Nonprofit organizations are one of the highly regulated forms of business organizations due to the nature of the form.
The primary purpose of nonprofit organizations is not to make a profit but to provide services and work for social causes. For nonprofit organizations, the statement of financial position is prepared instead of a balance sheet.
The statement provides the details of assets and liabilities in order of liquidity. The main component related to a nonprofit organization is donor contributions.
Donor contributions are accounted for and totaled separately in the statement of financial position. They are further classified into unrestricted, temporarily restricted, and permanently restricted donor contributions.
The statement of activities depicts the income and expenses and is equivalent to the income statement. The donation of goods is recorded under the revenue column of the statement of activities.
The last financial statement is a statement of cash flows which is similar to profit-making entities. However, financial indicators that depict the financial soundness of nonprofit organizations differ in the case of nonprofit organizations.
These are explained in detail below:
1) Operating reserve ratio
This is generally used benchmark to measure the financial health of nonprofits organizations. It measures the security of the organization on the lines of liquidity ratio.
The measure of operating reserve ratio indicates how long an entity can continue to carry on its operations without any sort of revenue coming into the business operations.
The operating reserve ratio is indicated in percentage. It can also be computed in the number of days as per the convenience of users. A high operating reserve ratio indicates that nonprofit organizations can carry out their operations without receiving any revenue.
A high operating reserve ratio i.e. nearer to 100% would indicate that organization has been funded by a reliable revenue source and the entity has a sound financial shape.
Looking from another way, the high operating reserve ratio may also mean that organization is losing various other opportunities to further its mission.
It is computed as,
= [Net assets without restrictions or i.e. unrestricted net assets – (fixed assets – debt related to fixed assets)] / (Annual expenses – depreciation and amortization).
The organization should be able to transfer 25% to operating reserves each year to be more efficient and sounder.
2) Program expense ratio
This indicator is also called program efficiency. This is an important metric for donors to measure program costs vs operational expenses.
The program expense ratio provides what magnitude of organization expense is incurred on services vs services as management or general expenses.
The program expense ratio is computed simply by dividing total program expenses by total expenses. Program expenses are closely related to achieving the objective and mission of the organization.
It helps to compare financials to administrative costs. The program expense ratio shall be further segregated into committed and non-committed expenses.
The accepted program expense ratio is 66%. Anything above this ratio is considered the gold standard and the management shall be applauded for the same.
3) Profit margin ratio
The profit equivalent in the case of a nonprofit organization would mean to increase the net assets without donor restrictions or an increase in unrestricted net assets.
The profit margin ratio is used to measure the magnitude of changes in net assets. It depicts either organization is earning or receiving more than it is spending on operations.
Profit margin ratio = Change in net assets without donor restrictions/Total unrestricted revenue and support.
Every organization has its own target and objective with regard to its nature, size, and goals. The budget processes are determined in order to achieve the desired profit margin ratio. Each entity desires to have a positive profit margin ratio.
It would mean the financial health of the organization is good, it is generating revenues and cash flow, and able to utilize the resources appropriately.
The nonprofit organization may intend to use some of its reserves for a project or even to create an emergency fund when any emergency circumstances happen. The best industry practice would be to have an operating profit margin of 25% and above.
4) Fundraising Expenses & Contributions or Fundraising efficiency
This measures how much fundraising activities are based on the expenses to raise contributions and revenues for the event. This is computed by dividing contribution or revenue by fundraising expenses.
If the nonprofit organization depends on contributions and grants, the relation between the total contributions and expenses need to be understood for fundraising.
It would help to check the cost of expenses or debt raised and would help to devise strategies for fundraising.
This further strengthens the application of future contributions of any fundraising that is going to happen. The industry acceptance fundraising ratio is 4.0.