FinanceLeadership

Understanding Nonprofit Financial Health

By February 27, 2019 No Comments

Key Ratios and Metrics and How to Calculate Them

 

By: Steve Zimmerman

At even the most solid nonprofit organizations some board members and executive directors wonder and worry, “Should we be concerned about the financial health of our nonprofit organization? Are we OK now? Will we be OK in the future?” Watching the traditional indicators of nonprofit financial health — like performance-to-budget or reserve size — is important, but they may not give you the immediacy of knowing whether you need to worry today.

These metrics don’t necessarily address cash availability. For example, you may have a large payment due to you from a government agency, but if they won’t be paying it for another two months, you may not be able to meet next week’s payroll. In such a situation you might be perfectly on track from an accrual point of view, but still be in serious trouble in terms of cash.

A CFO at a troubled organization told me, “The first and last thing I do in the morning and evening is look at our bank balance and see if we have enough cash to meet our next payroll. The budget looks fine, but cash flow is our biggest problem.” As a board member or ED how can you know whether you should worry? How can you quickly assess the financial health of your organization? Financial ratios serve as one way to answer such important questions. Analyzing these key metrics of nonprofit financial health — Payroll Ratio, Change in Accounts Payable, Revenue-to-Date Ratio, and Restricted Ratio — will give you a quick idea of whether you need to be asking more questions and take some action.

1. Payroll Ratio

nonprofit financial health payroll ratio

Payroll serves as one of the biggest stressors for executive directors. Divide the cash currently in your bank account by your total semi-monthly payroll expense including taxes and benefits. You want the payroll ratio to be at least two or else you won’t be able to meet the payroll after the next one unless some cash comes in.

Payroll Ratio Sample Calculation

You issue payroll twice a month and each payroll is $200,000. This includes:

  • the $165,000 of net pay due to the employees including any money that you might withhold for health insurance, garnished wages, and so forth,
  • plus the $30,000 for both employee and employer paid Social Security and other tax payments which will be sent to the government,
  • plus the $5,000 that will be paid into the 403b retirement accounts.

(It’s important to look at the total payroll expense of $200,000, even though not all of it will be paid on payroll day, otherwise you may find yourself owing large sums of money later to employees or the government and they will seek all means available to collect the amounts owed.)

nonprofit financial health payroll ratio

In this case, you’ll want to have $400,000 in the bank at all times to be sure that payroll and regular expenses can be met.

2. Change in Accounts Payable

As organizations struggle to meet payroll twice a month, they often let other bills go unpaid. This can be seen by an increase in accounts payable from period to period.  Some organizations appear to be doing well and have sufficient cash in the bank. But, the change in accounts payable will let you know if the bills come in faster than the cash to keep up with them. Accounts payable may go up and down over time. For example, if you have a big event coming up you may have higher than usual payables. However, if you see them increase consistently over time it may be reason to worry. And if you see any sharp increase, you should ask “Why has there been such a significant change?”

Change in Accounts Payable Sample

nonprofit financial health accounts payableIn this example, accounts payable nearly doubles, potentially due to holding bills longer to meet payroll because cash is low. If you see an increase in this indicator of nonprofit financial health, ask about increases in expenses that month (for something like an annual fundraising gala) or for how long bills are being held.

3. Revenue-to-Date Ratio

nonprofit financial health revenue to date ratio

For most community organizations, the largest expense is payroll; as a result, expenses tend to be relatively consistent from month-to-month. Whether revenue is on budget is often harder to judge since it arrives unevenly throughout the year.

To make it easier to know where you stand, divide your current year’s revenue by the prior year’s revenue at the same point in time. This ratio is most meaningful if your revenue and the streams that comprise it remain relatively consistent from year-to-year. In that case, you’ll want the ratio figure to be close to one. If it’s less than one, money is coming in at a slower rate and it may be time to re-visit expenses.

Revenue-to-Date Sample Calculation

nonprofit financial health revenue-to-date ratio

4. Restricted Ratio

nonprofit financial health restricted ratio

Net assets with donor restrictions consist, in part, of revenues from foundations and donors for which the organization must still perform some type of service. Let’s say a food bank gets a $20,000 grant from their community foundation to provide a nutrition education workshop. The $20,000 is considered a net asset with donor restriction until they deliver the workshop. But, payroll is due this Friday and the organization doesn’t have quite enough money to cover the personnel expenses for their meal delivery service.

So, they take part of the $20,000 check they received from the community foundation and use that to meet payroll. Legally this is acceptable, but it isn’t recommended, and the organization will have to replenish the $20,000 with unrestricted money they receive. Sometimes organizations with big receivables from government contracts use net assets with donor restrictions like a line of credit to make cash flow work. Therefore, we include accounts receivable in our financial ratio.

This ratio should be one or greater, to indicate that you have or will soon receive the money to perform promised actions.  While not as common, if an organization receives a multi-year pledge, this would also be considered a net asset with donor restriction and would be treated similarly and would be included in accounts receivable and added into the denominator.

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Each of these key financial ratios individually may not signal a problem. But, if you’re starting to get worried about your nonprofit’s financial health, they are a good starting point for financial analysis. The saying goes “desperate times call for desperate measures.” When your organization has cash flow trouble, Finance Officers often use these options to keep employees paid and make ends meet. By understanding these key financial ratios in nonprofit management, you can identify cash flow issues that may be challenging your organization and you can begin a larger conversation about your organization’s financial stability and viability.

Four Key Financial Analysis Questions for Nonprofit Board Members

To make it easy for board members, consider including the answers to these four questions along with the financial statements at your next meeting:

  • What is our current payroll ratio?

Analysis: We have enough cash for one payroll, but we’re stretched pretty thin.

  • Are our accounts payable increasing significantly?

Analysis: Yes. Our March A/P is approximately twice February A/P. We are holding some bills longer than usual because we need to conserve cash for payroll.

  • How does our total revenue year-to-date compare with the same number last year?

Analysis: Our revenue is down about 8% from last year reflected by a decrease in individual giving. We may want to start trimming our expenses if this doesn’t turn around.

  • Are we using restricted cash for other purposes?

Analysis: No, we’re not. Between our cash on hand and accounts receivable we have enough cash, just barely, to meet any obligations that we have promised to funders and not yet delivered.

Of course, after you look at these indicators of nonprofit financial health, you may be faced with some tough decisions to make in your budgeting process; however, by implementing an analysis of the key financial ratios, you’ll be able to communicate financial information more effectively helping others understand your nonprofit’s financial health, an important component of building a stronger and thriving nonprofit.


This post originally appeared in BlueAvocado.org on April 6, 2009, and has been updated to reflect our latest thinking.