Board Member as Detective: Basic Guidelines for Identifying and Evaluating Not-For-Profit Financial Statements

Posted on Oct 5, 2016

By Mike Nurse, CPA, CFE, CGMA and Shareen Corlett, CPA

According to a State of the Sector Survey done in 2015, 32% of non-profits say that achieving long-term sustainability is a top challenge for their organization. This is understandable because doing so takes a great deal of time, planning, and cultivation.

Under your duty of care as a board member, you play an important role in making sure that your organization is successful and maintains long-term viability. One of the most important things you can do in this process is to evaluate and ask questions about the organization’s financial statements. However, sometimes it is difficult to know where to start, or even what types of questions to ask when handed a set of financials.

The following article is a high-level “starter-kit” for understanding the types of statements you will be looking at as a not-for-profit board member, along with some guidelines for helping you get the most important and meaningful information out of your statements. Let’s start with the basics:

The Three Basic Financial Statements

The three basic financial statements that you will see as a non-profit board member are the Statement of Financial Position (aka Balance Sheet), Statement of Activities (aka Income Statement) and Statement of Cash Flows.

It is important to remember that no single report can tell the entire story of the Organization’s financial health, rather, the financial statements should be evaluated as a whole. In addition, the financial statements must be considered in the context of your organization’s current situation and environment, relationship to the program activities, and overall organizational strategy.

The Statement of Financial Position provides a snapshot of the organization’s financial position at any given point in time and includes the organization’s assets (what the organization owns), liabilities (what the organization owes) and net assets (assets minus liabilities, or funds).

The statement may also include prior year assets, liabilities, and net assets as a comparison. Assets are generally listed in order of their ability to be converted into cash. Therefore, you will see cash and cash equivalents listed at the top of the assets section, down to fixed assets (or depreciable assets) and/or long-term investments at the bottom.

Common liabilities that you might encounter are accounts payable, grants payable, and long-term debt. The net assets section shows the amount of net assets (or funds) that are unrestricted, temporarily restricted or permanently restricted.

The Statement of Activities shows support from contributions, other revenues such as investment income and expenses for a specific period of time. The “bottom line” (i.e. “net income”) reflects the changes to the organization’s net assets, resulting from that period’s income and expenses.

Similar to how net income accumulates in retained earnings on a balance sheet, the changes in net assets accumulate on the statement of financial position and appear as changes in unrestricted, temporarily restricted and permanently restricted net assets.

Expenses are typically broken out between program management and fundraising, either in total or detailed out by expense. This is important because it helps to demonstrate how your organization spends its resources toward accomplishing mission activities.

The Statement of Cash Flows reports the cash generated and used during a specific period of time. The cash flow statement is typically broken into three sections: cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.

Cash flows from operating activities describes cash generated (or used) from the core operating activities of the organization. Cash flows from investing activities reports the purchases and sales of long-term investments and fixed assets such as property, plant and equipment. Cash flows from financing activities reports any new debt or the pay-down of existing debt as well as any contributions received that were permanently restricted for endowment, or restricted to the purchase of long-term assets such as buildings.

The net increase (or decrease) in cash indicates the overall change in cash position for the organization during the specified time period. Finally, the footnote reports the exchange of significant items that did not involve cash, and reports the amount of income taxes and interest paid.

Now that you have an understanding of the three basic financial statements, the question then becomes, how should you go about reviewing them? What questions should you ask? Here are some key ways to read your organization’s financial statements quickly, to detect areas of strength and areas for improvement.

Evaluating the Three Basic Financial Statements

Let’s start with the Statement of Financial Position. One easy way to start is to compare the current period balances to the prior period (year/month/quarter), which will give you a big picture of what changed during that time and where the organization currently stands financially.

Look for large fluctuations between prior period and current period and ask why. For example, you might notice that the line of credit balance increased significantly over the prior period. You might already be aware of why this has occurred, but if you aren’t, this would be an important change to look into. Why did the organization take on additional debt? What is it being used for?

