Balancing the Mission Checkbook

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.

Some choices that nonprofit leaders have to make are really tough. Others are tougher. Right now, there are many nonprofits in Minnesota that need to make some of these choices in the next few weeks because of the strong possibility of a state shutdown. In the recent post When the Worst Case Scenario is Really Soon we advised all nonprofits that rely on payments from the state to start working on cash flow contingency plans. As reports are trickling in about notices and conversations with grant and contract managers at state agencies, it’s clear that these plans will need to go beyond cash flow. That’s when questions go from tough (can we pay the staff and bills?) to tougher (can we continue to provide services in our community?).

State agencies are developing their own plans to suspend operations if necessary, and they are dealing with uncertainty just like the rest of us. Many state grant and contract managers are contacting their nonprofits contractors to alert them to possible disruptions in payments or the risk that any services provided during a shutdown may not be eligible for retroactive payment. How much impact would a state shutdown have on your organization, and what kind of plans to you need? The answer (as always) is “it depends”. This very fluid situation demands multiple versions of “what if … “

• What if … a state agency pays funds to the nonprofits from a source other than the state general fund budget, including federal funds or a designated source? A worst case state shutdown could either stop or slow down payment processing of contracts and grants – you need to create a conservative cash flow plan.
• What if … the nonprofit has a long standing state contract or grant? Even with an active contract or grant, a shutdown would stop payments for the near term, and could cause a longer payment lag due to backlogs and other disruptions. Review the contract terms, or check with the grant manager, to confirm whether or not payments are certain for services provided during a shutdown. You need a plan for cash flow delays including both immediate term and some lag time.
• What if … the nonprofit has an established contract with the state that is signed annually with a start date of July 1st or later? This situation poses more risk to the nonprofit because of uncertainty whether a new budget will include a provision allowing retroactive contracts. The budget passed in July 2005, the time of the last shutdown, included such a provision (thanks to Minnesota Council of Nonprofits). You need to take this risk into consideration as you plan – is this a cash flow delay, or a possible loss of some revenue? Could your organization absorb the reductions if you provide services without retroactive payments?
• What if … the nonprofit has a new state grant or contract that begins July 1st or later, or is waiting for a final approval or announcement for state funds? These funds are at the highest risk as long as there is not a budget in place. Be very cautious about assuming that the terms will be untouched and retroactive once a budget is in place.
• What if … your nonprofit doesn’t rely on state funds, or receives small amounts from the state? Rather than feel relieved, think about the impact a shutdown may have on your clients, other organizations with whom you partner, and other community services. You may see a ripple effect in new requests for service, higher demand, or service disruptions elsewhere. Spend a little time brainstorming how your organization might be affected and how you could respond.

The what ifs could go on and on. The only way to answer any of them, and many nonprofits have more than one state contract or grant, is to systematically review the terms, check with grant managers (while they’re still available) and consider the options. In some cases, the options may fall into three categories: tough, tougher, and toughest. The Minnesota Council of Nonprofits is communicating policy information, news, and resources through email and a page on their web site. Nonprofits Assistance Fund is working with MCN to sponsor six free Government Shutdown Emergency Briefings around the state that will include background of how we got to this point, crisis communications techniques, financial planning, and open discussion with your peers. Register through the MCN web site.

For the last six weeks or so there have been quiet conversations and meetings at nonprofits to prepare contingency plans in case of a state shutdown. As with all contingency plans, no one wanted to have to use them. Now that the May 23^rd legislative adjournment date has passed, and the governor vetoed the budget bills as expected, the likelihood is much, much higher. The conversations have moved from private conference rooms to big meetings and headlines, including Shutdown Looms in the Star Tribune, and MPR’s post Get to Know a State Shutdown. The State of Minnesota must have a budget in place by July 1^st or the money to operate the state’s activities runs out.

How concerned should you be? I think that we’re probably all concerned about the broad policy question and impact on the state. How worried should you be in your role as a nonprofit staff or board member? If you receive funds that flow from the State of Minnesota, you should be very worried. There are a lot of variables to consider and information to sort out, and it’s hard to accurately predict exactly how the state government would manage the shutdown if it happens. At the time of the shutdown in 2005 some services were declared “essential” as described in the MPR article, but don’t rely on those decisions made by a different administration. Budget Commissioner Jim Showalter has said that a shutdown this year could be “much, much more extensive.”

We are urging all nonprofits that rely on payments from the state to develop a worst case contingency plan as soon as possible, with an emphasis on one thing: CASH.

Here are our recommended steps:

1. Do you have revenue that comes to you directly from the State of Minnesota? Do you have revenue that is indirectly from the state, even if it is paid to you through another entity, such as a county, a collaborative, or partner?
2. If you do receive state funds, how much do you expect to receive in July and August? What would be the impact if you do not receive any of these payments in July and August?
3. Now is the time to update your cash flow projection or create your first one. We have two good resources, the guide to Managing Cash Flow and the cash flow template (Excel) that you’ll find in the Nonprofits Assistance Fund resource library. If you need some help developing your projection, Contact Us to talk with one of our staff.
4. Do you have internal cash accounts or reserves that could handle the cash flow gap?
5. Do you have a line of credit available that could cover the cash flow gap? Would the loss of state payments affect your ability to access your credit line? If you don’t know, find out.
6. If nonpayment would impact your agency’s ability to maintain services, meet payroll obligations, or sustain basic operations, you need a cash plan fast. To be prepared, consider managing cash flow starting now to accumulate a temporary cash cushion even if you don’t have reserves.

If the cash flow projection gives you bad news, be prepared. There may be very tough choices to make about temporary service reductions, staff furloughs, or expense reductions or delays. There may be ways to lessen the impact with advance planning. That’s what contingency planning is for. Don’t wait.

