Financial Management in Non-Profit Organizations Explained

Introduction

Financial management of not-for-profits is comparable to financial management in the commercial sector in many respects; however, certain key differences shift the focus of a not-for-profit financial manager. A for-profit company focuses on profitability and maximizing shareholder value. A not-for-profit organization's main goal is not to increase shareholder value; rather, it is to provide some socially beneficial service on a continuing basis. A not-for-profit typically lacks the monetary flexibility of a commercial enterprise because it depends on resource providers who are not engaged in an exchange transaction. The resources provided are intended to deliver goods or services to a customer other than the actual resource supplier.

Therefore, the not-for-profit must demonstrate its stewardship of donated resources — money donated for a specific purpose must be used for that purpose, and only that purpose. That purpose is either set by the donor or implied in the not-for-profit's stated mission. The management and reporting activities of a not-for-profit must emphasize stewardship of these donated resources. Staff must be able to show that funds were used as directed by the donor. The shift toward an emphasis in external financial reports on donor restrictions has made the use of fund accounting systems even more vital (Financial Management of Not-for-Profit Organizations, 2011).

Budgeting and cash management are two components of financial management that are critically important for not-for-profit organizations. The organization must pay close attention to whether it has sufficient cash reserves to continue providing services to its clients. Cash flow can be extremely challenging to forecast because an organization relies on income from resource providers who do not expect to receive the service being provided. In fact, an increase in demand for a not-for-profit's services can trigger a management crisis. Contribution revenue is difficult to predict consistently from year to year. For that reason, the control of expenses receives heightened emphasis. Budgeting therefore becomes a critical activity for a not-for-profit (Financial Management of Not-for-Profit Organizations, 2011).

Management

Non-profit leaders and managers must develop at least basic skills in financial management. Expecting others in the organization to manage finances is a recipe for problems. Basic skills in financial management begin in the critical areas of cash management and bookkeeping, which should be conducted in accordance with certain financial controls to ensure accuracy in the bookkeeping process. New leaders and managers should move on quickly to learn how to produce financial statements and analyze those statements to truly understand the financial condition of the organization. As one resource notes, "Financial analysis shows the 'reality' of the situation of a business — seen as such, financial management is one of the most important practices in management. This topic will help you understand basic practices in financial management, and build the basic systems and practices needed in a healthy business" (All about Financial Management in Nonprofits, n.d.).

The leaders and staff of non-profit organizations must ensure that accounting records and financial statements are accurate and comply with regulatory requirements. For an administrator of a non-profit organization, managing the organization's finances is particularly demanding. A non-profit organization's income sources are often subject to changes in both economic conditions and the political environment, yet it must compete for labor and other inputs just like any other organization. Accurate recording and reliable reporting of financial information are fundamental requirements of financial management. Public accountability also demands a high degree of accuracy and dependability in financial data.

The financial statements of a non-profit organization provide a functional overview of the organization's economic health. Financial management involves both planning and implementation. A non-profit manager must be able to examine and understand historical and current financial information in order to develop financial plans that ensure the organization's operations are efficient and effective (All about Financial Management in Nonprofits, n.d.).

Financial Metrics

The fundamental difference between a for-profit business and a non-profit organization is how profit is treated. For-profits are permitted to retain and distribute a profit; non-profits are not. Non-profits can generate a surplus, but they must reinvest it back into the organization. For-profits can take their profit and distribute it to shareholders, owners, or whomever they choose (Why non-profit pricing, 2010).

Budgets are the organization's working plan for a fiscal period. They express, in financial terms, the board's and staff's decisions about how the organization will accomplish its stated purpose. The board and staff decide which programs will be undertaken in the coming fiscal year, and staff then allocates resources to ensure those programs are delivered. The budget charts a course for distributing and maximizing the use of resources. "Ideally it also identifies any financial problems that could arise in the coming year. In addition, the budget should provide indicators for gauging staff performance and give staff goals to reach and steps to achieve them. Methodical tracking and classification of program expenditures enhance management's ability to report on service efforts and accomplishments" (Financial Management of Not-for-Profit Organizations, 2011).

The financial metrics and incentives differ dramatically between for-profit and nonprofit organizations. The income statement, earnings per share (EPS), and growth in market capitalization are all widely used performance metrics and significant components of both long- and short-term decision-making in the for-profit world. There are virtually no equivalents for these measures in the nonprofit arena. Nonprofit offices do not display real-time stock price feeds. While for-profit financial skills are valuable on a nonprofit board, individuals must be attuned to the different nuances in financial reporting and to the role of finance in the nonprofit context. For instance, two financial metrics — free cash flow and revenue growth — are highly relevant to the nonprofit world as well. A significant additional source of funds for nonprofits is philanthropy in its various forms: annual giving, capital campaigns, and planned giving. "Cash flow is king and annual giving and capital gifts are often critical to financial viability" (Epstein & McFarlan, 2011).

