How to Evaluate A Nonprofit Organization’s Financial Stability?

Local government finance departments are frequently asked to evaluate the financial stability of nonprofit organizations. This could be nonprofits that the government is already working with, or to which it is considering making a grant.
​In such cases, the finance department should evaluate the nonprofit organization’s financial condition. It is wise to answer questions, such as ‘is the nonprofit strong enough financially to continuously operate for at least the time specified in the contract?,’ before starting a working relationship or providing funds to the nonprofit.
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The same questions should be answered for companies that a government is working with or considering working with, such as software vendors, franchisees or construction contractors.

What are the steps for evaluating a nonprofit organization’s financial stability?

The first thing to do is to obtain the three most recent years of financial statements for the organization. The level of detail and number of years that you should review will vary, depending on the importance of the nonprofit to the local government’s success.

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​However, the following five questions are commonly the minimum concerns you should address and verify when reviewing the organization’s financial statements:

1. Are the financial statements audited? If not, this increases the risk because the financial statements are less likely to be a reliable picture of the entity’s financial condition.
2. What are the results of the audit? Are there material weaknesses or significant deficiencies in internal control? Are there any findings of noncompliance with laws and regulations? Is the audit opinion “modified”? For example, do the auditors qualify their opinion, give an adverse opinion, express doubt about the entity’s ability to continue as a going concern, or provide explanatory information? Any modification to the standard auditor's opinion increases risk to a varying degree.
3. Can the entity pay liabilities as they come due? The current ratio (current assets divided by current liabilities) is the best measure of this ability. The current ratio should be at least 1.25 and there is a significant risk when it falls below 1.
4. Are unrestricted net assets (or equity or net position) adequate? Unrestricted net assets that equal less than 90 days of annual operating expenses means the entity is operating without much financial cushion. Negative unrestricted net assets would represent a huge risk.
5. Does the entity have a structural deficit? What is their excess of revenues over expenses for the past three years? If the increase/decrease in net assets over the three year period is negative, it may indicate they have a structural deficit.  

If any of these five questions above indicate increased risk, it is appropriate to have further conversation with entity management to determine:

a) whether there are good reasons and explanations for the risks noted (e.g., unrestricted net assets of less than 30 days of operating expenses may be acceptable if they have quick access to capital of a parent organization or a “white knight” funder); and /or
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​b) to agree on how they can mitigate the noted risks (e.g., improving their current ratio before entering into a contract with the local government).  

​Of course, the five financial strength considerations above represent only a simple review of the most important elements of an entity’s financial stability. If a more thorough assessment is desired, there are many other elements of financial strength you may want to consider, such as:

• Cash ratio = Cash and Cash equivalents / Current liabilities
• Operating cash flow ratio = Operating cash flow / Current liabilities
• Debt ratio = Total liabilities / Total assets
• Debt to equity ratio = Total liabilities / Equity
• Interest coverage ratio = Operating revenues / Interest expense
• Debt service coverage ratio = Operating revenues / Total debt service
• Asset turnover ratio = Operating revenues / Total assets
• Receivables turnover ratio = Net credit sales / Average accounts receivable
• Operating margin ratio = Operating revenues / Operating revenues
• Return on assets ratio = Excess of revenues over expenses / Total assets

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Please contact Kevin Harper directly if you’d like further help on how to evaluate an organization’s financial stability beyond and/or after the factors explained above.

Kevin Harper, CPA
kharper@kevinharpercpa.com
(510) 593-503

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