Finance Fear Factor Ratios

At even the most solid nonprofit organizations some board members and executive directors are beginning to wonder and worry, "Are we okay? Should we be worried?" Watching the traditional indicators of financial health -- like performance-to-budget or reserve size are important, but they may not give you the immediacy of knowing whether you need to worry today.

One of the main problems is that they don't necessarily address cash availability. For example, you may have a large payment due to you from a government agency, but if they won't be paying it for another two months, you may not be able to meet next week's payroll. In such a situation you might be perfectly on track from an accrual point of view, but still be in serious trouble in terms of cash.

A CFO at a troubled organization told me, "The first and last thing I do in the morning and evening is look at our bank balance and see if we have enough cash to meet our next payroll. The budget looks fine, but cash flow is our biggest problem." As a board member or ED how can you know whether you should worry? These four ratios -- Payroll Ratio, Change in Accounts Payable, Revenue to Date Ratio and Restricted Ratio -- will give you a quick idea of whether you need to be asking more questions and take some action.

Payroll ratio: cash in the bank /semi-monthly payroll expense

Perhaps the biggest stress for the executive director of an organization in trouble is "Can we meet payroll?" Divide the cash currently in your bank account by your total semi-monthly payroll expense including taxes and benefits. You want this number to be at least two or else you won't be able to meet the payroll after the next one unless some cash comes in.

Example

You issue payroll twice a month and each payroll is $200,000. This includes the $165,000 of net pay due the employees including any money that you might withhold for health insurance, garnished wages, and so forth plus the $30,000 for both employee and employer paid Social Security and other tax payments which will be sent to the government plus the $2,000 that will be paid into the 403b retirement accounts. (It's important to look at the total payroll expense of $200,000, even though not all of it will paid on payroll day -- otherwise you may find yourself owing large sums of money later to employees or the government and they will seek all means available to collect the amounts owed.)

In this case, you'll want to have $400,000 in the bank at all times to be sure that payroll and regular expenses can be met.

Increase in accounts payable

As organizations struggle to meet payroll twice a month, they often let other bills go unpaid. This can be seen by the increase in Accounts Payable from period to period.A Some organizations appear to be doing well and have sufficient cash in the bank. But, the change in accounts payable will let you know if the bills are coming in faster than the cash to keep up with them. Accounts Payable may go up and down over time. For example, if you have a big event coming up you may have higher than usual payables. However, if you see them increase consistently over time it may be reason to worry . . . and if you see any sharp increase, you should ask "Why?"

Example

Accounts payable on January 31: 47,000

Accounts payable on February 28: $45,000

Accounts payable on March 31: $85,000

The almost doubling of accounts payable here may be due to holding bills longer in order to meet payroll because cash is low. If you see an increase, ask if it is because of a large number of expenses that month for an event or if it is because bills are being held longer.

Revenue-to-Date Ratio: For most community organizations the largest expense is payroll, and therefore expenses tend to be fairly consistent from month-to-month. Whether revenue is on budget is often harder to judge since it arrives unevenly throughout the year.

To make it easier to know where you stand, divide your current year's revenue by the prior year's revenue at the same point in time. If your revenue budget from year-to-year is consistent you'll want the ratio figure to be close to one. If the ratio is less than one, money is coming in at a slower rate and it may be time to re-visit expenses.

Example

Revenue as of March 31, 2009: $320,000

Revenue as of March 31, 2008: $355,000
$320,000 divided by $355,000 is .90 which indicates an approximate 10% drop in revenue from year-to-year.

Restricted ratio: (cash + accounts receivable)/temporarily restricted net assets

Temporarily Restricted Net Assets consist of revenues from foundations and donors for which the organization must still perform some type of service. Let's say a food bank gets a $20,000 grant from their community foundation to provide a nutrition education workshop. The $20,000 is considered Temporarily Restricted until they deliver the workshop. But, payroll is due this Friday and the organization doesn't have quite enough money to cover payroll for their meal delivery service.

So, they take part of the $20,000 check they received from the community foundation and use that to meet payroll. This is fine, but the organization will have to replenish the $20,000 with unrestricted money they receive. Sometimes organizations with big receivables from government contracts use temporarily restricted net assets to make cash flow work. Therefore, we include accounts receivable in our ratio. This ratio should be one or greater, to indicate that you have or will soon receive the money to perform promised actions.

Each of these ratios individually may not signal a problem. But, if you're starting to get worried about your organization's financial health they are a good starting point. The saying goes "desperate times call for desperate measures." When your organization is in cash flow trouble these are the options that Finance Officers often use to keep employees paid and make ends meet. By understanding these ratios you can identify cash flow issues that may be challenging your organization and you can open up a bigger conversation about your organization's financial viability.

