Passionate Nonprofit Management

Sean Malone
President, Ten Chimneys Foundation
smalone@tenchimneys.org

Alternate blog title, in honor of "The Office" and Michael Scott: SOMEHOW, I MANAGE

2.21.2011 FINDING “THE BOTTOM LINE” IN NONPROFIT FINANCIALS

I love it when donors and community leaders take an interest in a nonprofit’s financials.  Really, I love it.  That kind of engagement is a tremendously good thing – for the donor, for the organization, and for the broader community.  In-depth exploration of a nonprofit’s financial statements, on paper, or by talking to the organization’s leadership, can tell a donor so much about an organization’s priorities, financial stability, sustainability, and efficiency.  The larger an organization, the more complicated the financials will likely be, and getting a thorough understanding of the financials and what they mean can, I’ll admit, be a very involved process.  But it’s truly worth it – particularly if you’re considering a significant investment in the organization.

That said, as excited as I happen to get about it personally, I understand that lots of people don’t share my passion for in-depth financial analysis.  (I do proudly own a t-shirt that says, “I heart spreadsheets.”) From my discussion with all types of stakeholders, I feel confident that when people say they’re looking for “the bottom line,” they mean a single number that conveys the organization’s financial performance (revenue minus expenses), confirming that the organization’s operations are sustainable if it were to have that same level of revenue and expense year after year.

Sites like Charity Navigator and Guide Star have made it easier than ever for donors (and potential donors) to find financial information about nonprofit organizations.  But there’s a problem: neither of those websites will give you the number you need.

And there’s an even bigger problem.  When you look at the summary financial information on either site, it seems like there is a bottom line.  Guide Star lists “Net Gain/Loss” at the bottom of the summary.  Charity Navigator lists “Excess (or Deficit) for the year” at the bottom of the summary.  Both numbers are calculated as total revenue minus total expenses.  This seems logical, right?  It seems like Total Net Income it would be that bottom line number we need.  But it’s not.  For nonprofit organizations, Total Net Income (Total Revenue minus Total Expenses) is very, very rarely a good indicator of an organization’s financial performance or sustainability.  In other words, the number you see on the bottom line isn’t really “the bottom line.” This is not a new discovery.  I’m not breaking any ground by explaining this; I’m not saying anything controversial.  Talk to any experienced nonprofit CFO or third-party auditor and they’ll agree.  (None of this is meant as an indictment of Charity Navigator and Guide Star.  I think both are fantastic resources and use them frequently.  But for their summary financial information, they both pull their data from an organization’s IRS-990, which doesn’t provide the figures they would need to convey a more accurate “bottom line” number.)

Rather than Total Net Income, the most useful single number to convey the bottom line on performance and sustainability is Unrestricted Net Income before Depreciation.  It doesn’t roll trippingly off the tongue, does it?  But it does a much better job of telling you how a nonprofit is doing.  Here’s why (and how you find it):


 
Part I: “Unrestricted Net Income”

For nonprofit organizations, Unrestricted Net Income (Unrestricted Revenue minus Unrestricted Expenses) gives a far more accurate picture than Total Net Income (Total Revenue minus Total Expenses).  The difference between the two is almost always on the revenue side – specifically, with contributed income.

Unrestricted contributions are pretty straightforward; a donor makes a gift and tells the organization it can use it for any purpose that will help it achieve its mission.

There are two kinds of restricted contributions.  Some contributions are restricted for purpose; a donor asks that the contribution be used to fund a specific program or project.  Other contributions have “time restrictions.”  This is far better known as a pledge; a donor makes a promise to give a certain amount of money in a future year (or over several years).

Pledges (time restricted contributions) are the reason that Unrestricted Net Income is so much more accurate than Total Net Income.  Following IRS guidelines:

  • Total Revenue counts all restricted gifts in the year that they are promised, whether or not the money has been received or the restricted purpose accomplished. 
  • Unrestricted Revenue, on the other hand, counts restricted gifts when pledge payments are received or once an organization has “released” a purpose-restricted gift by accomplishing whatever it promised to do with the funding.  

For example, let’s say that, in December of 2011, a loyal donor makes a pledge to contribute $20,000 a year for five consecutive years:

Pledge Payment Date    Pledge Amount

12/15/2012                        $20,000

12/15/2013                        $20,000

12/15/2014                        $20,000

12/15/2015                        $20,000

12/15/2016                        $20,000

Total Revenue will show income of $100,000 from that pledge in 2011, which, of course, will be misleadingly high.  It will look like the organization raised $100,000 more than it needed or spent during 2011.  Then, for the next five years (2012-2016), Total Revenue will be misleadingly low.  In each year, it will look like the organization raised $20,000 less than it needed or spent.  However, Unrestricted Revenue for that same $100,000 5-year pledge, will be $0 in 2011, since none of the gift is being received in or used for 2011 activities.  Then, for the next five years (2010-2014), Unrestricted Revenue will be $20,000 a year – perfectly reflecting the organization’s annual activities and performance (and the purpose/intent of the contribution).

