By Luke Pierce, CPA, Senior Manager at Blue & Co.

Leaders in the not-for-profit sector are often required to oversee and understand all parts of their organization. To the many leaders without an accounting background, financial statements can seem overwhelming. While a deep understanding of the debits and credits that build the financial statements may not be necessary, it is imperative that management has a basic understanding of their organization’s financial situation so that they can make informed business decisions.

Leaders need to look beyond individual balances to better understand the organization’s financial health. Below are some areas to help you better understand financial results.

Understanding Which Resources Are Available

When reviewing the statement of financial position, leaders must have an understanding of what their cash and investments can be used for. Generally speaking, cash and investments can be unrestricted as to their potential use, or they may carry a donor restriction. Unrestricted cash and investments can be used for operational needs, capital investments, fundraising, or any other purpose deemed necessary by the organization.

Restricted cash or investments are, as their name implies, limited to the purpose for which they can be expended by the donor’s intent. When creating operating and capital budgets for future periods, it’s important to understand the purposes for which cash and investments can be used. Once that distinction is clear, liquidity measures can help assess how far those resources will go.

Key Ratios to Measure Liquidity

When evaluating the health of an organization’s financial position, unrestricted cash and investments should be considered relative to the organization’s expenses.

Days cash on hand is a ratio that measures how long a business can continue to meet its operational needs if cash collections were to cease. To calculate this ratio, divide annualized total operating expenses, excluding non-cash expenses (i.e., depreciation), by three hundred sixty-five. This number represents daily average cash outflows. Then, divide total unrestricted cash and investments by daily average cash outflows to calculate days cash on hand.

It’s important to note that there isn’t a universal days cash on hand figure that organizations should aspire to maintain; sufficient liquidity depends heavily on the specific industry and other external factors. Organizations should calculate days cash on hand on a monthly basis and evaluate trends. If days cash on hand trend downward, management should understand why and consider revising budgets.

It’s also advisable to establish a minimum days cash on hand requirement via organizational policy.

Another key liquidity measure management should monitor is the current ratio to assess near-term payment needs. This is calculated simply as current assets divided by current liabilities. Current assets are assets that are available to be used or expected to be received within one year.

Current liabilities generally represent obligations that are expected to be settled within one year. As is the case with days cash on hand, there is no universal benchmark for the current ratio that businesses should try to maintain; however, the current ratio should generally be above 1.0 and should be regularly monitored for trend analysis.

Evaluating the Statement of Activities

While liquidity measures show whether an organization can meet its financial obligations, they do not fully explain why its financial position is changing. For that, leaders must also examine the statement of activities, which provides a snapshot of an organization’s revenues and expenses over a period of time. An excess of revenues over expenses is preferable; however, it’s important to understand the nuances of specific revenues and expenses when evaluating financial health, as organizations can experience decreased liquidity even when revenues exceed expenses.

The following are common areas where reported results may differ from cash movement due to timing differences or inconsistent results.

Unconditional promises to give (commonly referred to as pledges) are generally recognized as contribution revenue when the promise is made, but the actual cash may not be received until a later date, sometimes years after the revenue was initially recorded if the donor makes a committed planned gift. For gifts expected to be received in future periods, organizations should assess the collectability of their contributions receivable, especially if a donor becomes delinquent on pledge payments. It’s also important to consider the nature of contribution revenues.

Is it reasonably certain, based on knowledge of the organization’s donor base, that contribution revenues will remain consistent in future periods, or are contribution revenues inflated in a certain period by large one-time gifts?

Depreciation expense increases expenses, and therefore lowers net income, but does not involve an actual cash outflow. Purchases of fixed assets, on the other hand, often represent a significant cash outflow, but the statement of activities does not report this outflow because the transaction is balance sheet only at the time of purchase (depreciation is then recorded over the asset’s useful life). Similarly, payments on long-term debt are commonly a significant cash outflow, but only the interest portion of those payments is reflected on the statement of activities.

Investment income or loss should also generally be considered separately from revenues and expenses resulting from operations, as investment performance is inherently volatile and can be difficult to predict, especially in the short term.

Turning Financial Statements into Informed Decisions

Financial statements provide a wealth of information on an organization’s financial situation; however, no single balance, ratio, or reported surplus tells the full story of an organization’s financial health. Management should consider available resources, liquidity trends, operating results, and other aspects when analyzing financial data to make informed business decisions.

Want a clearer understanding of what your financial statements mean for your organization? Contact your local Blue & Co. advisor to discuss your available resources, liquidity trends, and operating results, and how those insights can support your budgeting and planning strategy.