By Helena Bouron, CPA, Senior Audit Manager
Nonprofits have a variety of unique aspects that distinguish them from for-profit entities. The nonprofits’ philanthropic and mission based approach combined, with operations that are not focused on earnings and profits, are commonly known as the biggest distinctions between these two types of entities. Every successful business, regardless of the type of entity, needs to capture and maintain meaningful financial and nonfinancial data that will serve as key performance indicators for assessment of the business performance and overall financial health of the entity. This is even more important for nonprofits as the financial information is subject to public disclosures and watchdog agencies, not to mention, donors are using financial information, that is made publicly available, to calculate ratios to assess the overall charity rating.
One of the more effective ways to determine how an entity is performing is through ratio analysis. Ratio analysis provides a quick comparison of the organization’s performance between periods or a comparison to entities operating in the same sector. One of the objectives of ratio analysis is for the management team to ask insightful questions and make inquiries about performance from insights not otherwise visible by simply reading the financial statements.
The financial statement ratios can be grouped into two different categories: 1) organizational security and 2) organizational efficiency.
Organizational security ratios include:
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- Liquidity ratios – these ratios measure the Organization’s ability to meet its short-term debt obligations and are a result of dividing cash and other liquid assets by the short-term borrowings and current liabilities. Generally, the higher the ratio, the better the safety net the Organization has to meet its current liabilities. Common examples of liquidity ratios include current ratio, quick ratio, working capital, viability ratio, cash ratio and liquid operating reserves ratio.
- Leverage ratios – these ratios are used to determine information about the Organization’s financing methods, showing how much capital comes in the form of debt or assessing the Organization’s ability to meet the obligation of the entity. They are an important tool for both internal and external users of the financial statements. One of the most important leverage ratios is debt-to-net assets ratio, which indicates how much debt the Organization is in and how much of net asset it has at its disposal. A high debt-to-net assets ratio generally indicates an Organization’s aggressive approach in relying and funding its operations with debt. Other types of leverage ratios include debt ratio and interest coverage ratio.
Organizational efficiency ratios include:
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- Activity ratios – these ratios measure the efficiency and productivity of the Organization’s use of its assets by indicating how efficiently management is using the assets at its disposal to promote revenue. Generally, the higher the number, the better off the Organization is. The most common examples of activity ratio include asset turnover ratio, accounts receivable turnover ratio and inventory turnover ratio.
- Expense ratios – these ratios provide an overview of the Organization’s expenses. The interpretation of these ratios should take into consideration the type of support the Organization receives and where the Organization is in its lifespan. Common examples include, fundraising efficiency ratio, internal and external overhead ratio and program ratio.
- Profitability ratios – these ratios measure the Organization’s ability to generate earnings related to revenue, net assets and assets. A higher value means the entity is doing well and is generating profits, revenue and cash flows. Examples of these ratios include, operating margin, gross profit margin, return on assets and return on net assets.
One important thing to remember is that the ratios of each Organization should be evaluated in the context of its programs and its mission and the comparison to other entities should be done after careful consideration of the types of programs, size, location and age of the Organization. Ratio analyses are more meaningful when compared period to period or when compared to competitors. Trend analysis and industry analysis are important aspects in the overall assessment process. There are multiple websites, including Guidestar.org and CharityNavigator.org that gather financial information about nonprofits and serve as a valuable benchmarking resource for nonprofits and for donors when assessing the financial health of each Organization. Do you know how your Organization compares?