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.

Worrying about cash shortfalls is, without a doubt, at the top of the list of stressors for nonprofit directors and finance managers. In this situation, everyone’s dream is to have a stash of cash – a cash reserve account set aside to tap at a moment’s notice to solve the problem. I’m reluctant to endorse a universal standard for reserves, but there are “rules of thumb” and accepted practices calling for nonprofits to hold reserves of three to six months of operating expenses. Well it turns out that this “best practice” is a practice in theory only for many nonprofits.

A study by the Urban Institute, reported in the Washington Post this week, Nonprofits Imperiled By Low Reserves found that 57% of the Washington area nonprofits studies had less than three months of reserves, and 28% had none. The June 2009 Nonprofit Current Conditions Report published by Minnesota Council of Nonprofits found new cash flow concerns caused by slower payments from county and state agencies. Surveys in Minnesota have found that at least 35% of nonprofits anticipate cash flow problems this year and 30% have one month or less of operating reserves. Low reserves and cash flow problems are not restricted to small or struggling nonprofits – it’s a widespread management challenge. The Urban Institute study contained an interesting finding, according to the Post article:

According to the study, larger groups were less likely to have sufficient operating reserves than smaller ones, a finding that surprised researchers. Seventy percent of charities with expenses over $5 million had low operating reserves, compared with 50 percent of groups with less than $100,000 in expenses.

This shouldn’t be that surprising when you do the arithmetic. Imagine that you run a nonprofit with an $8 million annual budget. Maintaining a three month reserve would require a $2 million cash account. That’s (a) a big number and (b) very difficult to build up in the low surplus, service delivery model of most nonprofits. Rather than dwelling on the best practice or target for designated cash reserve accounts, maybe nonprofits need to learn to be more sophisticated managers of cash and its relative, working capital. This financial concept was described well by Ben Cameron of the Doris Duke Charitable Foundation last week in a Chronicle of Philanthropy live online discussion, The Changing Role of Foundations.

Ben Cameron:
Most businesses recognize the need for ongoing working capital–it’s the heart of funds that allow a business to make strategic decisions around launching a new program or line of business, investing in a new facility, etc. I have been in discussions with some business executives who have been adamantly opposed to general operating support for arts organizations–thinking it gives organizations free license to be unstrategic and undisciplined–but instantly supportive of flexible working capital. In essence, the purposes are the same–the difference is in how the two terms are heard.

I’ve been advocating for better understanding of Nonprofit Capital for years. In the “nonprofits should be like business” debate, this is the one area where we do have a lot to learn. There aren’t many businesses that strive to hold a three month cash reserve account. That would be viewed poorly, in fact, because it’s an inefficient use of capital.

For peek at how the very largest and most sophisticated nonprofits solve a cash flow problem, read about how Dartmouth Joins Harvard, Princeton in Tapping Credit Markets. Because of the drop in endowments, Bloomberg reported that Dartmouth College just issued $250 million of 10-year notes “for liquidity and general working capital,” according to Julie Dolan, associate vice-president for fiscal affairs at Dartmouth.

Learn to love these words: Working Capital.

Following up on questions raised during some training workshops I presented last week, I’ve decided to start an occasional series called Mythbusters – Nonprofit Finance Edition. There are a number of pieces of “common wisdom” that I hear over and over again, and some of them are just not helpful. So starting with this post I’ll be adding my own spin to the Discovery Channel show Mythbusters (is it true that a penny thrown from the top of the Empire State Building will kill a person on the ground?).

Nonprofit Finance Mythbuster #1 – “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.

First, how much should nonprofits have in cash reserves? A single standard doesn’t factor in some important variables, starting with the stability of the nonprofit’s cash receipts. Organizations that have contracts or fees with regular and reliable payments don’t need as much in cash as organizations that rely on a few big grants, fundraising events or campaigns, or seasonal activities. I’ve reviewed financial reports from large nonprofits with pretty low cash balances. They wouldn’t meet a standard requiring three months of expenses, but they also have regular cash receipts from program fees, contracts, and year-round fundraising. They also have high quality receivables and other short-term assets (which create “working capital”).

The other myth is that nonprofits can go from step one, the board adopts a policy requiring a three month reserve, directly to step two, open the savings account. Somewhere in there, voila, the cash is generated to deposit the required amount. Where do cash reserves come from? Consider a hypothetical agency that provides mental health services with a $2 million annual budget. A three month reserve is $500,000. Starting from zero, they need to generate a 25% surplus of income over expenses to build these minimum reserves. This is unattainable in the near future, and it may be far more cash than this agency needs. If the mental health services are paid for by third party insurance payments and contracts with the county government, cash flow may be stable enough that about one month in operating cash, or $165,000 – $200,000, will be enough.

Bust this myth. Rather than falling back on an easy standard, each nonprofit needs to understand their revenue sources, project month by month cash flow, anticipate any shortfalls, build in some cushion for snags or surprises, and create a workable and customized policy.

My interest in financial mythbusting is inspired in part by a series I’ve enjoyed by Paul Shoemaker at his SVP Blog at Social Venture Partners Seattle. Over the past few months Paul posted a series called “10 Things We’d Like to Tell Every New Philanthropist.” For example, Lesson #3 – “I need to be careful to not let the non-profit get too dependent on my contributions.” Each of the questions that he poses seem to make sense, but he warns that these common misperceptions and mistakes need scrutiny and discussion to avoid the problems they can cause. He’s finished the list of ten lessons for philanthropists and said he would follow this series with “10 Things We’d Like to Tell Every Nonprofit.” I look forward to seeing his new top ten list.