I was reviewing a colleague’s annual budget yesterday and was immensely impressed; it was an absolute work of art – beautifully organized, meticulously categorized, and elegant in its straightforward ‘readability’. He told me that the pre-budgeting process required dozens of hours of sweat equity and planning, but that subsequent budgets are relatively easy. His hard and diligence was evident. My colleague is an exceptional nonprofit financial leader and worked arduously to hone his financial acumen. Many nonprofit executives are recruited on the basis of their passion and their commitment to the missions of their organizations and are brilliant on the programmatic side, but lack the skills and tools to effectively navigate the financial aspects of their organizations. Nevertheless, nonprofit executives have a mandate of financial accountability – not only from the Internal Revenue Service or state legislators – but also from the communities which their organizations serve. Even organizations that self-identify as “grassroots” groups are not exempt from this mandate.
In an age of increasing scrutiny, higher expectations for transparency and a challenging economy that dictates we “do more with less”, the question is, are you a financial manager or a financial leader? The two roles vary significantly, and have profound implications for your organization. Financial management is the collecting financial data, producing financial reports, and solving short-term financial issues. Financial leadership, on the other hand, involves guiding your nonprofit organization along a path leading to financial sustainability. The following represent a few key areas that separate managers from leaders.
Fortify Your Annual Budget. Your annual budget should help you reasonably project and track income, expenses, and cash flow. If you’re relatively new to nonprofit budgeting, you should have your budget reviewed by a professional accountant. Their trained eye and experience in the world of number-crunching will be an asset to you – they can detect aspects of financial management and planning that you may have missed, and will increase your confidence as you move forward. Reviewing the budget line-by-line should be a revelatory experience – you will learn when your most financially challenging months are; that employee benefits cost much more than you imagined; and perhaps that the events, services or programs that are the most beloved in your organization are limping along in terms of return on investment – perhaps even losing money. Make budgeting an inclusive process by involving your program managers, development director, business manager, and even key volunteers. Inclusivity creates “buy in” and the numbers don’t lie. Particularly during economically challenging times, you’ll be more likely to garner support among your staff for organizational belt-tightening and redistribution of resources if you demystify the money trail. People are always amazed to see where the money comes from, where it goes, and how much things actually cost. You’ll win advocates and sympathizers when you’re evaluating the merits of continuing programs, services, and events based on their return on investment. Lastly, your annual budget should be informed by at least three major organizational documents – your strategic plan, fund development plan, and marketing plan. If your organization lacks any of these critical planning tools, now is the time to implement a strategy for developing them. You can’t develop accurate, reliable budgets if you don’t know what your organization needs are – now and in the future.
Send “Sacred Cows” to Market. One of the biggest mistakes that new nonprofit executives make in budgeting is ‘shelving’ the budget for the rest of the fiscal year once it’s been approved by the board. The purpose of an annual budget is to anticipate future expenses and income with the goal of producing a net positive financial condition. Your responsibility as the captain of the financial ship is to navigate your organization to a surplus or allocate reserves through a planned deficit. Programs, services, and events should be periodically monitored throughout the course of the year (e.g., on a quarterly basis) to determine if they’re aligned with parameters established in the annual budget. Those that are consistently poor-performers should be considered for the chopping block. This is a painful and difficult reality, but exercising strong financial leadership requires bringing your team to the reality that programs that are not supported sufficiently to produce a net financial result cannot continue ‘as is’.
I know firsthand how difficult it is to suggest to one’s staff and board that beloved events and programs that bleed money” be discontinued, reinvented under a different model, or supported through dedicated, reliable funding. Nobody likes to hear that their 24th annual big-shot gala may be axed because it actually costs more to put on in funds and staff than it brings in. In broaching these “sacred cow” programs, executives should also ask, “Why exactly are we doing this?” A lot of times, the answer is, “Because we’ve always done it (or “because we’ve always done it this way”). As painful and challenging as it sometimes is, the necessity of financial solvency trumps history and habit as a basis for evaluating and possibly discontinuing revenue-bleeding programs, services and events. This is where strong, decisive leadership comes in – you’re not always going to make people happy with your decisions, and it may not win you any popularity points, but you’re doing the right thing on behalf of the organization, and that is the higher goal and purpose. Leaders do what is right and necessary, not what is popular.
