Shoring Up Financial Stability: The Basics of Your Nonprofit’s Financial Statements
Being on the board of a nonprofit can be a precarious situation. You have the liability of leadership without the pay, and it’s tempting to leave financial matters to the accountants and treasurer.
But they aren’t the only people who should be watching your organization’s financial statements. These records do more than tell the financial story of your nonprofit; they can also warn you of trouble ahead. So you need a basic knowledge of the purposes they serve and the information they contain.
In a previous Nonprofit CPE Series webinar, James Moore managers Ben Clark and Karsten Derendorf joined partner and Nonprofit Services Team leader Mark Payne. Together they discussed how to shore up your nonprofit’s financial stability, and part of that is understanding the basics about these important reports.
Financial statements are divided into four components, each of which presents information in its own way and for unique purposes.
Statement of Financial Position
Also called a balance sheet by commercial entities, the Statement of Financial Position describes exactly what its name evokes — the financial position of your organization at a specific point in time.
“The reason why it’s called a balance sheet is because there’s a formula there that should balance,” said Karsten. “Your assets should equal your liabilities plus your net assets. A balance sheet that doesn’t balance means you have issues going on.”
It’s important to note that the other three components of your financial statements reflect certain periods of time. To see your nonprofit’s overall financial health or long-term trends, you’ll have to look at balance sheets from year to year.
The Statement of Financial Position includes three categories of information. Assets vary from one nonprofit to another, but you’ll generally see the following:
- Cash and cash equivalents
- Certificates of deposit
- Pledges, grants or accounts receivable (Note: These need to be unconditional; i.e., you must be able to recognize the revenue without doing anything else to get it.)
- Prepaid expenses such as insurance, rent or anything else you pay ahead of time
- Fixed assets/property and equipment/capital assets
- Collections (art collections, etc.)
Ben and Karsten commented on a few exceptions and important details for this list. For example, your cash and cash equivalents here differs from the notes on your financial statement. In this case, they reflect reconciled cash balance with any outstanding checks and deposits. (The notes only state your balance in your bank account at year’s end.)
Additionally, your data under pledges/grants/AR need to be from unconditional sources. In other words, you should be able to recognize the revenue without having to do anything else to receive it. This also means being careful with pledges and their sometimes-uncertain nature. Often donors will pledge for one year, only to change their mind the following year for any number of reasons. Or they might pledge but not give that first donation at all. Either way, the result is the same — money you counted on but never received.
“Pledges are a great way of painting a rosy picture when maybe it’s not all collectible in the end,” said Ben. “You have got to be careful with your pledges and make sure they’re going to be collected.”
Next you have your liabilities. This includes accounts payable, or what you’ve been billed to pay for expenses you’ve incurred. You also have accrued expenses; these are expenses for which you haven’t been billed yet but you know you’ll have to pay. These could be repair work performed on your nonprofit’s building or even payroll costs for days not yet worked.
Deferred revenue is also included in your liabilities. This is money you have received but haven’t earned yet. An example of this could be receiving a large grant with conditions that must be met before you can recognize the revenues. And finally you’ll see long-term debt, which covers loans like a building mortgage.
The last part of your balance sheet equation is your net assets, which is the portion of your assets that you retain if all the liabilities were to be paid off. These are divided into those without donor restrictions and those with donor restrictions.
Statement of Activities
This is your nonprofit’s income statement. It helps you understand your revenues throughout the year, where your money was spent and your overall bottom line. The most common revenue sources cited on nonprofit statements include:
- Contributions – donations, gifts or transfer of assets. These include contributions with donor restrictions and contributions without donor restrictions.
- Program service revenues
- Governmental grants
- Special events revenue
- Investment income
A nonprofit must make money in addition to fulfilling its mission. While this won’t happen every year, realizing a profit some years allows you to save money for use in tougher times.
“It used to be the rule of thumb was to have three months of reserves as cash reserves,” said Mark. “But in the last year or so (with COVID anyway), I want to see six to nine months of reserves because we don’t know what the future’s going to hold. I think there’s a lot more uncertainty than there has been in the past.”
Your Statement of Activities demonstrates your income abilities and provides clues to increasing funds. For example, you might see a lower-than-usual level of special events revenue. This could prompt you to develop more effective events (or emphasize further the sources that provide more income).
Statement of Functional Expenses
It’s a refrain often heard from donors: How do you spend your money? This is addressed in your Statement of Functional Expenses (and also included in your IRS Form 990). It demonstrates how much of your expenses are related to program services, member services or general administrative costs. All nonprofit organizations must provide a Statement of Functional Expenses in their financial statements
It’s your nonprofit’s responsibility to estimate which expenses go into which categories. In some cases, this is a fairly straightforward process. For example, food expenses for a homeless shelter are obviously related to program services.
Other instances aren’t so cut and dry. Imagine the electric bill for that same homeless shelter. While the building is primarily used to house and feed the homeless, it also contains administrative offices. Activities using electricity in those offices support functions such as accounting and other back-office activities. In these cases, the amount of the bill is divided between program services and administrative costs (using square footage as an allocation base).
The Statement of Functional Expenses can be useful when determining whether your administrative costs are higher than they should be. Having a low number in that category can appeal to donors, some of which like to see a number as low as 10%. You can also use this statement as a benchmark against other nonprofits to see if you’re in line with industry standards.
Statement of Cash Flows
“I like to think of the Statement of Cash Flows as a big checkbook,” said Ben. “It shows you the cash you started with and what you ended with.” While true, this component also categorizes your cash into one of three buckets. The category for each cash flow depends on how it’s spent or received:
- Operating – This is for everyday activities including program activities and administrative operations. Examples include medical supplies for a federally qualified health center or office supplies for the administrative area of the aforementioned homeless shelter.
- Investing – Use this category when buying equipment or fixed assets for your organization, or when using cash to purchase investments. Cash received from selling investments will go here as a cash inflow.
- Financing – This includes anything related to loans or other forms of financing. If you receive a loan, this would be a financing inflow; payments to that debt would be a financing outflow.
Sometimes called footnotes, these cover additional information about the data included on your statements. The point is to help the reader better understand your financial statements and your financial and operating prospects. This information includes accounting principles used by management, descriptions of your nonprofit and other required disclosures to ensure your statements conform with Generally Accepted Accounting Principles (GAAP).
How often should I see these financial statements?
At the very least, a nonprofit’s board members should see the financial statements once a month. Generally they’re presented at the monthly board meeting. However, board members should receive them with enough time to review them before a meeting. (Five business days is a good guideline.)
“Generally, the organizations that get in trouble financially are the ones that do not know their numbers,” said Mark. “If you know your numbers, you have a problem and you can hopefully circumvent it. If you don’t know your numbers and it’s been six months since you’ve looked at them, that’s terrible.”
Working knowledge of your financial statements — and timely, regular review of them — is part of the battle to stay on top of your organization’s finances. When combined with an understanding of your budget, internal controls and financial red flags, the result is a well-informed board that can competently guide your nonprofit to a successful future.
So take the time to understand these important documents. And don’t hesitate to contact your nonprofit CPA if you have questions about them.
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