Organizational Health Standard #2: Financial Management

High performing nonprofits must understand how to manage their money. Charities cannot promise great things to supporters and run out of resources along the way. A delicate balance of maintaining healthy reserves, minimizing debt, and sticking to a budget is required. Donors don’t want to a bait-and-switch where increased donations go to debt service or get stockpiled in the bank without any increased impact. And no one can tolerate financial mismanagement where an organization lives in the red with unrealistic budgets or doesn’t put the majority of its funds into mission-related activities. 

These all-too-common errors justify why managing a nonprofit’s financial resources is step 2 in the 6-step process for evaluating nonprofit performance. As a reminder, the 6 steps involve measuring charities against 30 standards for nonprofit performance arranged in the following categories: (1) Leadership, (2) Financial Management, (3) Sustainability, (4) Leverage, (5) Strategy, and (6) Impact.  We explored the first 6 standards for evaluating leadership last month. Today we will explore 4 standards for gauging the financial management of charities.

Operating Within Your Means

Although national governments across the globe have discarded the constraints of spending what you receive from the public, nonprofit organizations cannot afford to imitate them. Apart from periodic and temporary debt financing, healthy charities operate within their means. Annual program promises should be carefully crafted from budgetary projections.

To make sure an organization operates within its means, ask these 3 questions:

• Has the organization ended in the black 2 out of the last 3 years?
• Is the Total Current Debt level less than 30% of Total Income?
• Are there more than 6 months of Cash Reserves on hand?

The answer to all 3 questions about financial management should be YES!  A negative response to any of these cursory questions should lead to follow-up questions with the organization’s CFO (or CEO for smaller operations). Why do these questions matter? Here is what we’ve learned over the past 10 years.

Fiscal Deficits: Has the organization ended in the black 2 out of the last 3 years?

If an organization ends the fiscal year in the red more often than not, it indicates fundamental financial management problems. An unexpected dip in the economy or loss of a major donor can explain one year’s budget deficit. 2 or 3 straight years of fiscal deficits indicate an unrealistic budgeting process or an insufficient set of spending controls. 

I have evaluated charities that end multiple years in the red and still refuse to lower their budget and make tough decisions. One start-up educational institution set the same million-dollar budget 3 years in a row despite never raising more than 2/3 of the $1 million budget. Our client had to stop giving because what was promised to happen each year would always end up getting cut due to financial shortfalls. A high-performing charity must envelop its mission-related activities within its available resources. If 2 of the last 3 years ended in the red, your charity isn’t maintaining sound fiscal discipline.

Debt Level: Is the Total Current Debt level less than 30% of Total Income?

Let me first say, “I know.” The 30% benchmark is arbitrary. It does not correspond to a legal violation or ensure a charity’s financial failure. The 30% benchmark is partially based on industry standards for a healthy Debt-to-Income ratio for businesses and personal finances (even though my standard is calculated quite differently than monthly debt expenses divided by gross monthly income). Second I have seen the value of using the 30% standard in nonprofit evaluations. 

While evaluating a training organization, I noted that the $2.1 million Total Income was matched by over $1 million in debt. Upon further investigation, I determined that 10% of every donation had actually been spent to pay interest the preceding year. Yes, those were interest payments that made no progress on reducing the principal debt. When I alerted a brand new client to this dynamic, he was not impressed. He didn’t know, and he didn’t intend for 10% of every gift to be wasted on the interest from a series of poorly financed decisions.

Although it is possible for an organization to finance a large infrastructure project and exceed the 30% mark without going under, I have never seen it without problems. Most times it indicates a sloppy use of debt that begins to prevent full execution of program services. Other times it simply misleads donors who don’t want to see another chunk of their donations go to debt service on top of the already troublesome overhead costs. Feel free to disagree with this standard or add a caveat. But don’t avoid asking the tough questions when charities pile up debt in excess of 30% of Total Income.

Cash Reserves: Are there more than 6 months of Cash Reserves on hand?

Charities can operate with slim financial cushions. I see it all the time. I can also rock climb without a rope. It’s just not the best idea, and it makes my wife very nervous. 

The 6-month benchmark is another arbitrary selection, but we think it serves a specific purpose. Grant requests commonly point toward activity to take place in the coming year. An organization with more than 6 months of cash reserves will in our experience be able to do what they plan to do in the next year even with major drops in funding. From our perspective, it removes the possibility of donor disappointment. 

We have had organizations receive support after a description of all the programs they will execute during the year. Then halfway through the year you get a call that kids camp is about to be canceled due to lack of funds. That’s a quick way to steal the joy of giving. The organization should not have overpromised program execution without healthy cash reserves.

Here is the fourth and final standard for quickly verifying appropriate financial management.

Financial Audits: Does the organization pay for Annual Independent Financial Audits?<

There is not much to say about this simple “yes” or “no” question. Very few donors have the expertise, and no one has the time to perform a forensic audit of a charity’s finances. The task of finding fraud or financial conflicts-of-interest should be left to experienced CPAs. In most cases where a charity is exposed for financial misconduct, it has avoided annual independent financial audits in the past. Take for example the Three Cups of Tea controversy. The charity Central Asia Institute only paid for 3 independent financial audit in 11 years (2001-2011). That would have tipped off any informed giver to back away. 

Although I can understand why small start-up charities with less than a half million in annual revenues don’t pony up the money to pay for annual audits, I still expect them to have an outside financial review at least every 3 years.

1/3 of the Way There

Analyzing the above-mentioned financial management health indicators gets you past step 2 of the 6-step nonprofit evaluation process. The next post will explore the generally applicable standards I recommend for evaluating Financial Sustainability. If you are wondering where to find the data needed for this cursory evaluation, Nonprofit Analytics provides it to subscribers in 2-page Analytical Overviews that can be acquired for any U.S.-based 501(c)3.

Remember these 6 steps and 30 standards comprise only a cursory evaluation. It’s not the level of due diligence appropriate for major gifts.  But we do hope the simple questions related to publicly available data empower donors of all sizes and sophistication to get informed quickly and give more wisely.