Manage Financial Risk. Anticipate what’s coming down the pike for your organization. One of the biggest mistakes that new nonprofit executives make is overestimating income and underestimating expenses. The result could be disastrous when actual figures fail to meet expectations. In his book First Things First: the Ultimate Guidebook for Early Stage Nonprofits, consultant Tom Iselin advises executives to minimize their risk by reducing the amount of income they project by 20 percent and similarly increasing the amount of estimated expenses by 20 percent. By creating some budgetary breathing room, you can more easily accommodate any new risks and organizational opportunities that avail themselves throughout the fiscal year.
To Diversify or Not to Diversify . . . That is the Question. Intuitively, it would seem to be a sound practice to diversify your sources of income. After all, if you put all of your proverbial eggs into one basket, and then you lose the basket, your eggs are history.
It turns out that revenue diversification does not, by itself, help organizations maintain financial sustainability, nor is it a reliable predictor of nonprofit financial performance (Lin, 2010). Furthermore, the degree to which your organization should diversify its income streams is dependent on the services provided or field. For example, organizations with missions related to public and mental health tend to rely heavily on public funding through government grants, whereas individual gifts comprise a sizable fraction of the budget of animal rights and protection groups. The degree of revenue diversification you need for your organization boils down primarily to two factors: 1) how reliable are your current revenue streams, and; 2) how competitive are they? Shifting revenue streams is often easier said than done, due to organizational culture, skill sets, and/or capacity.
Your organization may rely heavily upon government and private grants, but in a challenging economy, grant programs are either disappearing altogether and/or award amounts are being dramatically reduced. As a result, the remaining pool of grant awards is becoming increasingly competitive. For some major government programs, your chances of receiving an award may be as low as 7 percent (National Institute of Health) or even l percent or less (National Science Foundation). If you’re considering diversifying your revenue and shifting from government toward individual gifts, it will be absolutely essential that your organization has a thriving culture of philanthropy, an experienced development staff, an executive director who supports and participates in cultivating, soliciting, and stewarding major gifts, and a board of directors that acknowledges and accepts their role in active fund development, as well as contributes annual gifts to the organization. Without all of these wheels in motion, such a revenue shift will be destined for failure. Evaluate your need for diversification carefully, and be sure to examine your existing capacity (staff, infrastructure, resources, etc.) for making any shifts in your reliance upon any single revenue stream.
Be a Master of Managing Cash Flow. Most leaders of active non-profits produce a monthly balance sheet and income statement. These are necessary and show where you are financially at any given point in time, but they don’t tell you anything about whether you’ll have enough cash on hand to pay your bills going forward.
A cash flow projection involves looking at the difference in timing of your revenue generation and expenses. Starting with the cash you have today – month by month – will you have enough cash to pay your bills and manage your program responsibilities over the course of the next 12 months (at least). Here are the steps to put one together . . .
1) Know Your Current Cash Situation. Pay particular attention to your unrestricted cash resources on hand. Knowing that you have $25,000 in your organization’s checking account doesn’t tell the whole story, because “x” percentage of that amount consists of restricted funds that cannot be used for general operating expenses and current cash flow needs. Consequently, your organization doesn’t have as much money in the bank as its balance reflects. Some savvy organizations choose to place restricted funds in other accounts, such as high(er) interest-generating CDs, to the best benefit of the organization.
2) Ensure Your Annual Budget is Accurate and Well Developed. Also, that the budget is based on realistic assumptions. This is especially true for development revenue, for which you might want to make a rule about projections, such as the organization bases future development assumptions based only upon the successes of the previous three years.