Let’s say that a different donor contributes $10,000 in 2011 to fund a specific program that will take place in 2012. The problem with Total Revenue is the same. Total Revenue will show income of $10,000 from that restricted gift in 2011, which will be misleadingly high.  It will look like the organization raised $10,000 more than it needed or spent.  Then, Total Revenue in 2012 will be misleadingly low; it will look like the organization raised $10,000 less than it needed or spent. However, Unrestricted Revenue for that same $10,000 restricted gift will be $0 in 2011.  Even though the cash was received in 2011, the restricted purpose wasn’t accomplished yet, so Unrestricted Revenue doesn’t count it.  Then, in 2012, Unrestricted Revenue will show income of $10,000 – once again, perfectly reflecting the organization’s annual activities and performance, and donor’s intent.

If an organization doesn’t have any multi-year pledges or restricted gifts, then the Total Net Income and Unrestricted Net Income will be the same.  But if there is a difference, Unrestricted Net Income is the best starting point for determining a nonprofit’s real “bottom line.”



Part II: “Before Depreciation”

The other issue that can get in the way of understanding of a nonprofit’s bottom line is non-cash Depreciation, particularly if the organization has undergone a major construction/capital project in the last 40 years or so.

Let’s say that an organization raises $40 million through a capital campaign and builds a brand new facility (theatre, museum, shelter, etc.) to support its mission.  The new facility is completed on December 31, 2011.  The IRS requires that the cost of the new facility be spread out over its “period of usefulness,” often defined as 40 years.  Starting in 2012, the organization would book $1 million a year in non-cash Depreciation Expense (in addition to annual operating cost associated with the new facility – maintenance, repairs, utilities, overhead, etc.)

There are logical reasons that for-profit organizations are required to book capital expenditures this way.  Among other reasons, non-cash Depreciation Expense allows for-profits to more easily put aside cash for future capital costs (such as a new $40 million building 40 years later, or whatever the for-profit needs in the future).  Nonprofit capital projects, however, do not work that way.  Donors are not generally inclined to make large contributions for an organization to put in the bank to use at some future undetermined time for some future undetermined capital project.  Nor should they be.  If a nonprofit wants to undertake a large capital project, it is, and should be, the organization’s responsibility to make a strong case to the community and individual donors about the value of and need for the project.  Nonetheless, a nonprofit in the scenario above will be expensing $1 million a year in non-cash depreciation for a project they’ve already paid for and completed.  Which means that, if this nonprofit is sustainably accomplishing its mission and performing at peak efficiency, it will misleadingly have a Net Loss of $1 million every year.

If you review nonprofit financials, you’ll find that many vibrant, successful, and prudently managed nonprofits have negative Total Net Income year after year – entirely due to significant non-cash Depreciation Expense.



Part III: Calculating Unrestricted Net Income before Depreciation

Unfortunately, you can’t find Unrestricted Net Income on Guidestar or Charity Navigator.  Sure, now I tell you, right?  Both sites draw their financial data from the IRS-990 form, which only states total revenue, expense, and net income.  The easiest way to get the information you want is to contact the nonprofit and ask them for a copy of their most recent audited financials (or annual report).  Audited financials will clearly state Unrestricted Net Income as a line on the primary Statement of Operations.

Dealing with non-cash Depreciation is easier, since it is listed on the IRS-990 and on audited financial statements.  So, to determine a nonprofit’s real bottom line, it often makes sense to start with Unrestricted Net Income and simply “add back” the entire line of Depreciation Expense (or subtract it from Unrestricted Expenses and recalculate Unrestricted Revenue minus Unrestricted Expense).


Note, if an organization has not undergone any major construction or capital project in the last 40 years, Depreciation will be small.  If it’s small, if it seems immaterial compared to total revenue and expense, you should not make any adjustment for Depreciation. Subtracting Depreciation from Unrestricted Expenses isn’t perfect; there are some smaller capital expenditures, such as computer equipment, that may be more reasonable to expense annually.  But the level to which depreciation can dramatically overstate Total Expenses far, far, far outweighs the potential for understating Total Expenses.)


Epilogue
Of course, as I said at the beginning, a nonprofit’s financials offer so much more than a single-number bottom line.  But if a quick-check-in bottom line is what is prompting you to look at a nonprofit’s financials, Unrestricted Net Income before Depreciation is the number you want.  If you don’t want the bother of requesting audited financials, at the very least, add back non-cash Depreciation to whatever the number you’ve found as Total Net Income.  If the number is still negative, give the organization a call and ask them why.  And, in any event, thank you for wanting to know.  Truly.  Casual donors don’t ask these questions; passionate ones do.  And the passion and generosity of people like you are the reason that “your” nonprofit is able to accomplish its mission and serve its community.


Notes

  1. sean-malone posted this