Ratios to the Rescue
Kenneth Tornheim, CPA, CFE
As much as you might prefer to concentrate on only your not-for-profit’s mission, strong financial health is vital to pursuing those goals. Financial statements provide essential information on your fiscal footing. However, you can expand everyone’s understanding of your organization’s performance and sustainability by monitoring a variety of ratios.
Reasons to “ratio-nalize”
While financial statements will always play an important role, they are not necessarily the best way to communicate performance to stakeholders. Ratios grab information from your financial statements and can be presented as easy-to-process snapshots.
Ratios also help stakeholders keep an eye on overall financial condition, identify worrisome and promising trends, and make informed decisions. Among other things, they can provide a picture of your organization’s current financial standing, its adequacy and use of resources, and its reliance on certain types of funding. Ratios also are an invaluable tool for your leaders’ decision-making.
Here are some ways to calculate your organization’s general financial health:
- Current Ratio = Current Assets / Current Liabilities
The current ratio indicates the ability to satisfy short-term financial obligations (debts due within the coming year). A current ratio of “1” or more generally demonstrates the ability to meet those obligations.
- Accounts Receivable (A/R) Ratio = Accounts Receivable Aged More Than 90 days / Total Accounts Receivable
As the A/R ratio increases, the risk of collection/billing problems and cash flow issues due to lack of expected revenue increase as well.
- Accounts Payable (A/P) Ratio = Accounts Payable Aged More Than 90 days / Total Accounts Payable
The A/P ratio can reflect cash flow or more severe financial problems. For example, the organization may be having trouble paying its bills on time.
Ability to cover costs
These ratios compare your not-for-profit’s liquid assets to the ongoing cost of operations:
- Defensive Interval (DI) = Cash Plus Marketable Securities (excluding permanently restricted investments) Plus Current Receivables / Average Monthly Expenses
The DI measures the number of months’ expenses that the organization can cover if no additional inflows of quick assets occur, such as cash, marketable accounts and current receivables. It is particularly useful when contribution inflows are highly variable. A high or increasing value generally is better than a low value.
- Liquid Funds Indicator = Net Asset Balance Less Restricted Endowments, Land and Plant, Property and Equipment / Average Monthly Expenses
This indicator shows the number of months before the not-for-profit will completely exhaust its liquid funds, assuming no additional revenue inflows. Because it excludes restricted endowments, it is more conservative than the DI. But like the DI, high or increasing values are positive indicators.
Use of funds
How efficiently and effectively do you use your resources? Consult these ratios:
- Fundraising Efficiency = Contributed Income / Fundraising Expense
In recent years, many donors have focused on the amounts not-for-profits spend on fundraising compared with the amounts raised. This ratio shows the average dollar amount raised for each dollar in fundraising spending.
- Program Expense Ratio = Program Expense / Total Expenses
The ratio evaluates a not-for-profit’s mission efficiency by considering the extent of funding that goes to programs, as opposed to administrative or other expenses. Alternatively, stakeholders may scrutinize the administrative expense ratio, calculated by swapping out program expense for administrative expense.
- Cost per Unit of Service = Program Expense / Number of Units of Service
When not-for-profits provide identifiable units of service (for example, meals served), this ratio assesses the financial efficiency of the program over time.
Overreliance on funding sources
Say that the ratios determine that your organization receives almost all of its support from government funding and individual donations.
- Reliance Ratios
Reliance ratios can reveal an unhealthy dependence on one funding source. To determine your reliance on any specific funding type (for example, government grants and contracts, individual donations or earned income), divide the amount of that funding by total income.
You could see those sources recede if a recession hits, which would threaten your survival. So, it would be wise to find ways to diversify your income now.
In a time when charitable-giving incentives are shrinking, not-for-profits need to pay more attention than ever to their financial performance. The ratios above can help you steer away from potential problems and market your organization effectively to donors.
Sidebar: Making the most of financial data
To use ratios effectively, first determine which ones are most appropriate for your organization. Different not-for-profits have different revenue sources, financial vulnerabilities, donation and expense patterns. Also, the adage “garbage in, garbage out” applies to financial ratios. The ratios are only as reliable as the data used to compute them. Your not-for-profit must take steps to ensure that its financial information is accurate, complete, and calculated in a consistent manner.
Finally, whether monthly, quarterly or annually, you will want to calculate financial ratios across certain periods. A single-period ratio can shine some limited light on an organization’s financial health, but it is of little use for decision making by leaders. Stakeholders can learn more from watching trends, and these trends must be viewed in the context of relevant internal and external factors, such as a significant one-time gift or an economic downturn.
Sarah Widlock, CPA
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