More not-for-profit organizations are recognizing the benefit of financial performance measurement as a strategy for evaluating operations, programs, services and financial stability. One useful measurement tool is financial ratio analysis. It involves taking data from your financial statements, using it to calculate ratios appropriate for your not-for-profit, and then benchmarking those ratios against past performance, management objectives or other organizations.
Financial ratio analysis can help you assess your organization's overall financial condition and flag financial patterns that might be harmful or those that are successful. It could be the winning strategy you need to stay ahead in the numbers game.
When starting out
Before you begin figuring out financial ratios, you should determine what you want to learn about your organization. Customary questions include:
- Are our financial resources applied efficiently and effectively to support our mission?
- Is there an appropriate match between the sources from which our resources are derived and their use?
- Are our present resources sustainable?
- What sources of funding are available to support our mission?
Helpful metrics and ratios
Once you state your goals for financial ratio analysis, it's time to quantify your financial information. Here are some metrics and ratios every not-for-profit organization can use:
Viability ratio. It compares expendable net assets (including unrestricted and temporarily restricted net assets) to long-term debt. This ratio indicates a not-for-profit's relative liquidity or its ability to cover its debt. It serves as a basic indicator of financial strength because it measures the availability of cash and other liquid assets to meet the organization's financial obligations.
Current ratio. This ratio indicates your organization's ability to meet short-term financial obligations by comparing your current assets to your current liabilities. Ideally, you want to have a current ratio of at least 1.0, and preferably greater. A current ratio under 2.0 may indicate an inability to pay current financial obligations with a measure of safety.
Quick Ratio. Many banks use the quick ratio comparison to gauge financial stability. It compares quick assets (current assets less inventory and prepaid expenses) to current liabilities. Your organization's quick ratio should not be less than 1.0.
Operating reserve. This ratio addresses the question of whether resources are sufficient and flexible enough to support your mission without having to borrow externally. It compares expendable net assets to total expenses. It describes your organization's ability to fund programs and other expenses from expendable net assets, should no additional operating revenue be available. Not-for-profit organizations should aim to have an operating reserve ratio of no less than 25 percent, or enough to cover at least three months of their annual expenses.
Change in net assets. It measures financial performance by answering the question: "Did your organization live within its means during the year?" While an organization's success shouldn't be judged by whether it had a positive or negative change in net assets for one year, consecutive deficits should be cause for concern.
Operating margin. This is an important forecasting ratio because it illustrates your not-for-profit's ability to produce a potential surplus, which could be drawn on if needed in future years. It's determined by subtracting expenditures from revenues and dividing that sum by your revenues.
Program efficiency. It compares total program expenses to total expenses. Having this information can help you demonstrate to potential funders how efficient your organization is in fulfilling its mission.
Operating reliance. To show how much your not-for-profit is able to pay for total expenses solely from program revenues, divide program revenues by total expenses.
Fundraising efficiency. Do you know how much you're generating from fundraising activities? This ratio indicates the amount of contributions that result from fundraising expenses by dividing the former by the latter.
As you consider the various ratios, identify which ones are relevant to your organization. Then select appropriate benchmarks and determine what the comparisons might indicate.
Keep in mind that just as a manufacturing company and a gas station chain are in different businesses with different financial indicators, a specific ratio will have different meanings to different nonprofits. Your not-for-profit organization's type and its diversity of revenue streams, peaks and valleys of expenses and susceptibility to economic downturns will have an influence over its financial health.
Using monthly, quarterly, or even yearly financial ratio analysis can help you get ahead in the numbers game by providing you with valuable insight into your organization's financial future. By using this tool, you'll be able to identify strengths and weaknesses — and take appropriate action to help your organization achieve its mission.
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