Over the next 10 minutes you’ll understand how to read nonprofit financial statements and be informed on the financial performance for the organizations you have the privilege of leading or hope to lead.
Being a member of a nonprofit board is extremely rewarding. In addition to meeting new professionals and opening new opportunities you also have a duty to serve. A large part of this duty to serve is to ensure your members receive the most value for their membership, donation, fee, or even their donated time. This means that understanding the nonprofits financial statements is part of your duty. I know at this point you’re thinking, “oh we have a treasurer for that” or “we have a director of finance that does that.” Do they? Are they really looking to ensure that the board strategy is aligned with spending or just not exceeding spending? As a member of the organization and board you have an obligation to understand the financial health of the organization you’re leading. The good news is we’re going to cover, this entire topic in 10, painless minutes!
Conventional profit margins basically don’t apply, nonprofits actually can’t earn profit, plus it’s more about the organization’s mission. Also, the revenue streams and equity differ. In the next four parts we’ll cover financial statements from Form 990, key parts of the annual report, how to read an annual report quickly, and critical financial performance ratios required when leading a nonprofit organization.
PART 1: Financial Statements (Form 990)
Form 990 is a required annual filing for nonprofit organizations to the IRS. This form includes a lot of information and some of the most valuable include the following five financial statements: balance sheet, reconciliation of net assets, statement of functional expenses, statement of activity and the statement of revenue.
Consolidated Financial Summary (annual report)
This statement is an aggregated view of financial position. Provides overall health of a group of companies (multiple nonprofits).
Balance Sheet
This provides assets and liabilities (no owner’s equity in a nonprofit). This statement is useful to understand liabilities (company obligations, taxes payable, warranty obligations, accounts payable). However, one important piece is missing and that is the company’s brand and reputation. You’re interested in the available working capital and the degree the organization is leveraged by debt. Also, quickly read through the footnotes, they often prove useful.
Reconciliation of Net Assets
This view provides a reconciliation of the beginning net assets for the year to the ending balances and reports changes.
Statement of Functional Expenses
The goal isn’t to make profit, but it is to run an efficient business. This statement chunks expenses into three categories program expenses, administrative expenses and fundraising expenses. It enables you to compare expenses ratios between categories especially the cost of fundraising and general administration.
Statement of Activity
This basically replaces the income statement and concentrates on the total organization reporting revenues, expenses and changes in net assets resulting from revenue and expense impacts. Also, this statement shows asset classes including: unrestricted assets, temporarily restricted, and permanently restricted with totals.
Statement of Revenue
This statement outlines contributions amounts, program service revenue, and other revenue (investments, securities). This shows the amount of money the organization received during the financial statement period.
PART 2: Key Annual Report Information
The annual report is to the shareholders or in our case likely donors. It has four main objectives: provide financial information, highlight achievements, promote the company, and other information (typically around how lives are being improved). You don’t need to read the report cover-to-cover, but it is worth quickly skimming for major topics of interest. There are 8 major areas of most annual reports outlined below:
- Letter from the chairman
- Sales and marketing
- Ten-year summary of financial results
- Management discussion and analysis
- Letter of CPA opinion
- Financial statements
- List of directors and officers
- Membership growth or contributions (stock price history is only used by for-profit company’s)
PART 3: Reading an Annual Report
Here is the 5-minute approach to running through an annual report and getting the major sound bites before you have time to read it in depth.
- Financial statement – scroll to the financial statement section typically called a Consolidated Financial Summary. This will give information on the nonprofits surplus or deficit for the period ending. Here you’re looking quickly for profitability, growth, and stability.
- Gut Check – based on the chairman letter and your read of the financials you should have a basic idea if the company is headed upward or downward
- CPA Opinion – this often has to be requested from the organization’s headquarters (not part of the Form 990). In general, if the auditor’s opinion agrees with the financial statements it’s said to be an unqualified opinion. If the auditor’s opinion disagrees with the financial statements, it’s said to be a qualified opinion, thus questioning the validity of the financials.
- Footnotes – these often prove fruitful, and are worth the read.
By now you have scanned likely a 40-page document and have a reasonable understanding of the financial position of the company as communicated by the board and chairman.
Next we want to look at three performance indicators to compare to historical and peer data (other nonprofits) including: 1. program efficiency ratio, 2. operating reliance ratio, and 3. fundraising efficiency ratio.
(1) Program Efficiency Ratio = (program services expenses / total expenses)
Tells you: how much is being spent on the primary mission (boards and donors are quite interested here)
(2) Operating Reliance Ratio = (unrestricted program revenue/total expenses)
Tells you: validates if you as a board member could pay all expenses from program revenues alone. If not where is the revenue coming from? Is that revenue stream temporarily or permanently restricted?