The accounting structure of nonprofits also differs from that of for-profits. For instance, nonprofits do not typically apply standard accrual accounting principles. Instead, they use fund accounting. For organizations that hold an endowment, considerable pressure exists on the board to manage it efficiently and establish an appropriate rate of withdrawal. Debt and its servicing requirements are also vital issues for those nonprofits that access the public debt market.

Because of financial reporting metrics, the for-profit world tends to have a strong short-term performance focus. Meeting quarterly earnings targets, hitting the annual earnings goal, and responding to fluctuations in stock price all drive a short-term orientation. The pace of the nonprofit is quite different. The heart of its financial activity is the annual budget, its revenue estimates, and the difficult choices it must make about various costs. Monthly reviews center on success in meeting cost and income targets, with variances against budget examined regularly. In reality, however, negative variances do not carry the same weight on internal and external assessments of performance as a missed EPS number does for a for-profit. "Beyond all of this, of course, is the need to peer around the corner and look toward the organization's long-term future challenges, which can be five to 10 years in the future" (Epstein & McFarlan, 2011).

Conclusion

Even though for-profits and non-profits run their businesses in different ways, their fundamentals are essentially the same. They both work to carry out the missions they have set for themselves in the most effective and efficient manner. The end result is that both types of organizations aim to be successful, and each has its own distinct approach to achieving that goal.

Appendix: Non-Profit Accounting Definitions

Source: Shanker, 2012.

The primary significance of non-profit accounting definitions is that they reflect the unique nature of non-profits. Unlike for-profits, non-profits have no owners and no investors. The revenue cycle is different for non-profits, often involving donations and grants rather than sales or fees for services. Many people become confused when working at a non-profit — even those with years of accounting experience — because they must learn new concepts and new ways to analyze a financial situation in order to be effective in this sector.

A foundational concept in the non-profit world is the net asset. Simply stated, a net asset is assets minus liabilities. Net assets are also called funds. Rather than showing retained earnings or owner's equity, non-profit financial statements show net assets. Organizations classify net assets in three categories: unrestricted, temporarily restricted, and permanently restricted. Non-profits use unrestricted net assets for daily operations. When a non-profit receives funds designated for a specific program or for future use, they are recorded in the temporarily restricted net asset — not in deferred revenue. The permanently restricted net asset contains endowments and other funds intended to be maintained in perpetuity. The non-profit typically may use only the income from a permanently restricted net asset, not the principal. When accountants close the books at the end of a period, they do not close all accounts into a single retained earnings account. Instead, each account is closed to the appropriate net asset category.

Grants are critical to many non-profits; some organizations exist primarily because of them. Grants can come from government agencies and private foundations, and they are usually large in size and tied to specific programs within the organization. By definition, grants do not need to be repaid — they are not loans. Governments and foundations award grants so organizations can provide goods and services to a community, such as food for the homeless or basic reading classes for disadvantaged adults. Non-profits typically account for grants as restricted revenue, recorded in a temporarily restricted net asset. Direct and indirect costs are important terms in grant management. Direct costs are directly related to a specific program; indirect costs are those that cannot be attributed to a specific program, such as utilities and insurance. Grant contracts often define and permit indirect costs. For example, some contracts allow fringe benefits to be classified as indirect costs.

Non-profits use their own standard financial reports. The statement of financial position is the non-profit equivalent of a balance sheet. The concept is the same as the for-profit balance sheet, and the reports look very similar. The statement of activities is the income statement equivalent, summarized by project, though it may be presented in detail like a regular income statement. Rather than showing profit or loss, it shows changes in net assets by type. A third report, common in social services non-profits and some other organizations, is the statement of functional expenses — a matrix-style report with detailed expense line items as rows and classifications such as program, management and general, and fundraising as columns.

Non-profits file tax returns, and many pay taxes. The primary tax return is Form 990, which comes in several variations depending on the organization's size and revenue. When a non-profit competes directly with for-profit businesses, it files Form 990-T and pays unrelated business income tax (UBIT) — a tax on income from activities unrelated to the non-profit's mission, similar in nature to regular business taxation. An example would be a non-profit operating a pizza parlor that competes with other restaurants. The Internal Revenue Service provides detailed exceptions and rules governing this area.