Four Key Questions

To make it easy for board members, consider including the answers to these four questions along with the financial statements:

  • What is our current Payroll Ratio? $465,000/$400,000 = 1.2. We have enough cash for one payroll, but we're stretched pretty thin.
  • Are our Accounts Payable increasing significantly? Yes. Our March A/P is approximately twice February A/P. We are holding some bills longer than usual because we need to conserve cash for payroll.
  • How does our total revenue year-to-date compare with the same number last year? $420,000 / $455,000 = .92. Our revenue is down about 8% from last year reflected by a decrease in individual giving. We may want to start trimming our expenses if this doesn't turn around.
  • Are we using restricted cash for other purposes? ($132,000 + $18,000)/ $145,000. = 1.03. No, we're not. Between our cash on hand and accounts receivable we have enough cash, just barely, to meet any obligations that we have promised to funders and not yet delivered.

Of course, after you look at the ratios you may be faced with some tough decisions to make in your budgeting process, but you'll discover that implementing them will lead to a stronger and thriving organization.

Steve Zimmerman is principal of Spectrum Nonprofit Services, a consulting firm for nonprofits in Milwaukee, Wisconsin. He also writes for Blue Avocado's Personal Finance/Money Matters column.

See also: Loans From Board Members

Comments (14)

  • I found the comment that it is "fine" to use temporarily restricted cash for temporary purposes and then repay the money later, irresponsible. Unless funders have granted temporary use in their terms, I have never heard that this is an acceptable use of these funds. Decision makers reading this should assume that if they have reached a point where they feel the need to use restricted funds for purposes other than those intended by their funders, then is is time to cut expenses.
    This seems like a slippery slope for any organization, especially one with cash problems, to engage in. One that could quickly put them amiss with foundations and donors.

    Apr 15, 2009
  • I think Steve was speaking from an accounting perspective. GAAP standards on temporary restrictions do allow you to 'borrow' restricted funds temporarily but the standard is that all must be squared up before the end of the fiscal year. From that perspective, I think he means "fine" = "legal". Your comments really have more to do with what makes a good business practice for a non-profit.
    I think all non-profits should think about having a finance policy that codifies when/if temporarily tapping into restricted funds is acceptable. That way you are more transparent and everyone is on the same page.

    Apr 15, 2009
  • Can someone speak more regarding the ratios typically looked at by foundations for: program salaries, administration costs, administrative salaries, program expenses, professional expenses, equipment purchasing, fundraising, etc.
    Is there a good resource available for finding recommended ratios for good non-profit standard practice?

    Apr 16, 2009
  • i would love to see some ratios like this... typical ones from business have limited use

    Apr 16, 2009
  • Regarding the practice of tapping into restricted funds, I agree with the slippery slope metaphor. I am very uncomfortable with an endorsement of this practice on anything other than emergency basis, in which case written permission should be sought from the donor. Bank lines of credit are designed for the scenario described by Mr. Zimmerman. Organizations that cannot obtain such credit must budget cash flow all the more carefully.

    I disagree with the anonymous commentator’s statement that “GAAP standards on temporary restrictions do allow you to 'borrow' restricted funds temporarily …” I reviewed the FASB Codification and do not find anything that suggests such a practice is acceptable. The accounting standards provide a net asset framework for classification based on stipulations as set forth by the donor.

    The greater issue here, in my view, is fiduciary responsibility and ultimately the trust of the public. Aside from possible legal consequences, once an organization crosses the line, what next? Should we borrow from trust fund taxes as well (e.g. employee withholding or sales tax collected) prior to the due date of these payments? How about borrowing from permanently restricted assets (e.g. endowment funds) as well? The only difference between temporarily and permanently restricted assets is that the former may expire with the passage of time or accomplishment of a specified use. The issue has implications beyond satisfying the technical requirements of a specific donor stipulation or interim accounting procedure. In short, don’t go there.

    Apr 16, 2009
  • Anonymous

    I agree with Mr. Walsh's comments. Bank lines of credit are for operations and careful cash flow management procedures should be in place to make sure that operating funds are available for operating purposes. I am a CPA that works with many nonprofits and there have been times that our clients have been in the position that they need to use the temporarily restricted funds for operations. We disclose this as part of our audit .I am not aware that the FASB codification allow this practice. It does provide guidance on disclosure requirements regarding this practice. From a fiduciary perspective Mr. Walsh's comments are right on. I have also had the opportunity to sit on many boards. I would never encourage or condone this practice.

    Jul 09, 2012
  • On one hand I agree wholeheartedly with the importance of not borrowing from restricted cash. As an executive, consultant and board treasurer I have worked hard to make it possible for organizations to avoid doing so.

