Financial fitness

Financial fitness

What is your organization’s financial fitness? Are you ready for the gauntlet of uncertain grant timing, seasonal activity, capital reinvestment, and unexpected changes?  (By the way, that leaky roof, it needs replacing.) We are at the start of quarter 2, are you on track to meet your goals? In this post, we explore financial fitness and introduce three key questions and six metrics that can help you gauge your fitness level. Improvement is rarely an accident, these measures will help you understand your current position and plan for the future.

Feeling financially unhealthy? You are not alone. In the Nonprofit Finance Fund’s State of the Sector Report, the authors note that while some positive indicators are taking hold, financial health is still a dream for many organizations. The top challenges noted by respondents were achieving long-term sustainability (32%), ability to offer competitive pay and/or retain staff (25%), and raising funding that covers full costs (19%).

Financial health means different things to different organizations (often based on their business model). Three key questions apply for all organizations:

  1. Liquidity: Do we have adequate cash to meet operating needs? (short-term focus)
  2. Adaptability: Do we have the flexibility to make strategic adjustments (medium-term focus)
  3. Sustainability: Do we have access to funds to address future needs? (long-term focus)

Regardless of past success, financial fitness requires active management from the board, executive and staff roles.  Each area of focus is connected to the ones above. Typically, if you have liquidity problems, focusing on sustainability will be challenging. Conversely, without a strategy to advance adaptability and sustainability, an organization will often struggle (now or in the future) with liquidity.

So how do we measure our financial fitness? There are several simple ratios, easily calculated using your financial statements, that can provide some indications.  A simple table with definitions, calculations, and targets is included at the bottom of the post.

Liquidity measures

Cash on hand: how long can we operate without funds?

Calculation: cash and current investments ÷ daily cash required

Daily cash required = (annual budget – non-cash expenses, pass-through, and one-time expenses) ÷ 365

Cash on hand measures how many days of expenses can be covered with the current balance of unrestricted cash. If no more money came in, how long could we last?  A long standing rule of thumb has been 3-6 months of cash on hand is ideal, but the rationale behind this is unclear. If your cash flow is volatile (expenses and revenues vary significantly), then more cash on hand is needed.

Current ratio: how much capacity do we have to pay our bills?

Calculation: current assets ÷ current liabilities

The current ratio is an indicator for the ability to pay its obligations in a timely way and can be useful for predicting cash flow in the near future. A current ratio that is less than “1.0” may be a predictor of a future cash flow problem, meaning there will not be enough cash (current assets) to pay the bills (current liabilities).

Adaptability measures

Net asset reserve: how much “cushion” for risk can we afford?

Calculation: unrestricted net assets ÷ daily expenses

This is very similar to the cash on hand measure, with a longer time frame in mind.  How much capacity do you have to make adjustments, investments, or changes?  The amount of reserves you need depends on your organizations goals and trajectory. Do you have an innovative idea you want to test? A major shift in focus in the future? Major costs on the horizon? If so, setting a policy for building reserves will be critical.

Reliance ratio: how much do we depend on a single source for funding?

Calculation: Biggest funder (or program) ÷ total income

This measures dependence on a certain source or types of incomes.  Again, the business model of an organization dictates what is desired or targeted. Past research has shown that organizations feel less stable when dependent on a single source (> 75%), but also when funding is very diversified (no source > 20%).

Sustainability measures

Profitability ratio: how much can we reinvest in our future?

Calculation: change in unrestricted net assets ÷ spending on operations

Nonprofit is not a business model. Success takes investments, in programs, in infrastructure, in collaboratives. To thrive, we believe leaders must find a way to generate a surplus that can be invested to create the future, more impactful organization(s) needed to make dramatic community change. What percentage is the right percentage varies (unfortunately “it depends” is a common theme for all measurements). However, a baseline minimum can be identified based on your organization’s assets. From there, incorporating your target investments will give you a financial goal.

Minimum profitability: Inflation rate (3.4%) * Total Assets ÷ spending on operations.

This minimum makes two key assumptions: (1) if you do not have assets, you do not require a surplus. (We would argue you have far more investments to make than just capital ones). (2) If you do have assets, you will need to repair/replace them at some point.

If your profitability ratio is consistently below the minimum, that is a red flag. It means that in the long term, the organization will not be able to reinvest in existing assets (e.g., that leaking roof, it won’t be getting fixed).

Please note, this is a bare minimum. Regardless of your organization’s goals, growth or reinvestment are likely a part of your future. Beyond capital expenses, investments in professional development, community engagement, and collaboration will all require funding. That will require funding – where and how it will come is the exciting question you must tackle J.

If current programming does not cover this minimum, alternatives must be found. This could be through new, revenue generating programs, creative partnerships, or capital campaigns.

Now that you are equipped with three key questions and six key measures for understanding your financial fitness, what do you do next? Measuring over time (past three years) can identify where your organization is trending and identify big questions.

Interested in learning more? Woods Bowman has a wonderful book, Finance Fundamentals for Nonprofits, and the Nonprofit Finance Fund and the Nonprofit Assistance Fund are a great resource for tools and messages regarding nonprofit financial performance.

Financial fitness, of course, is only one part of organizational capacity. Our next posts will focus on understanding mission impact.

FactorRatioQuestionCalculationTarget
LiquidityCash on handHow long can we operate without funds?Cash and equivalents ÷ daily operating expensesVaries, traditional ideal over 3-6 mo.
LiquidityCurrent ratioHow much capacity do we have to pay our bills?Current assets ÷ current liabilities > 1 at minimum, higher is better
AdaptabilityNet asset reserveHow much “cushion” for risk can we afford?unrestricted net assets ÷ daily operating expensesVaries on future plans, ideal over 6 mo.
AdaptabilityReliance ratioHow much do we depend on a single source for funding?Largest revenue source ÷ total revenue Varies on business model, less than 80% and greater than 20% often preferred
SustainabilityProfitability ratioHow much can we reinvest in our future?Change in unrestricted net assets ÷ spending on operationsSee below. Include costs for human, program, organization, and infrastructure development
SustainabilityMinimum profitabilityWhat is the bare minimum we need to support existing assets?Inflation rate (3.4%) * total assets ÷ spending on operationsThis is the target for covering assets, the bare minimum.
2017-05-28T16:04:07+00:00