumulative effect of all of a nonprofit’s financial activity over the years and signals financial health or problems. Healthy nonprofits build up assets, cash reserves, and unrestricted net assets, and maintain reasonable amounts of debt. Nonprofits with serious financial problems report diminishing cash, insufficient working capital, restricted funds diverted to current operations, negative unrestricted net assets, and creeping debt levels. Those are the red flags that should make board members jump up and down and shout – look over here.

Yellow flags are on the income statement. Slow down, look both ways. Red flags are on the balance sheet. Stop – now!

Resources:

• For a quick review of how to read nonprofit financial reports, watch these very short video primers.
• For a more extensive review of the marvels of balance sheets, refer to our Balance Sheet Cheat Sheet and the article Why Do Balance Sheets Matter by Rodney Christopher.
• I’ll dig into these flags and indicators at a session at the Nonprofit Finance and Sustainability Conference on April 19^th. Register now!

It’s been gratifying to hear and read the great feedback about An Executive Director’s Guide to Financial Leadership published in the current issue of The Nonprofit Quarterly. I enjoyed writing the article with co-author Jeanne Bell from CompassPoint Nonprofit Services. We have very similar approaches to finance as a tool for mission and community impact. Nonprofit managers and directors have posted online comments and given me direct feedback that they appreciate the practical guidance that goes far beyond bookkeeping basics. These principles help to build strong infrastructure and capacity, and break some habits that aren’t serving our organizations very well.

I encourage you to read the full article (and subscribe to the magazine!)  Here is the brief “Executive Director’s Finance Cheat Sheet” of the eight key business principles that we believe are essential for financial leaders.

1. Develop your annual budget with a commitment to its net financial result—whether surplus or planned deficit—and then adjust spending during the year if income is not coming in on pace to yield that net result. Then, complement your annual budget with rolling financial projections that incorporate your most current information about probable future financial results.
2. Diversify your income cautiously, ensuring you have the capacity to develop and sustain the programmatic and operational requirements of attracting each new resource type well.
3. Develop cash flow projections along with the budget and rolling projections so that you can anticipate any cash flow problems well in advance, when you have more options.
4. Plan goals for financial reserves based on your typical cash flow cycles and risks and incorporate reserves into all financial plans and policies. Be sure to foster a financial culture for staff and board that understands the importance of a regular operating profit or surplus.
5. Pursue restricted funding from those foundations and corporations that understand and value your organization’s mission and particular strategies for achieving impact. When pursuing restricted funding, develop proposal narratives and accompanying budgets that link staff development to program design to superior outcomes, including all related costs as direct.
6. Ensure that your finance function is always properly staffed; if necessary, use a mix of staff and expert contract consultants to achieve this.
7. Discuss expectations for financial roles and responsibilities with board leadership to create accountability and information flow that matches the size and life stage of the organization. Make sure to invest time to develop meaningful financial report formats for the board that reinforce organizational strategies and goals and supports the board in fulfilling their responsibilities.
8. Introduce the concept of enterprise risk management to your team and initiate an internal assessment of a full range of risks.

Read the article and let me know what you think and what other principles we should add. For those of you in Minnesota, we’ll have a chance to hear directly from Jeanne Bell at a conference coming up in April that Nonprofits Assistance Fund is co-hosting with Minnesota Council of Nonprofits. Watch for more information soon!

Nonprofits Assistance Fund advises its clients to think about financial statements as a way to tell the story of their nonprofit missions. How organizations raise resources (mixes of earned and donated revenue, for example), where they spend money, and what they impact as a result of using resources are the narrative arcs of your financial statements.

The stories are told within a common context. Narratives have rules of grammar, and the financial statements have rules about how we describe resources so we all have a common understanding. These rules (Generally Accepted Account Principles, or GAAP) are periodically reviewed and revised to help make sure we are all still speaking the same language, so our stories are well understood.

Someone has to keep the rule book, and in the case of GAAP, that is the Financial Accounting Standards Board (FASB). Nearly two decades ago, FASB changed the nonprofit rule book, because the stories being told under the old rules were sometimes confused tales the average reader couldn’t always decipher. Rules about how we account for temporarily restricted net assets and more were revised to make things a bit clearer. FASB has had more time to see the stories unfold, and the nonprofit sector has now grown more mature, and it’s time once again to think about how these numbers tell our tales.

