The financial soundness of a not-for-profit is of considerable interest to its donors, suppliers, employees, and volunteers, because they all have an interest in the ability of the organization to achieve its goals and to continue in existence. There are a variety of tools that can be used to help evaluate the financial soundness of a not-for-profit.
Several traditional ratio analyses can be applied to a not-for-profit’s financial statements, such as the current ratio,the quick ratio and days in accounts payable.
The current ratio is a measure of liquidity that is calculated by dividing current assets by current liabilities. A higher current ratio is better than a lower one, with 2:1 being preferred. The quick ratio is a refinement of the current ratio with inventory being deducted from current assets, because inventory is more difficult to liquidate. A quick ratio of 1:1 is usually considered good:
Current ratio =
Current assets / Current liabilities
Quick ratio =
(Current assets – Inventory) / Current Liabilities
Days in accounts payable measures the number of days that an organization takes to pay its vendors and is calculated by dividing accounts payable by total purchases and multiplying by 365. An increase in the number of days from one period to the next indicates that the entity is paying its vendors more slowly and could mean that it is experiencing a liquidity problem.
Days in accounts payable =
Accounts payable / Purchases x 365
Another valuable technique that can be used is horizontal analysis which is also commonly known as trend analysis. This type of analysis involves the comparison of financial information over a series of reporting periods and can be utilized to help identify trends in financial results. In order to develop a useful analysis that will present a complete picture, as many years as possible should be included. The first year analyzed is considered the base year with each subsequent year amount expressed as a percentage of the base year amount. Horizontal analysis should be performed over the statements of net assets and the statements of changes in net assets as this will help to illustrate how each item has changed in relationship to the changes in other items.
Vertical analysis, which is the proportional analysis of a financial statement, is also an important method to consider. This technique is most commonly used within a financial statement for a single time period to help determine the relative proportions of account balances
and better understand the composition of the financial statement. To perform vertical analysis, each line item should be calculated as a percentage of another item. For example, on a statement of activities, each line item could be stated as a percentage of total revenue, membership dues or contributions, depending on what is most relevant to the organization. These numbers can then be used for a timeline analysis, for example by comparing compensation as a percentage of revenue over time. If this number has a history of being 30%, an increase to 40% would merit further investigation.
A financially strong not-for-profit generally obtains its revenue from a number of sources, so a decline in contributions from a few donors typically will not have a catastrophic effect on total revenue. An organization’s concentration of revenue can be analyzed by obtaining a list of donors and to sorting by the amount contributed. If the majority of contributions are from a few large donors, this can highlight the need for management to explore new fundraising avenues. Some donors can be counted on to regularly contribute, but other contributions will be more variable and may require considerable effort to obtain, so it is also useful to consider this risk when analyzing the overall financial soundness.
Not-for-profit organizations are often evaluated based on the proportion of total expenses that are used in programs, fundraising, and management and administration. Analyzing expense concentrations can reveal whether resources are consumed by delivering program services or by administrative and fundraising expenses. The program efficiency ratio is one measure that can be used to determine expense concentrations. This ratio is calculated by dividing program expenses by total expenses. Donors typically expect that 80% of total expenses should be spent on programs.
These tools should help to analyze the financial health of a not-for-profit, but ultimately non-financial considerations also have an impact on financial health. These considerations include the support of donors, the experience of the board of directors and the ability of management to fulfill the mission of the organization.
By: Rudolph J. Coertzen, CPA | Manager