3) Project Cash Flow Reports for a Minimum of 12 Months. This allows board members and stake holders to evaluate cash flow over the full operating cycle of the organization. Don’t just take your expenses + income and divide it by 12 months. Typically, the timing of money coming in doesn’t align with the timing of when money goes out. You will likely have months when you have positive cash flows, and other months during which you’re essentially borrowing from the revenue generated during positive cash flow months to make it through the operating year. The point is that you must be aware of when funds are coming in, particularly for grants, and be careful about making assumptions about when they’re coming in, and the subsequent timing of program and service expenses.
A well-developed cash flow projection can proactively communicate the reality of your organization’s cash cycle, and the fact that you may be in deficit mode for some months, while operating in surplus mode for others during the 12 months of the year. Incoming revenue is often sporadic in nonprofits, and a cash flow projection communicates the timing of those revenue “peaks and valleys”. If nothing else, it prevents board members and stakeholders from panicking when they realize you’ve been operating in the red for the past three months, when in the bigger picture, you’re doing okay and holding the line of your annual budget.
Build a Reserve. I haven’t met an executive director yet whose financial goals didn’t include establishing a reserve fund. Reserve funds (sometimes called “rainy day funds”) are set aside in the event of a financial emergency or disruption to the organization’s cash flow, thus ensuring continuity of programs and services and keeping the organization afloat. Cash pays the bills, so having a surplus of working capital – even a small amount – positions your organization more strategically by ensuring that you can pay your bills in the short term and have adequate resources for expanding capacity for the future.
Once your board agrees upon the need for a reserve fund, the next question is usually, “How much should we put in the reserve fund?” The Better Business Bureau Wise Giving Alliance suggests that nonprofits should not have more than three years worth of expenses in their reserve – a level to which very few small and emerging nonprofits can aspire. A more reasonable reserve target recommended by the Nonprofit Operating Reserves Initiative Workgroup is 25 percent, or three months, of the annual expense budget.
What the right amount is for your organization will depend on two main factors that contribute most to an organization’s volatility, namely: 1) revenue streams, and; 2) spending levels. We alluded to the first factor in a previous section.
Organizations that have predictably-timed contracts or fees with regular payments don’t need as much in cash reserves as organizations that rely on sporadic sizable grants, annual fundraising events or campaigns, or seasonal influxes of income. In terms of the “how to” of establishing a reserve fund, for most small nonprofits, a reserve fund is built up slowly over time, from accumulated unrestricted budget surpluses. It goes without saying that in order to seed a reserve fund in this way, the executive staff and board must steadfastly refuse to operate in a deficit mode.
Once your organization is successful in accumulating a reserve, be very assiduous and strategic in how you use it. As Barr and Bell (2011) illustrate, the best use of reserve fund is for a short-term solution to predictable shortfall in operating funds, and not as long-term solution to income gaps created by structural, systemic financial problems. Finally, it’s also important to have a realistic plan to replenish depleted funds from future surpluses.
Reserve funds will help ensure that nonprofit organizations begin to operate beyond crisis mode, which is essential for the continued long term survival of nonprofit organizations. If you’re new to the idea of nonprofit reserve funds, I highly recommend downloading the Operating Reserve Policy Toolkit for Nonprofit Organizations.
Few if any nonprofit executives enter the sector because of their love of finances and number-crunching. In fact, leaders of new and emerging nonprofit organizations typically begin their careers unskilled and uneducated in how to raise, save, spend, and invest their organization’s funds. Ensuring that your nonprofit has a sustainable future requires financial leadership which in turn, requires vision, planning, and adopting a big picture view of the organization, beyond the limits of daily crises and short-term goals. With training, staff and board involvement, and strong leadership, you will create an environment in which financial leadership can flourish.
Lin, W., 2010. Nonprofit revenue diversification and organizational performance: an empirical study of New Jersey human services and community improvement organizations. Doctoral Dissertation. Rutgers University, Newark, New Jersey, 211 p. URL: http://bit.ly/Yyo8XN