Balancing the Mission Checkbook

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.

There was a breakthrough last week for nonprofits. In a joint announcement, Guidestar and other major charity “watchdogs” made a very strong case that overhead ratios are meaningless. The phrase used in the opening paragraph says the ratio is “useless for evaluating a charity’s impact.” Read the full release The Worst (and Best) Way to Pick a Charity This Year and then copy it to share far and wide. Some of the reasons for de-emphasizing this ratio cited in the announcement will be familiar to nonprofit leaders:

• It tells you nothing about the impact the charity has on the people it’s trying to help.
• It discourages charities from investing in tools and expertise that would make them more effective.
• The rules for determining overhead costs are vague and every charity interprets them differently.

Hooray! I’ve been one of many voices speaking out on this problem for a long time, most recently in the post Donors and Overhead: Maybe They Don’t Care. This step by some of the most prominent national watchdogs, especially Charity Navigator, is huge. Ken Berger, CEO of Charity Navigator, elaborated on his own blog:

We do concur with the fundamental truth that the most critical dimension in evaluating a nonprofit has to do with achieving meaningful results.

Charity Navigator has been criticized for relying too heavily on the overhead ratio and other simplistic measures for their rating system. Berger has been blogging about their plans to shift to a more comprehensive approach, and this announcement is a breakthrough.

This feels like a gamechanger because now we can stop arguing about whether overhead is an accurate measure of charity performance. It’s not. Clearing that hurdle doesn’t get us to the finish line, though. Everyone in the nonprofit sector should cheer that the watchdogs are encouraging donors to review the impact and effectiveness of nonprofits – but how? There is not a single, simple alternative method to evaluate the effectiveness of all nonprofits. It’s essential for nonprofits to invest some time and brainpower to figure this out.

The organizations behind the press release have their own approaches:

• Consumer reviews: The personal experience approach of Great Nonprofits relies on a broad network of people who are involved with nonprofits to submit comments and ratings. Users of the website can search and browse for stories that interest or inspire them. Think of this as the Amazon reader reviews or TripAdvisor comments equivalent for nonprofits.

• Experts: Philanthropedia, on the other hand, relies on panels of experts in four different fields to pool their knowledge and assessment of which nonprofits are the “top” in effectiveness. Their “mutual funds” of nonprofits can become your vehicle for giving. In some ways this is a global, scaled up version of how we’ve used the local United Way.

• Data: GiveWell has a laser focus on reliable research and evaluation at nonprofits to support anecdotal stories or claims about impact. Read about their low opinion of the way nonprofits currently evaluate effectiveness. If better quality outcomes supported by good evidence is needed, then GiveWell will be there pushing us all.

Whatever approach you trust or endorse, get to it now. It will take us a long time reverse course for all the donors, advisers, and institutions that have used the program cost ratio as a stand-in for value. You’re going to have to offer some other data to replace it. Make it mean something. Ken Berger of Charity Navigator issued this call to action:

The nonprofit sector must get its act together and make sure it is really helping provide meaningful change in communities and peoples lives. It is life or death for many of those we serve whether we are effective or not. So let’s work together to measure, manage and deliver what is really important to make our world a better place.

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.

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.