    I feel the same way about driving over 65 miles an hour. They're both bad ideas, but the reality is that most people do it. Many, many great organizations couldn't get by without doing so.

    The two real problems in my view are actually: First, that some executive directors and others don't realize that they are actually borrowing from restricted funds. By not understanding it, they may make other poor decisions and exacerbate the situation. 

    Second, the key causes of borrowing from restricted funds are a) the inexcusable length of reimbursement times from governments (as Mark Ishaug pointed out in his OpEd in the last issue on "Too Many Nonprofits," many community nonprofits wait 6 months, 10 months, 14 months for funds owed them as reimbursements for monies spent under approved contracts. And b) the practice by foundations of giving mostly project money. 

    Borrowing from restricted funds isn't a great idea, but let's get real.

    Apr 16, 2009
  • No one could disagree with Jan Masaoka's comment about the challenges nonprofits face and why it might be pragmatic to see temporarily restricted assets as a source of cash-flow financing. However, there is a third problem Jan overlooks: The executive director's judgment may be clouded by wishful thinking in the face of a cash shortfall. In other words, faced with a crisis the executive director might construct a rationale that makes the situation look like a temporary working capital problem. Perhaps the executive director convinces himself or herself that a pending grant is likely and can be spent for current fiscal year expenses. Financial pressures have a tendency to cloud clear thinking. Therefore, as a matter of policy, I would argue that at a minimum all board's should adopt policies requiring the executive director to request and receive the board's approval before using restricted cash. However, because the danger is so real, I would go further: if a working capital loan is unobtainable the organization should seek the permission of the source of the restricted cash before borrowing it. I think it is essential for reasons of transparency. Equally as important, asking permission requires the organization to demonstrate to a third party (the funder) that the problem is indeed a cash-flow problem. The board's attention is also needed because it may be the organization's first indication that it is undercapitalized or in getting into even more serious (not temporary) financial trouble.

    Apr 17, 2009
  • Thank you for the comments and I'm pleased with the discussion. I agree that it can be a slippery slope if organizations do dip into temporarily restricted funds, and it may certainly be a "best practice" to not use temporarily restricted funds just as it is a "best practice" to collect receivables within 30 days. Sometimes the best intentions don't work out.

    Executives should look at their cash flow situation and assess whether a shortfall in unrestricted funds is due to timing or sustainability before they dip into restricted funds. Often times these decisions are made at the last minute without the latest releases being put in for work already performed or the organization may dip into temporarily restricted funds without even realizing it.

    This ratio is intended to give the board an opportunity to see if the organization is using restricted funds while allowing for some flexibility due to delayed government payments. Yes, a line of credit can help with those - but in today's environment even the best nonprofits are having trouble getting lines of credit.

    Steve Zimmerman
    Spectrum Nonprofit Services

    Apr 20, 2009
  • Good robust discussion of a very important issue. More to the practical side, every borrowing situation is, of course, unique but it has been my observation that organizations with demonstrated sustainability and a good receivable in the form of a pending grant or contract payment able to pledge such along with other backup collateral are able to obtain short-term financing through commercial sources. An additional resource to consider in situations where financing cannot be obtained through traditional lending sources is a community development lender. For example, one such lender serving my home State of North Carolina is Self-Help Credit Union, which actively lends for such bridge financing and other nonprofit needs.

    Apr 21, 2009
  • Anonymous

    I found the comment that it is "fine" to use temporarily restricted cash for temporary purposes and then repay the money later, irresponsible. Unless funders have granted temporary use in their terms, I have never heard that this is an acceptable use of these funds. Decision makers reading this should assume that if they have reached a point where they feel the need to use restricted funds for purposes other than those intended by their funders, then is is time to cut expenses.

    Jul 24, 2009
  • GAAP standards on temporary restrictions do allow you to 'borrow' restricted funds temporarily but the standard is that all must be squared up before the end of the fiscal year. From that perspective, I think he means "fine" = "legal". Your comments really have more to do with what makes a good business practice for a non-profit.This seems like a slippery slope for any organization, especially one with cash problems, to engage in. One that could quickly put them amiss with foundations and donors.
    ==================================
    I am william now a days preparing ccna questions

    Feb 15, 2010
  • The above thought is smart and doesn’t require any further addition. It’s perfect thought from my side. 

    Jun 03, 2010
  • Anonymous

    i understand very well the discussions and will strongly help me as a financial analyst but my humble request is to know the standard ratio of restricted funds to unrestricted funds ratio and program expenses to administrative expenses ratio. Like the current ratio the standard is 2:1, what about those keeping in mind the issue of sustainability

    Sep 25, 2011

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