 # SOLVENCY

Solvency or leverage is the ability to pay all debts if the business were sold tomorrow. Solvency is different from liquidity because it deals with the long-term ability of an organization to continue to exist and expand. The debt ratio and the debt-to-equity ratio are two common measures of organizational solvency.

## Debt Ratio

The debt ratio is used to measure the ability to pay all debts if the organization was sold tomorrow. It is calculated by dividing the total liabilities by the total assets. The debt ratio calculates the long-term solvency of a company. The total debt ratio should be 1.0 or less. A company with a high debt ratio is in danger of becoming insolvent, and risks going bankrupt.

Debt ratio = Total liabilities/Total assets

Example:

The following information was found on the Christine Center balance sheet, December 31,2008.

Liabilities: \$100,000 Assets: \$200,000

Calculate the debt ratio!

Solution:

Debt ratio = \$100,000/\$200,000 = 0.50 or 50%

Interpretation:

Fifty percent of Christine Center assets have been financed by debt.

## Debt-to-Equity (Fund Balance) Ratio

The debt-to-equity ratio (DER) measures the proportion of long-term debt to common equity or fund balance. Example:

The following information was found on the B-Mart Foundation balance sheet, December 31,2006.

Liabilities: \$250,000

Fund balance or equity: \$100,000

Calculate the debt-to-equity (fund balance) ratio.

Solution:

DER = \$250,000/\$100,000 DER = 2.5 or 250%

Interpretation:

B-Mart Foundation has \$2.50 cents of debt and only \$1.00 in equity to meet this obligation. Or

for every dollar of equity financing, B-Mart Foundation uses \$2.50 of long-term debt or

B-Mart Foundation owes \$2.50 for every dollar it owns.

# EFFICIENCY

Efficiency is the ability of an organization to deliver the maximum service possible with the lowest amount of human, material, and financial resources. The asset turnover ratio is an example of efficiency measure. Other nonconventional measures, such as the percentage of change, the growth ratio, the common size ratios, and the fund mix ratio can provide valuable information to analyze trends and the efficiency of an organization.

## Asset Turnover Ratio

The asset turnover ratio (ATR) measures the productivity of an organization, which is how much income or revenue was generated from assets employed. The formula used to calculate asset turnover is the total revenue divided by average total assets. The amount of average total assets is calculated by adding the values of total assets in the beginning of the year to the values of total assets at the end of the fiscal period, then dividing the number obtained by 2.

ATR = Total revenues/Average total assets

Example:

Consider the following information from the balance sheet and income statement of the ABC community foundation.

Total revenue: \$4,000,000

Total assets, beginning of fiscal year: \$3,000,000 Total assets, end of fiscal year: \$2,000,000

Step 1:

Average total assets = (\$3,000,000 + \$2,000,000)/2 Average total assets = \$2,500,000

Step 2:

Asset turnover ratio = \$4,000,000/\$2,500,000 Asset turnover ratio = \$1.6

Interpretation:

For every \$1 of assets employed, ABC community foundation generates \$1.6 of revenue. The asset turnover ratio is compared to ratios of other organizations of similar size. Percentage change: Percentage change is the calculation of the percentage of change from 1 year to another in line items of financial statements (balance sheet, income statement, statement of cash flow).

# RULES TO CALCULATE PERCENTAGE CHANGE

1. Calculate the difference between the number for period "A" (most recent period) and the number for period "B" (preceding period).

2. Divide the difference by the number for period "B."

3. Multiply the result by 100.

Example:

The balance sheet of B-Mart Foundation for 2009 and 2010 reflect the following cash information:

 2009 2010 Cash \$50,000 \$40,000

What is the percentage change from 2009 to 2010?

Solution:

1. Calculate the difference between the number for period "A" and the number for period "B."

"A" - "B" = \$50,000 - \$40,000 = \$10,000 Divide the difference by the number for period "A."

\$10,000/\$40,000 = 0.25

Multiply the result by 100.

0.25 X 100 = 25%

Interpretation:

From 2009 to 2010, B-Mart Foundation has recorded a 25% increase in cash.

Growth ratio (GR): The growth ratio measures the percentage of change in the fund balance of a nonprofit organization. The growth ratio indicates the financial growth of a nonprofit organization over time.

Common size ratios (CSR): Common size ratios are used to compare trends in financial statements of an organization over time or to compare the financial situations of various organizations with similar profiles. The common size ratio for a line item is calculated by dividing the item of interest by the reference item.

For assets: Common size = Asset of interest / Total assets

Example:

Cash : \$4,135 Total assets: \$18,056 Calculate the common size ratio for cash!

