Using financial ratios to detect problems in nonprofits

“This survival of the fittest implies multiplication of the fittest.” — Herbert Spencer

If I told you that virtually every Federal and state government Funding source is evaluating and monitoring the fiscal health and financial viability of your nonprofit organization, would you believe me?

If I asked the question above just five years ago, the answer would have been “maybe.” Now, the answer is a resounding “Yes,” and every tax-exempt organization must evaluate its fiscal viability and understand the financial evaluation methodologies of its funding sources. Unfortunately, as is true with many aspects of government funding, there is no single method used by either the federal or state government agencies. The same issue applies to foundations, grants, and major donors.

The answer to the question changed in 2015, after the collapse and bankruptcy of a New York City–based agency known as FEGS, with $250 million in annual revenue. The Human Services Council of New York City conducted a study after the bankruptcy filing and issued an excellent report entitled “New York Nonprofits in the Aftermath of FEGS: A Call To Action” (available at https://humanservicescouncil.org/wp-content/uploads/Initiatives/HSCCommission/HSCCommissionReport.pdf?q=commission/hsccommissionreport.pdf). In my view, each and every tax-exempt board of directors and management team member should read this report. The report is an excellent analysis of why successful and long-standing organizations can fail fairly quickly. Reading the report may help you to avoid a similar financial calamity.

My recent column demonstrated the increasing need for financial dashboards to be used for purposes of clear and thorough communication of monthly financial results to both board and management. This column will take a deeper dive into how and why financial ratios and operating performance indicators and key metrics can be used to achieve every organization’s goal of accountability and transparency in communicating with board and management.

Two of the most frequently asked questions in any business financial crisis are, “Why didn’t we know this was going to happen?” and “Where were the auditors in warning us about our financial decline?” Unfortunately, the answers to these questions are not readily available from a financial-statement audit or internal monthly financial statements. What can an organization do to provide this key information on a timely basis?

In my view, the most significant benefit in evaluating and anticipating financial decline is a financial dashboard tailored to your specific organization. Visualize, if you will, two sheets of paper — each having four quadrants. The eight quadrants that we generally recommend are the following.

a) Balance sheet financial ratios

b) Operating ratios and performance indicators

c) Salary and Fringe Benefit Ratios and Metrics

d) Billing, program revenue, and units of service

e) Human resources — recruitment, retention, and vacancies

f) Regulatory and corporate compliance reporting

g) Cash flow and capital purchases

h) Projected actual to budget variances and action steps required

This column will be the first in a series of four that will each address two of the dashboard quadrants suggested above. For the record, there is no requirement that you must use the quadrant descriptions above. However, for effective use and communication of your dashboard, we strongly recommend that you use color-coding, as follows:

• Red = a negative variance and possible action required

• Yellow = falling short of the expected target/metric, but not yet of serious concern

• Green = positive results in achieving the target or metric

A variety of research projects have focused on providing business owners and management with a financial-analysis model that can serve as a predictor of bankruptcy or risk of financial crisis. One of the earliest and most well-known models was developed by Edward Altman, a professor at New York University. Professor Altman’s Z-Score Analysis uses financial ratios to develop a score indicating the probability of bankruptcy or financial crisis in a commercial or for-profit enterprise. His model does not readily apply to nonprofit organizations.

Our firm has been providing nonprofit clients with a financial viability and sustainability methodology for more than 20 years. Known as A-Score, from the organization’s edited financial statements, we calculate 12 readily available financial ratios to develop a “score” as a predictor of financial stability and future viability. Each ratio is assigned a weight in the calculation. The resulting score is based on a 100-point scale. This assessment tool is most useful on an annual calculation basis. 

However, in the case of financial dashboards, they should be prepared monthly and most likely analyzed in-depth no less than quarterly. You will not be surprised to know that each ratio/metric in the calculation should be included in the first two dashboard quadrants listed above. The 12 ratios used in developing the A-Score are the following.

Quadrant 1 – Balance-sheet financial ratios:

- Ways cash on hand — This represents the number of days that operating expenses of the organization could be covered with existing cash reserves. The target is 30 days or more, and if the investment portfolio is included, the target should be at least 60 days.

- Ways outstanding in accounts receivable — This represents the number of days revenue that the organization has tied up in the process of being paid. The target in this case may vary depending upon the payer sources for your agency and their typical payment terms — for example, commercial-insurance companies may not pay as timely as government sources (example: Medicare, Medicaid) or vice versa. 

- Current ratio — This is a measure of liquidity/cash flow and represents the relationship between assets that are expected to be converted into cash in the next 12 months (numerator) compared to liabilities that need to be paid in that same timeframe (denominator). This ratio has a target level of greater than 1 to 1, with a preferable target of greater than 1.2 to 1. A ratio of less than 1 to 1 will always be red.

- Line-of-credit balance as a percentage of total current assets — The ideal target is to have a zero balance on the line of credit for at least 30 days each year. If a line of credit is necessary for cash-flow purposes, a target level of less than 10 percent is appropriate.

- Ways outstanding in vendor accounts payable — Most vendors expect to be paid in 30 days; therefore, the target ratio is usually between 30 days and 40 days.

- Total liabilities as a percentage of net assets — This represents a leverage ratio and the target level should not exceed 2 to 1. Bankers would generally prefer no greater than 1.5 to 1, unless there is a dedicated revenue source for debt repayment.

Quadrant 2 — Operating ratios and performance indicators:

- Debt-service ratio — This is commonly referred to as “banker’s cash flow.” This ratio calculates the ability of the entity to generate sufficient operating cash flow to pay principal and interest on its debt obligations. The desirable target is greater than 1.25.

- Ratio of net surplus to total revenue — The ability to generate operating and bottom-line surpluses in the nonprofit sector is the lifeblood of financial stability. The federal government is the only business enterprise that has demonstrated the ability to survive decades of continuous deficits. This is clearly evident now that our national debt is near $22 trillion. The desirable target for the operating surplus ratio is between 1.5 and 3 percent of surplus for every dollar of operating revenue. Every tax-exempt service sector may have its own realistic targets for operating surplus. However, the bottom line surplus target after non-operating items should ideally be greater than 2.5 percent. 

- Percentage of total revenue received from the largest single-payer source — Ideally, the target should be less than 50 percent. However, most Medicaid and Medicare providers may exceed 70 percent.

- Administrative expenses as a percentage of total expenses — Gov. Andrew Cuomo’s Executive Order #38 established a maximum of 15 percent. However, most government payors are expecting 10 percent or less. This is just one of the factors driving mergers and affiliations.

- Fundraising revenue as a percentage of total revenue — This target can also vary, but ideally, for mature fundraising activities, the target should be between 2 percent and 3 percent of operating revenues. 

- Fundraising revenue as a percentage of fundraising expenses — Depending upon the extent of and years devoted to fundraising, this target should be between 2 to 1 and 3 to 1. If planned giving through legacies and bequests are relatively common for the organization, a 5 to 1 target is not unreasonable.

You now have suggestions for two of my suggested eight dashboard quadrants. The remaining quadrants will be addressed in future columns.                                       

Gerald J. Archibald, CPA, is a partner in charge of the management advisory services at The Bonadio Group. Contact him at (585) 381-1000, or via email at garchibald@bonadio.com