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Seven Measures of Financial Health

November 24, 2014

Headshot_john_hooverThe Internal Revenue Service is requiring more public disclosure from charities. The industry has data aggregators – GuideStar, Charity Navigator, and the Urban Institute, to name a few – that aid in this process. But a comprehensive analysis of an organization’s finances is the only way to really understand its overall health and viability. And while a verdict of weak or declining health is never welcome, it can be seen as an opportunity to move forward with new strategies, partnerships, collaborations, or even a merger.

Before you can determine your organization's financial health, however, you need to ensure that you are looking at the right measures:

Step 1: Determine what you want to measure. Identify your top measures. Focusing on a handful of top measures makes it easier to take a deeper dive into the data, while too much analysis can compromise stakeholders' ability to focus on the bigger picture.

Step 2: Establish benchmarks and targets. Each area of the social sector is different. To determine a reasonable target range for each of your measures, you need to have a good understanding of your peers and competitors. For example, universities often have significant operating surpluses that they then redirect to their endowment, scholarship, and/or capital funds. Once you've determined the appropriate ranges, establish targets in the top quartile for each measure, and use the bottom quartile as an early warning "time-to-right-the-ship" system.

Step 3: Determine your units of measure. Choosing the right unit – whether it's percentage, a ratio, or time – for each measure will help you tell a story that brings additional donors and stakeholders to the table.

Step 4: Use a consistent period of time. A rolling five-year period is a good length of time for establishing organizational trends. For instance, if four of the last five years resulted in operating deficits and there is no action plan to achieve a surplus, it's likely the deficits will persist. On the other hand, revenues can change significantly from one year to the next. A charity may record revenue in year one but not spend it until year two or three. Looking at year one – or year two or three – in isolation could skew the picture and lead to unwarranted optimism or concerns. Looking at all three years or, even better, a rolling five-year period, will give you a more accurate picture.

Below are some commonly used measures of financial health:

#1: Liquidity. The ratio of current assets to current liability indicates an organization's ability to pay its short-term debts. Current assets include cash, money markets funds, short-term receivables, and prepaid expenses. Current liabilities include payments due to vendors, loans due in less than a year, and payments due to employees. A target ratio of 1:1 or better indicates that the current assets are equal to or better than current liabilities.  Sample target: ratio of 1.25 or better.

#2: Solvency. The ratio of total unrestricted net assets to total liabilities is a good measure of an organization's ability to react to difficult economic pressures without having to encroach on donors' restricted gifts. Sample target: 2.0 or better.

#3: Reserves. This indicates the number of days an organization could continue to operate if its revenue was severely curtailed. While such a scenario for most organizations is unlikely, cash flow can fluctuate. Indeed, rarely do receipts from donors match up with the timing of expenses incurred or paid. For example, a charity may receive nearly 80 percent of its annual budget in a single month after a fundraiser but spend only a twelfth of that amount every month. Sample target: 90 days or better.

#4: Operating Surplus. This is expressed as the percentage of annual revenue on hand after all expenses have been paid. Some boards believe that a budget is balanced when the difference between revenues and expenses is zero. However, a healthy budget should produce a surplus that can either be reinvested back into the mission or the organization or applied to an endowment, capital improvements, equipment upgrades, staff development, or a rainy-day fund. Sample target: 2.25% or better.

#5: Cash on Hand. This is limited to cash and cash equivalents over total expenses. These are the most liquid assets and can be used to pay expenses. Anything less than two weeks means the charity runs the risk of not being able to pay staff in an emergency. It is difficult, however, to raise money for a working capital fund. An established discipline during the budget process that allows for reserves, capital improvements, and/or endowment allows for cash on hand to grow over time. Sample target: 90 days or better.

#6: Expense Ratio. This is expressed as the percentage of revenues spent on program services, management, and fundraising. Expenses are mostly about funds for mission and programs, not overhead and special events. That said, an organization can spend nearly all its time and resources on program services and still face challenges to its ability to grow, including its ability to provide a competitive benefits package that attracts great talent, sporadic financial reporting, and uneven fundraising. Time should be spent to increase the percentage of program services with more long-term funding arrangements. Sample target: program, more than 75%; management, less than 10%; fundraising; less than 15%.

#7: People Ratio. The IRS Form 990 includes a count of staff. One good indicator of productivity is the amount raised or spent over the number of employees. For instance, for "American Friends of" charities, the average amount raised in a sample per employee was $1.06 million. When compared to that benchmark, we found that one such group was raising an average of more than $8.1 million per employee. After a series of discussions with management, it was determined that the organization's staff and infrastructure could not keep up with the demand from donors and faced growing quality and continuity risks. Both issues were deemed as opportunities for improvement, and the organization, with our help, developed a plan of action to address them. Sample target: for a cohort of U.S. charities with foreign educational programs and revenues greater than $20 million, $1.25 million per employee at the corresponding "American Friends of" affiliate.

The purpose of measures is to identify opportunities and plan accordingly. As always, the best decisions are informed by the best information.

John Hoover serves as senior vice president and chief financial officer of The Andrea and Charles Bronfman Philanthropies. Prior to joining ACBP, Hoover was vice president of finance and administration for the Jewish Communal Fund, one of the nation's largest public foundations. For more advice and wisdom from the folks at ACBP, check out the spend-down area of the Foundation Center's GrantCraft site.

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