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.
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?"
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.
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.
See also: Loans From Board Members