FASB is considering changes to net asset categories. The specific changes are not final, but it reflects some thoughts Nonprofits Assistance Fund has been promoting with clients. Nonprofit net assets – what you are worth when you take away everything a nonprofit owes from everything a nonprofit is worth – can be described in better detail and with more narrative heft than just whether the asset has a donor-imposed restriction. A single lump of resources at the end of the day is useful information, but showing board-designated categories within the larger context of net assets helps convey intention about the direction and thoughtfulness of the management over time.

Board-designated categories can come in different flavors depending on the needs of the organization and story it may tell. A group with a building or other expensive fixed assets may want to show a designated reserve for repair and replacement work. A nonprofit with significant ups and downs in cash flow may want to show a specific board designation for a cash-flow management account. A nonprofit considering a merger or acquisition may need to show a designated reserve for one-time expenses related to growth.

Each case will vary, but a few well-chosen designations will help your nonprofit story gain understanding – and therefore more support – with audiences. FASB may soon change the rule book, in which case nonprofits will want to align their narratives with the new guidelines. Stakeholders will appreciate the added information, and designations can help nonprofits keep on their strategic targets. After all, when we tell our stories to others, we hear them again ourselves.

Brad Kruse, Program Director at Hugh J. Andersen Foundation with Steve Boland, Nonprofits Assistance Fund

The Minnesota Council of Nonprofits’ Minnesota Foundations 2012 conference was another info-packed afternoon, talking about all the news from the latest edition of the Minnesota Grants Directory. Hundreds of grant-seekers gathered to share what they know about philanthropic support in Minnesota, and occasionally to bemoan how funders just don’t get us.

The conversation shifted to ways nonprofits can help granters. One suggestion was to add a good narrative to budgets or financial documents. Financial narratives are brief comments that can accompany grant proposals and can be extremely helpful for potential funders. Nonprofit organizations that use financial narratives have the opportunity to explain unusual or exceptional circumstances and avoid any potential confusion or misunderstanding.

Some possible situations to explain in a financial narrative:

• Is there anything in your document that would stick out as unusual for the first-time reader?
• Are there any unusually large or exceptional sources of revenue requiring explanation, such as receiving a planned gift or one time grant?
• Explain if your organization received a multi-year gift that will be recognized all in one year and expended over multiple years. A simple sentence or two can go a long way in explaining an unusual surplus in one year and then deficits in one or more years after. If applicable, be sure to report temporarily restricted income and explain the restriction.
• Does your organization have an internal, board-restricted reserve or other internally restricted funds as opposed to having cash on hand? If so, does your board have a cash reserve policy? Explain cash reserves and any policies in the narrative.
• If your organization has a deficit or multiple-year deficits, put the situation in context and use the opportunity to explain what the organization is doing to address the situation.
• If your organization has a healthy balance sheet with surpluses, put the situation in context and explain your need. “Why not spend down your resources before seeking more?” You likely have a good answer. Write it down.
• Explain if the special event revenue line. Is this one special event or the totals from several special events?
• Does your individual giving contain special events or are those listed separately?
• Large amounts of in-kind contributions can raise questions. Provide some detail that explains how these donations fit the guidelines for in-kind contributions.
• Does your program budget contain all committed funds or only partially committed funds and the plan(s) to raise the necessary funds?

Obviously, not all of these questions are appropriate for every situation and financial narratives should be kept brief. A financial narrative that goes on for pages and pages is usually not as helpful. A brief, one-page or less narrative can be an important tool in helping your organization tell your story and make your case.

Now that most nonprofits have filed the new version of the IRS 990, you might be taking a deep breath of relief that you got that big change done with and over. Don’t let the 990 sit in a drawer, though. Not after all that work. The new 990 is a big step forward to bring better, more usable information to a wide range of stakeholders including current and prospective donors, watchdog groups, public officials, media, and other nonprofits. Ultimately, the most important user of your 990 is you.

