Financial Sustainability Analysis
As previously explained, sustainability is the ability of an organization or a project to fulfill its vision and mission, meet its goals, and serve its clients over time, regardless of changing funding conditions. In that context, sustainability can be assessed in terms of the organization itself, the services provided, and its finances. Further, I have already argued that financial sustainability is the ability of a project, a program, or an organization to maintain broader sources of funding in order to provide standard services to its clients over time. Financial sustainability is a process, not an end. It can be evaluated through profitability, liquidity, solvency, efficiency, and effectiveness. The purpose of this chapter is to introduce the concept of financial sustainability in relation to the use of financial statements. The chapter introduces selected financial ratios to assess the profitability, liquidity, solvency, efficiency, and effectiveness of a nonprofit organization.
Profitability is the surplus of revenue over expenses. Profitability used to be a forbidden word in the nonprofit world. Today, this is no longer the case. Scholars and practitioners in nonprofit organizations and nonprofit management have come to the realization that nonprofit entities cannot spend all the money that they receive every year. They must save some of their funding for future use. The lack of profit is now considered a "going concern" for a nonprofit organization. Profit margin and return on assets are two examples of measure of profitability.
Profit margin: The profit margin helps measure how a company uses its revenues and controls its expenses to generate an acceptable rate of return. The profit margin is calculated by dividing the net profit by the net sales. The profit margin calculates the percentage of net profit that a company generates for every dollar in sales.
Profit margin = Net profit/Net sales
The following information was found on the Annie Foundation income statement for the year ending December 31,2009:
Net profit: $70,000 Sales: $90,000
Calculate the profit margin!
Profit margin = $70,000/$90,000 Profit margin = 0.777
The profit margin of Annie Foundation is 77.7%. This profit margin must be compared with the industry average profit margin to determine whether it is lower or higher.
Return on assets (ROA): The return on assets is a measure of the return on the total investment of an organization.
ROA = Net profit/Total assets
The following information was found on the HOPE Association income statement and balance sheet.
Net profit: $100,000 Total assets: $800,000 Calculate the return on assets!
ROA = $100,000/$800,000 ROA = 0.125 or 12.5%
For every $100 of assets, HOPE Association has a return of $12.50.
Liquidity is the ability to meet cash requirements (e.g., pay bills). Many nonprofit organizations are faced with the challenge of undercapitalization and do not have enough cash or liquidity to pay their regular bills. As a result, they have to cut core programs and sometimes dissolve. It is important for nonprofit organizations to assess their liquidity, anticipate potential for undercapitalization, and develop strategies to address such an issue. The liquidity of an organization can be measured by the current ratio, the net working capital, and the acid test or quick ratio or liquidity ratio.
The current ratio helps measure the ability to pay the bills on time. It is calculated by dividing the total current assets by the total current liabilities. In other words, the current ratio calculates how many dollars in assets are likely to be converted to cash within a period of 1 year to enable a company to pay its debts during that same year. Most companies consider 1.5:1 or 2:las an acceptable ratio.
Current ratio = Total current assets/Total current liabilities
The following information was found on the Annie Foundation income statement and balance sheet, December 31,2008.
Current assets: $200,000 Current liabilities: $100,000
Calculate the current ratio!
Current ratio = total current assets/ total current liabilities Current ratio = $200,000/ $100,000 Current ratio = 2.00 times
Annie Foundation's current assets are two times the value of its current liabilities.
Net Working Capital
Net working capital (NWC) measures the ability of an organization to face unforeseen expenses. It is calculated by subtracting the current liabilities from the current assets.
NWC = Current assets — Current liabilities
The balance sheet of Corrie foundation provides the following information for June 30, 2008:
Current assets: $24,000 Current liabilities: $20,000 Calculate the working capital!
NWC = Current assets — Current liabilities NWC = $24,000 - $$20,000 NWC = $4,000
The current assets of Corrie foundation exceeded its current liabilities by $4,000 in June 30, 2008. In other words, Corrie foundation has a positive net working capital to weather an unforeseen financial crisis.
The net working capital and the current ratio (CR) serve the same purpose. The difference is that the NWC refers to an amount of cash or near-cash asset, whereas the CR is a ratio.
Quick (Acid-Test) Ratio
The acid-test or quick ratio or liquid ratio measures the ability of an organization to use its near cash or quick assets to immediately pay its current liabilities. A quick ratio of over 1:1 will enable an organization to pay back its current liabilities; whereas a company with quick assets lower than 1:1 cannot currently pay back its current liabilities.
Note that inventory is excluded from the sum of financial assets. Ratios are a financially viable option for business entities but the liquidity of the liabilities shows financial stability.
The higher the ratio, the greater the company's liquidity (i.e., the better able the company is to meet current obligations using liquid assets).
QR = (Current assets - inventory)/Current liabilities
The following information was found on Annie Foundation's balance sheet, December 31, 2007:
Current assets: $200,000 Inventory: $80,000 Current liabilities: $100,000 Calculate the quick ratio!
Quick ratio = ($200,000 - $80,000)/$100,000 QR = $120,000/$100,000 QR = $1.2
Annie Foundation has $1.2 of quick cash for every dollar it owes. Ideally, the quick ratio should be 1:1. A quick ratio higher than 1:1 indicates that the business can meet its current financial obligations with the available quick funds on hand. A quick ratio lower than 1:1 may indicate that the company relies too much on inventory or other assets to pay its short-term liabilities. Many lenders are interested in this ratio because it does not include inventory, which may or may not be easily converted into cash.