Understanding Nonprofit Financial Statements
Without some assistance, nonaccountants may find it difficult to fully understand financial statements. But your nonprofit organization may benefit if you and other key personnel learn the fundamentals of financial statements. Here’s a primer to help you interpret the numbers.
Every nonprofit organization’s financial statements produced for external use should include four parts:
- A balance sheet (sometimes called a statement of financial position),
- An activities statement (sometimes called support, revenue, expenses and changes in net assets),
- A cash flow statement, and
- Explanatory footnotes.
Voluntary health and welfare organizations should also include a statement of functional expenses.
The Balance Sheet
The balance sheet is a snapshot of your financial situation at a moment in time, such as at your year end. The balance sheet shows:
- What you own,
- What you owe — in the form of loans and accounts due to others and some-times grant or contract money that you have received but not yet fully earned, and
- Your equity or net assets.
The balance sheet lists assets and liabilities in order of liquidity. That is, how quickly they can be turned into cash or will require cash.
Net assets consist of the difference between what you own and what you owe, and are broken down into donor-restricted amounts. Donor restrictions can be either temporary or permanent.
The Activities Statement
The activities statement shows support, revenue and expenses for a set period, such as the most recent year. It reports all income you received during the year and identifies amounts temporarily or permanently restricted by donors. It also reports income by function as well as your major programs and supporting services, including an impor-tant reconciliation of net assets.
The reconciliation shows specifically how last year’s net assets plus this year’s surplus or deficit produce this year’s net assets.
You can design the activities statement to report your regular operating activities sepa-rately from nonoperating activities, such as investment results.
And comparing the monthly activities state-ment with your budget can be useful in explaining changes from your original expectations.
The Cash Flow Statement
The cash flow statement reconciles the sur-plus or deficit to the change in cash balance. For instance, depreciation is an expense in your activities statement but does not require cash. Unpaid revenue you earned and have not yet collected is included in income — but does not increase cash.
The cash flow statement groups cash flows into these types of activities:
- Normal operating activities,
- Investment activities, such as pur-chase or sale of investments or fixed assets, and
- Financing activities, including loans and repayments.
Footnotes are valuable for understanding how the financial statements were prepared. They explain whether the organization follows the cash or accrual basis of accounting. When you use the accrual basis, you record revenue when earned and expenses when incurred, not when they are paid. Footnotes provide addi-tional information about:
- Loan terms,
- Lease commitments,
- Other potential liabilities, and
- Volunteer services and other contributions.
Reviewing Financial Statements
What should you look for when you review a financial statement? Start with the surplus or deficit. Nonprofit organizations can have either in any year, but repeated deficits or results that differ greatly from budgets are cause for concern.
Other important topics to consider in your financial review include:
Donor restrictions. The financial statements should use net asset classes to reflect donor restrictions, including both temporary restric-tions that will be removed by events or the passage of time and permanent restrictions, such as donor-established permanent endowment funds.
Board designations. Only donors can impose restrictions. The board may choose to use unrestricted assets for a specific pur-pose. Unlike donor restrictions, board desig-nations can be changed at the governing board’s discretion.
Donor conditions. Donor-imposed condi-tions on contributions are outside your con-trol. For example, matching requirements mean that contributions are not recorded. But if donors have not imposed conditions, donor-pledged contributions should be recog-nized in the financial statements even if you won’t receive them until a future year.
Timeliness. The date financial information is available depends on your nonprofit’s complexity and need for outside information, such as invoices from suppliers and reports from investment managers. But in general, information the organization prepares should be available within four to 12 weeks after the balance-sheet date.
Investments. Look at your investment return. Have you adopted a sound and pru-dent investment policy, taking into account how long the money can be tied up?
For example, have you placed funds that can be invested for only a few weeks or months in money-market accounts, and invested endowment or retirement-plan funds in a diversified portfolio of stocks and bonds? Ask board members or outsiders with finan-cial expertise to help develop your invest-ment policy.
Most important, make sure your organiza-tion follows the policy.
Functional expenses. Expenses should be reported by the function they accomplish. Each major program can be a function. Together these are referred to as program expenses. Operating costs should be classified as management and general. Costs to bring in contributions and donations should be classified as fundraising costs.
Some organizations also have membership-development costs. Supporting services include management and general, fundraising and membership development.
Aging of amounts owed to the organiza-tion. The age of receivables due the organiza-tion is important. The older these become, the less likely they’ll be collected. Watch the trends here. Be sure a collection policy is in place and that it is followed.
Ratios. Important ratios that will help you understand financial statements include:
- Current ratio. Obtain this ratio by dividing current assets by current liabilities. This ratio shows the non-profit’s ability to pay its current bills and should generally be not less than 1 to 1.
- Program services percentage. Divid-ing program services by total expenses shows what portion of your expenditures you use to provide direct service. Dividing program services by total support and revenue gives insight into how much of your total budget you spend on program services. Generally, a percentage of 70% to 85% or more is good, but this depends on the nature of your organi-zation. Organizations must spend at least 75% of their total revenue each year on program services to be a part of the combined federal United Way campaign.
- Ratio of fundraising costs to fund-raising revenue. This ratio gives insight into the cost of raising money for a specific event and also for your entire fundraising activity. Although this ratio varies widely, fundraising costs exceeding 50% of the revenue raised may cause questions about your primary purpose. When calcu-lating fundraising costs, do not clas-sify direct expenses, such as meal costs for a fundraising dinner, as fundraising costs.
Tax-filing requirements. Be sure that annual filings are complete and familiarize yourself with the content of these public documents that anyone may peruse. Some important federal filings include:
- Form 990 or 990EZ and 990
Schedule A for all organizations eligible to receive contributions,
- Form 990T for organizations that conduct unrelated business activities, and
- Form 5500 for organizations with employer-funded qualified retirement plans or employee benefits plans.
Computer security. Determine what computer-security measures the organization uses, including backups and off-site storage of backups, password and surge protection, and up-to-date antivirus software.
Independent accountants reporting on an organization’s financial statements supply an accompanying letter stating which of the four types of report they prepared:
- An audit report, which represents the most thorough level of verification and typically includes confirmation of accounts with outsiders and verification of calculations,
- A compliance audit, which is also fairly extensive and focuses on verifying com-pliance with requirements of specific funding grants or contracts,
- A review, which is less intensive and typically involves analysis of normal relationships — such as comparisons of loan interest with amounts owed, payroll taxes with payroll, and account balances or activity with those of previous years and with budgets, or
- A compilation, which involves the least oversight and is limited to putting infor-mation received into proper financial statement format without further inves-tigation or analysis.
But regardless of the type of service pro-vided, the independent accountant will look further if anything appears to be wrong.
Understanding Is Key
These explanations of balance sheets, activi-ties statements, cash flow statements and explanatory footnotes should help demystify the language of accountancy. With demystifi-cation should come understanding, allowing you to interpret the numbers like a pro. The importance of understanding financial statements can hardly be overemphasized.
If you need help, give our nonprofit specialists a call at (630) 665-4440.