Part of the value comes when you pull together all the pieces to have the form completed. The new 990 requires information about mission, program accomplishments and costs, board members and key staff, policies and governance practices, compensation, fundraising, finance, and much more. While many nonprofits rely on their audit firms to complete the 990, most of the required information is not financial and must be supplied by various departments or staff of the organization. The second part of the value comes from continuing to use the 990 as a communication and analysis tool. Here are four suggestions.

As an organizational tutorial

Read the whole 990, front to back. New managers, board members, emerging leaders, or anyone else on staff who wants to know more about the organization can get a complete overview of the organization by reading the complete form including all of the schedules. This assignment will also help you identify any questions or sections that need to be clarified or completed more thoroughly.

As a financial analysis tool

The 990 contains a complete financial report in a standard format. The new form expands the financial information, particularly the income section, to provide more complete data. Most financial analysis steps can be conducted using the 990. To make it easier, Nonprofits Assistance Fund created a new tool that we call the “990_Decoder.” Transfer the three financial pages from the Core Form onto this spreadsheet and you will generate a familiar looking Balance Sheet and Income Statement and a page of six standard nonprofit financial ratios. These can easily be used for comparison with other years or with other, peer nonprofits. Just “decode” their 990, too. We’re happy that the Minnesota Council on Foundations likes to decode 990s, too.

As a source of comparable compensation data

A month ago we were fielded a number of requests for help from board members of nonprofits who were responsible for obtaining information about executive director compensation from comparable organizations. In many cases, salary surveys fit the bill, such as the thorough review that Minnesota Council of Nonprofits compiles. Another simple approach is to create your own peer group of 4 or 5 nonprofits that are of similar size and type of service. Compile a custom comparison by using Guidestar to collect compensation data from your peers’ IRS 990s. Compensation is usually listed in Part VII on page 7. Guidestar registration is easy and free for the basic search. The information will be at least a year old, but as we told the board members we talked with, no one got much in the way of salary increases last year anyway.

As a communications tool

One of the unique features of the 990 is the Program Accomplishments section that is now the second page of the form. Hopefully you have taken advantage of the opportunity to communicate specifically what activities you completed, who you served, and how this work had an important impact in the community. Take an hour or so and read the Program Accomplishments for your nonprofit and then read the section for a few other organizations that you admire. How well did they communicate their work? How did you do? Learn from other organizations and look for ways to promote your 990 as another communications tool. Post it on your website (along with you audit, please).

Don’t let the IRS 990 sit around gathering dust. Give it a workout and help both your organizations and the nonprofit sector show the value of transparency and accountability.

We’ve heard a lot from nonprofit clients in the last week or so about cash – too little, too restricted, or just right. Maybe the right amount, but the wrong timing. Maybe the right timing, but too risky or some other problem that results in cash on the balance sheet ending up as only “cash” on paper.

Here are three stories:

• Organization 1 has been holding a nice balance in a money market investment account for the last two years. The funds were earned from a special grant-funded project but no one ever figured out whether there was an ongoing restriction on the earnings. Now they wonder if they can use this idle cash as an operating fund.

• Organization 2 has a substantial balance in a building reserve fund and no money in operating reserves. There are no improvements planned and the building has been well maintained, but the policy keeps this cash out of reach to address immediate needs.

• Organization 3 has operating reserves invested in a bond fund and realized that the value of the account has dropped with the market. The treasurer thought that the fund was like a money market account and didn’t realize there was risk of market fluctuations.

In all three cases the nonprofit was accurately reporting the asset balance on financial reports. Beyond verifying an accurate number, though, it’s important to have a solid grasp of all the strings and restrictions that might hinder your ability to use that cash when you need it. Some restrictions are external, such as temporarily restricted grants. Other strings on cash result from internal decisions related to investment decisions, reserve policies, or overly-complex designations and conditions.

Thomas McLaughlin addresses the problem of illiquid cash in this week’s Streetsmart Financial Manager column in The NonProfit Times.

How Liquid Are We, Really? Cash is king, or queen, depending on the realm. As long as you have sufficient cash you can outlast most blows the environment delivers. But you need to be sure that the things listed as cash really are cash.

Nonprofits Assistance Fund has created a quick cash analysis resource to help nonprofits easily distinguish cash that’s liquid and available from other types of restricted, designated, or hard-to-access funds. You can download this Cash and Investment Analysis worksheet now.