Solution:

Common size cash = \$4,135/\$18,056 = 0.23 Multiplied by 100

Common size cash = \$4,135/\$18,056 = 23%

For liabilities: Common size = Liabilities of interest/Total liabilities and fund balance

Example:

Accounts payable: \$1,553

Total liabilities and fund balance: \$18,056

Calculate common size ratio for accounts payable!

Solution:

Common size ratio for accounts payable = \$1,553/\$18,056 =0.09 Multiplied by 100

Common size accounts payable = 9%

For income or revenue: Common size = Income of interest/Total income or revenue

Example:

Cost of goods sold: \$2,000 Operating expenses: \$100 Total revenue: \$2,400

Calculate common size ratio for cost of goods sold, then for operating expenses!

Solution:

Common size cost of goods sold = \$2,000/\$2,400 =0.833 Multiplied by 100

Common size cost of goods sold = 83.3%

Common size operating expenses = \$100/\$2,400 = 0.042

Multiplied by 100

Common size operating expenses = 4.2%

TABLE 10.1 Sample Comparative Balance Sheet and Comparative Common Size Balance Sheet

 Assets 2002 (in U.S. Dollars) Percentage (%) 2003 (in U.S. Dollars) Percentage (%) Current assets Cash 4,135 23 5,347 29 Accounts receivable 1,661 9 1,188 6 Inventory 2,546 14 2,674 14 Grants receivable 1,950 11 1,114 6 Total current assets 10, 292 57 10,323 56 Long-term assets Land building and equipment 6,283 35 7,074 38 Vehicle 1,481 8 1,170 6 Total long-term assets 7,764 43 8,244 44 Total assets 18,056 100 18,567 100 Liabilities and fund balance Current liabilities Accounts payable 1,553 9 2,432 13 Notes payable 1,228 7 1,318 7 Acquisition contracts 11,935 66 6,202 33 Total current liabilities 14,716 82 9,952 54 Long-term liabilities Notes payable 5,543 31 1,504 8 Deferred credits 36 0 0 Total long-term liabilities 5,579 31 1,504 8 Total liabilities 20,295 112 11,456 62 Fund balance -2,239 -12 7,111 38 Total liabilities and fund balance 18,056 100 18,567 100

TABLE 10.2 Sample Comparative Income Statement and Comparative Common-Size Income Statement

 2008 (in U.S. Dollars) Percentage (%) 2007 (in U.S. Dollars) Percentage (%) Net sales 2 400 100.0 1800 100.0 Cost of goods sold 2 000 83.3 1400 77.8 Gross margin on sales 400 16.7 400 22.2 Operating expenses 100 4.2 80 4.4 Net income 300 12.5 320 17.8

## Fund Mix Ratio

Nonprofit organizations use different types of funds, which include, but are not limited to:

- Current unrestricted funds or undesignated funds: All funds that can be spent at the discretion of the administration and the board of the organization.

- Current restricted funds or designated funds: Funds that must be spent only for the specific purpose designated by a donor (individual, corporation, or government). These funds cannot be reallocated for nondesignated purposes regardless of the financial needs within an organization.

The FMR measures the level of flexibility that an organization has to make fund reallocation decisions. The FMR is calculated by dividing the amount of unrestricted funds by the total

assets.

FMR = Unrestricted funds/Total assets

Example:

The United Way of Oshkosh balance sheet provides the following information for December 31,1999:

Total assets: \$800,000 Unrestricted funds: \$100,000 Calculate the fund mix ratio!

Solution:

FMR = Unrestricted funds/Total assets FMR = \$100,000/\$800,000 FMR = 0.125 Multiplied by 100 FMR = 12.5%

Interpretation:

Only 12.5% of United Way of Oshkosh funds are available for reallocation. This ratio indicates a very small level of flexibility, depending on the size of an organization and the standard in comparison to other organizations of the same size.

# EFFECTIVENESS

Effectiveness is the ability to manage the resources and programs to fulfill the mission and vision of an organization. Effectiveness can be measured through the program emphasis ratio.

Program emphasis ratio (PER): The program emphasis ratio measures the proportion of its income or revenue that a nonprofit organization spent on program support. It is calculated by dividing the cumulating of expenditures on management and fund-raising by the total income or revenue. There is a common agreement among stakeholders of non-profit organizations, that NPOs should spend at least 65% of their resources on program support expenditures.

PER = 100% — [(Management + Fund-raising)/Total income]

Example:

Oshkosh Historical Foundation (OHF) income statement for the year ended December 31, 2004:

Total management: \$75,000

Fund-raising: \$15,000

Total income: \$450,000

Calculate the program emphasis ratio!

PER = 100% — [(Management + Fund-raising)/Total income] PER = 100% - [(\$75,000 + \$15,000) / \$450,000] PER = 0.80 Multiplied by 100

PER = 80%

Interpretation:

OHF spent 80% of its income on program support expenditures. 