Best Metrics: Decoding Nonprofit Financials

What if I told you that a nonprofit's financial statements could reveal more about its mission and impact than its annual report? In a recent episode of the "Best Metrics" podcast, host Glenn Dunlap, Co-Founder and CEO of Peerview Data, interviewed Catherine Demes Maydew, Director of Government and Nonprofit Consulting at Creative Planning. Together, they discussed the fascinating world of nonprofit financial reporting, particularly the footnotes to the financial statements. As Catherine puts it, "These are your financial reports. This tells your story, so make sure your footnote isn’t just the bare bones. Sometimes, more is better."

CPAs and financial advisors are no strangers to complex financial statements. But when it comes to nonprofits, the game changes. We're not just looking at profits and losses; we're decoding how effectively an organization fulfills its mission while maintaining financial health. Decoding nonprofit financial statements requires a nuanced understanding of sector-specific statements, footnotes, and ratios to effectively guide organizations in balancing mission-driven goals with financial sustainability and donor accountability.

In this article, we'll unpack three critical areas of nonprofit financial reporting that can elevate your advisory game:

1. Decoding nonprofit-specific financial statements like the Statement of Financial Position and Statement of Functional Expenses
2. Unveiling the hidden power of footnotes in telling a nonprofit's full financial story
3. Mastering key financial ratios and metrics that illuminate a nonprofit's true financial health

After listening to the podcast, you'll be better equipped to read nonprofit financials and interpret the complex narrative they tell about an organization's impact and sustainability. 

Decoding Nonprofit-Specific Financial Statements

When looking at a nonprofit's financial statements, you might feel like you’re reading a foreign language. That's because nonprofits have their unique financial dialect. Let's break down two key statements that are crucial for understanding a nonprofit's financial health: the Statement of Financial Position and the Statement of Functional Expenses.

The Statement of Financial Position is the nonprofit version of a balance sheet. But here's where it gets interesting. Catherine advises, "I always look at the bottom of the statement of financial position, where you find the net asset section." This is where you'll find the breakdown of restricted and unrestricted net assets.

For example, if a nonprofit receives a $1 million grant for a specific program, that money appears as restricted net assets because it can only be used for that program. On the other hand, unrestricted net assets can be used for anything the organization needs, from covering payroll to paying for utilities.

“I look to see, was there a deficit for the year? How much is restricted for the organization and how much is unrestricted?” Catherine says.

Catherine emphasizes the importance of asset liquidity: "I scroll to the top of the financial report and I look to see whether those unrestricted net assets are available for use. Are they liquid? Are they tied up in something in other assets that isn’t liquid?" This analysis helps you understand if a nonprofit has the cash flow to support its operations and mission.

The Statement of Functional Expenses is another nonprofit-specific gem. This statement breaks down expenses into program services, administration, and fundraising categories. It's like a financial GPS showing exactly where a nonprofit's money is going. Unlike a for-profit's income statement, this statement helps you assess how efficiently the organization fulfills its mission.

Catherine points out, “What you want to watch for is a social service organization with very little in programming. Then we need to ask, ‘Where did they spend the money?’ If it’s all in management, that’s an indication that either they’re not spending or allocating the dollars correctly.”

Understanding these unique financial statements allows you to provide targeted advice on resource allocation, cash flow management, and mission alignment. As a trusted advisor, decoding these statements is your key to helping nonprofits navigate the delicate balance between financial health and mission impact.

But financial statements are just the beginning. To truly understand a nonprofit's financial story, you also have to know how to read the footnotes. Let's explore why these seemingly minor details can make a major difference in your nonprofit financial analysis.

The Hidden Power of Footnotes in Nonprofit Financials

If financial statements are the main story, consider footnotes as compelling subplots that give depth and context to a nonprofit's financial narrative. In nonprofit finance, footnotes aren't just afterthoughts—they're often where the real action happens.

So why are footnotes so crucial in nonprofit reporting?

First, footnotes can reveal critical information about funding source concentration. Imagine a nonprofit that appears to have a healthy balance sheet. However, a footnote might reveal that 80% of their funding comes from a single source. This concentration could spell trouble if that source were to suddenly decide to point their dollars in a different direction.

Footnotes also provide essential context for large grants or restricted funds. Let's say a nonprofit shows a significant increase in assets. Exciting, right? However, a footnote might explain that this is due to a multi-year grant, with most of the funds restricted for use in future years. Without this context, you may think the organization is flush with immediately available cash.

Catherine provides a great example of how footnotes can clarify seemingly contradictory positions: "Say we just got this $1 million grant, right? It came in just before year end, but it's not something we're going to spend until next year.  The footnotes tell donors and other stakeholders what the organization is going to spend that money on." Without this footnote, stakeholders might wonder why the organization is still fundraising despite a large cash balance.

Footnotes help stakeholders understand the full picture of a nonprofit's financial situation beyond what the main financial statements can convey.

Mastering Key Financial Ratios and Metrics for Nonprofits

When it comes to nonprofit financial health, not all ratios are created equal. The unique nature of nonprofit organizations requires a specialized set of metrics to understand their financial performance and sustainability truly.

Let's start with the Functional Expenses Report. As Catherine explains, "That statement of functional expense really tells a story. It just lays out how a dollar that comes into the organization is spent across management in general fundraising and programs." This report is crucial for understanding how efficiently a nonprofit is using its resources to fulfill its mission.

But here's where it gets tricky: there's no one-size-fits-all approach to interpreting these ratios. Catherine notes, "You can't necessarily compare a theater organization to a social services organization, and you can't even compare all your social service organizations together." For instance, a theater might have higher program expenses due to production costs, while a social services organization might have higher administrative costs due to case management needs.

One key metric Catherine emphasizes is the net margin ratio. This ratio helps assess an organization's ability to generate a surplus, which is crucial for long-term sustainability. As Catherine puts it, "We would love to have a surplus every year, so we really need to be budgeting for a surplus in some way, shape or form." 

However, the concept of budgeting for a surplus in nonprofits can be counterintuitive. Catherine advises, "I really strongly advise clients not to budget for deficits because that means you're eating up your surplus." Instead, she recommends budgeting for a small surplus or break-even, which provides a buffer for unexpected expenses or revenue shortfalls.

Advisors can use these metrics to guide nonprofits in several ways:

1. Help organizations set realistic financial goals based on their specific type and mission
2. Identify potential areas of concern, such as over-reliance on a single funding source
3. Assist in developing strategies to improve financial health, like diversifying revenue streams or optimizing expense allocation.

By mastering these key ratios and metrics, we can provide valuable insights that help nonprofits make informed decisions about resource allocation, fundraising strategies, and long-term financial planning. Ultimately, the goal is to help these organizations balance their mission-driven goals with financial sustainability, ensuring they can continue making a positive impact for years.

Elevating Your Nonprofit Financial Advisory Game

Mastering nonprofit financial reporting is crucial for any CPA or financial advisor working with these organizations. From decoding sector-specific financial statements to interpreting footnotes and key financial ratios, we've equipped ourselves with powerful tools to guide nonprofits toward financial sustainability and mission success.

By understanding their unique financial metrics, we're not just crunching numbers—we're helping organizations tell their financial stories more effectively. 

But the journey doesn't end here. Listen to the full Best Metrics podcast episode featuring Catherine Demes Maydew to dive even deeper into these topics and gain more practical insights. You'll hear detailed case studies and get actionable advice on implementing these financial strategies in real-world nonprofit scenarios. Additional episodes of Best Metrics, dive into topics like Real Estate, Technology and SaaS, Healthcare, Manufacturing, and more!