(3) Fundraising Efficiency Ratio = (unrestricted contributions / unrestricted fundraising expenses)
Tells you: how efficient the organization is at raising money
Part 4: Financial Performance Ratios
There are twelve performance ratios that you should benchmark when you slide into your seat on the board. Each time financial performance comes up (and it will come up a lot), you should have these handy. This will ensure you’re able to speak to the critical issues of the organization and align strategic values with tactical direction and performance.
(1) Administrative cost ratio = (administrative expenses/total revenue)
Tells you: relationship of administrative costs to total expenses (also known as the Overhead Ratio: Fundraising and Administrative costs as a proportion of Total Revenues). There are mixed feelings on this ratio. It’s good to have in mind as many will refer to it regardless.
(2) Program cost ratio = (administrative expenses/total revenue)
Tells you: relationship of program expenses as a proportion of total expenses
(3) Surplus margin = (net income/total revenues)
Tells you: Surplus or deficit. A surplus margin ratio of less than zero indicates that expenses exceed revenues, and a surplus margin ratio of greater than zero indicates that revenues exceed expenses.
(4) Defensive Interval (DI) = (Cash + Marketable Securities + Receivables) / Average Monthly Expenses
Tells you: Reflects how many months the organization could operation if no additional funds were received.
(5) Liquid Funds Indicator (LFI) = (Total Net Assets – Restricted Net Assets – Fixed Assets) / Average Monthly Expenses
Tells you: determines number of months of expenses that can be covered by existing assets
(6) Liquid Funds Amount (LFA) = (Dollar Value of Unrestricted Net Assets-Net Fixed Assets + Mortgages and Other Notes Payable)
Tells you: quantifies the liquid unrestricted dollar amount that an organization has available to meet current obligations
(7) Savings Indicator (SI) = (Revenue – Expense) / Total Expense
Tells you: Determines if an organization is adding or consuming its net asset base
(8) Debt Ratio (DR) = Average Total Debt / Average Total Assets
Tells you: determines percentage of assets provided by debt, high values indicate liquidity problems, and potential borrowing challenges
(9) Contributions and Grants (CG) = Revenue from Contributions and Grants / Total Revenue
Tells you: used to measure trends in short vs. long term strategic funding goals in how organization is spending month e.g. do they align with the strategy.
(10) Government Grants (GG) = Revenue from Government Grants / Total Revenue
Tells you: Similar to Contribution and grants, used to measure trends in short vs. long term strategic funding goals in how organization is spending month e.g. do they align with the strategy. This could also demonstrate organizational dependency to government funding.
(11) Program Service Expense (PX) = Program Service Expense / Total Expense
Tells you: Ratio of program expenses to all expenses. As a reference the Wise Giving Alliance of the Better Business Bureau set a standard of 65% for this ratio.
(12) Revenue Ratios = Revenue Source / Total Revenue
Tells you: proportion of each revenue stream contributes to the organizations total revenues. This enable you to create a revenue stream value map.
The following revenue streams are commonly uses as benchmarks:
- Contributions (donors) receipts
- Government grants or reimbursements (e.g. Medicaid, Medicare)
- Program services revenue
- Investment revenue
- Fundraising revenue
There many ways to contribute to your organization in your role on the board. One of the most effective is to ensure the value and trust that members, donors and supporters place in your leadership team is earned by providing the most value to your membership.
Understanding your financial statements and initial indicators of financial performance is a great first step.
“Price is what you pay. Value is what you get.” – Warren Buffett
References
Accounting Tools. (2015). Which financial statement is the most important? – Questions & Answers –
Accounting Tools. (2015). Which financial statement is the most important? – Questions & Answers – AccountingTools. Retrieved October 3, 2015, from http://www.accountingtools.com/questions-and-answers/which-financial-statement-is-the-most-important.html
Allen, K., & Economy, P. (2007). Reading an Annual Report – For Dummies. Retrieved October 4, 2015, from http://www.dummies.com/how-to/content/reading-an-annual-report.html
Bierman, L. (2011). Key performance indicators: Principles of selection for nonprofits. Retrieved October 4, 2015, from https://www.sageworks.com/blog/post/2011/06/03/Key-Performance-Indicators-Principles-of-Selection-for-Nonprofits.aspx
HealthLeaders Media. (2010). Predictive Modeling May Reduce Hospitalizations. Retrieved October 3, 2015, from http://healthleadersmedia.com/page-1/TEC-257573/Predictive-Modeling-May-Reduce-Hospitalizations##
Holman, A. C., Ihrke, D. M., & Grasse, N. J. (2011). The Analysis of Key Financial Ratios in Nonprofit Management. Retrieved from http://www.ritzholman.com/news_files/Nonprofit%20Presentation.pdf
Keating, CPA, E. K. (2008). How to Assess Nonprofit Financial Performance. Retrieved from www.nasaa-arts.org/Learning-Services/Past-Meetings/READING5.pdf
Peter Nichol, empowers organizations to think different for different results. You can follow Peter on Twitter or on his blog. Peter can be reached at pnichol [dot] spamarrest.com.