(taken from the Sept/Oct 2006 issue of On Balance magazine)

Using Ratio Analysis to

gauge nonprofits' health

By Andrew C. Holman, CPA and Katy L. Sommer, CPA

A financial health crisis in nonprofit accounting? Is there a CPA in the house? Just as doctors continually look for new ways of healing patients, CPAs must diagnose and determine the best course of action to serve their nonprofit clients.

The nonprofit sector comprises more than 10 percent of the U.S. economy. Financial health is a key issue facing the directors and administrators who manage these entities. Fortunately, CPAs can play a vital role in assisting the nonprofit sector in assessing financial health using ratio analysis techniques. While this is a common practice in business advising, it is not often used in the nonprofit arena.

Nonprofits are distinguished from private businesses in that they have no owners or outside ownership interests. At the same time, the revenue stream of a nonprofit often consists of a complex combination of donations, earned revenue, government grants and income from fund-raising. In addition, nonprofit net assets (equity) are often broken into unrestricted and restricted pieces. CPAs can help organizations navigate through these financial complexities.

One of the best ways to assess fiscal health is by using a set of financial ratios targeted for nonprofit use. Let’s take a look at the numbers in action. ABC nonprofit had some substantial financial changes in 2005. It completed a major addition to its building and also hired additional development staff to assist with fund-raising. The following financial statements show the effect of these changes and compare totals to 2004.

"Regina Sims, CPA" is a board member and donor who has raised questions regarding the fiscal health of the organization based on these changes. Sims has offered to conduct an analysis using nonprofit ratio analysis.

Sims produced the following  from the organization’s financial statements:
Fiscal analysis Current Ratio Defensive interval Liquid funds indicator Liquid funds amount Fund-raisinf efficiency	2005 2.16 7.25 (6.53) $ 54,000 7.22	2004 3.19 8.05 1.10 $136,500 12.30

From this information, Sims was able to make the following observations:

Organization assets did grow by the substantial amount of $454,000 from 2004 to 2005. This consisted of a major building addition of $450,000 that was financed by donations and a mortgage increase of $300,000. To meet the growing cost of operations, the organization also drew an additional $50,000 on its line of credit by year-end. At the same time, cash in the bank grew by $95,000 over the prior year.

In spite of the large growth in debt, the current ratio shows that the organization still has a positive ability to meet obligations, although this is reduced from 2004. The organization also has a positive defensive interval of more than 7 months.

This means it can operate for more than half a year without needing additional funds. However, due to the need for financing of the addition, the liquid funds indicator has gone from a positive to negative number. While not a cause for alarm, this indicates that the organization will have to monitor its ability to repay debt over the term of the mortgage while maintaining its long-term fiscal viability.

In this regard, the liquid funds amount remains a positive number in 2005 over 2004 but also needs to be monitored in conjunction with the liquid funds indicator. Fund-raising efficiency is quite good; $7 was returned for every $1 spent in 2005.

This information provided some needed insight to the donor and organization. They then set up a plan to monitor these key indicators on an ongoing basis.

CPAs can interpret key financial information for nonprofit organizations. Fiscal analysis of this type is not designed to take the place of regular internal fiscal oversight. Nor is it designed to create financial benchmarks that all organizations must achieve. Instead, this type of fiscal analysis helps cut though some of the numbers and assist organizations and donors in reviewing key elements of a nonprofit’s fiscal health with the CPA as a trusted adviser.

Nonprofit ratio computation methods
Ratio or value Current ratio   Formula Current assets/current liabilities   Usage Indicates ability to cover current obligations. Greater than 1 is a positive indicator	Ratio or value Defensive interval   Formula Cash + marketable securities + receivables/ Average monthly expenses   Usage Determining the number of months of expense that an organization has in current reserves	Ratio or value Liquid funds indicator   Formula Net assets-restricted net assets-fixed assets/ Average monthly expenses   Usage Determining the number of months of liquid reserves	Ratio or value Liquid funds amount   Formula Unrestricted net assets-net fixed assets + debt related to fixed assets   Usage Quantifies value of "liquid" reserves	Ratio or value Fund-raising efficiency   Formula Contributions/fund-raising expenses   Usage Determining the effectiveness of fund raising. The higher the number the greater the fund-raising efficiency.

 

Andrew C. Holman, CPA and Katy L. Sommer, CPA are both partners with Ritz, Holman, Butala, Fine LLP in Milwaukee. They can be reached at andy@ritzholman.com or katy@ritzholman.com.

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