Next, take a look at the “current ratio” (total current assets divided by total current liabilities). This ratio helps to measure whether or not your organization has enough resources to pay down its debts over the next twelve months. Generally, you would want to see a high current ratio (i.e. well above one), which would mean that your organization has more than one dollar in assets to pay down every dollar in liabilities.

Strategically, you can utilize the statement of financial position to help you identify how much buffer the organization has against unexpected challenges (i.e. how much cash you have on hand vs. locked up in investments?). It will also help you identify if the organization is in a position to invest in new opportunities, or if the organization needs to invest in new assets to help accomplish its mission.

The Statement of Activities can give you insight into the various revenue and expense trends of the organization. When reading the Statement of Activities look at the current income and expenses as compared to the budgeted income and expenses. Does it make sense? Are there budgeted goals that have not been met yet and why? Also look at the current year income and expenses as compared to the prior period. Are there significant changes? If yes, why? Does it fit with the changes in your organization’s operations?

Strategically, you can apply certain ratios to help you understand efficiencies (or lack thereof) in the organization’s activities. For example, the “fundraising efficiency” ratio (total contributions less government grants divided by fundraising expense) measures the relative cost to produce voluntary contributions from the general public. In other words, how many dollars does it cost the organization to raise each dollar in funds?

Another important ratio is the program service expense ratio (program service expenses divided by total expenses). This measures the efficiency of funds spent on the organization’s mission as it relates to total expenses. This is an especially important ratio from the perspective of a donor.

The Statement of Cash Flows can be used in a variety of ways, and is basically a summarized version of the Organization checkbook. Most importantly, it helps you understand what happened to cash going into and out of the organization.

The first thing that you should look at is the “bottom line” (i.e. net increase/decrease in cash) and compare that to the difference between prior year and current year cash and cash equivalent balances found at the top of the Statement of Financial Position. These numbers should be the same. If they aren’t, then the information that you are looking at is either incomplete or incorrect.

Next, you should check to see if there was positive “cash provided by operating activities” vs. negative “cash used by operating activities”. Generally, it is a good sign to see a positive number here. Most importantly, you should be aware of whether this number has been increasing or decreasing over time. This can give you a clear indication that something is changing in the organization’s ability to generate cash.

Positive or negative cash flows in the Investment and Financing Activities sections are hard to judge as good or bad. For example, a negative cash flow in investing activities may mean that the organization has been purchasing long-term investments, which isn’t necessarily good or bad, but it does provide important information about how funds are being used.

Although the cash flow statement by itself says nothing about profitability, one indicator that you can look at is to compare the amount of operating cash flow to the change in net assets on the Statement of Activities. If they are significantly different, you may want to examine the non-operating activity of the Organization to see if it is reasonable, and enhancing or detracting from your core operations.

A Note on Functional Expenses

A common “fourth” report is often included with non-profit financial statements, called the Statement of Functional Expenses. This statement breaks out expenses between program services, management and general and fundraising.

Why is it important to understand the breakout of these expenses? Budgeting is one reason, but another is the clear fact that contributors want to know how their money is being used. The statement of functional expense goes on to the IRS Form 990, which is a public document for all to see.

When reading your organization’s Statement of Functional Expenses, be sure to compare totals between program, management and general, and fundraising. Is too much being allocated to management expenses and not enough to the organization’s programs, or is the organization in its first years of operation where this would be a common allocation? How much is going to salaries and how much of that salary line is going to program versus management expenses? Is the other expense line very high and can any of that be put to another category, such as office expenses?

As a board member, you play an important role in making sure that your organization continues long into the future. Having a basic understanding of the financial statements, and knowing the right questions to ask, will go a long way to helping you make this happen.

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Shareen Corlett is on the Accounting and Consulting Services team at Clark Nuber. Contact Shareen.

 

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This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.

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