Acting as a financial analyst, what questions woul...

Acting as a financial analyst, what questions would you ask Valley of the Sun United Way’s CFO regarding the changes in the organization’s financial statements over the years? Why is it important that you ask financial questions of the organization?

 

 

Question 2 – Use at least four financial ratios as performance measures of the organization. Refer to Ch. 5 of Financial Management for Human Service Administrators

 

 

C H A P T E R

5 Financial Analysis

The previous two chapters provided a basic introduction to financial statements,

accounting, and double entry bookkeeping. Now we are going to discuss how the

information contained in financial statements can be used to assess the financial

condition of human service agencies. As was the case in the past two chapters, the

focus here is again on the analysis of financial statements of private nonprofit

human service agencies.

Financial Analysis Ratios

Financial analysis can be defined as the process of using the information provided

by financial statements to calculate financial ratios that assess the financial condition

of human service agencies (Hertzlinger & Rittenhouse, 1994:133). The use of

financial analysis in business has been a common practice for nearly a century

(Hairston, 1985). The applicability of financial analysis to private nonprofit human

service agencies has long been advocated (e.g., Hairston, 1985; Hall, 1982; Lohman,

1980). Unfortunately, financial analysis still has yet to catch on as a working concept

in most private nonprofit human service agencies. This state of affairs is

unfortunate because the use of financial analysis can provide insights into the

financial condition of human service agencies that might not otherwise be noted.

Financial analysis should not be confused with the computation of unit of service

costs. Unit of service costs are different and are discussed in Chapter 7.

A multiplicity of financial ratios are available for use in assessing the financial

condition of human service agencies. In a meta analysis, Kennedy (1996) identified

more than twenty financial ratios advocated by one or more authoritative

sources (e.g., Dalsimer, 1995; Elkin & Molitor, 1985; Hall, 1982; McMillan, 1994).

From this rather large collection, seven basic financial ratios are selected that are

believed to be particularly relevant for private nonprofit human service agencies:

(1) the current ratio, (2) the long-term solvency ratio, (3) the contribution ratio,

(4) the programs/expense ratio, (5) the general and management/expense ratio,

(6) the fund-raising/expense ratio, and (7) the revenue/expense ratio.

55

 

The Current Ratio

The current ratio is developed from the statement of financial position (or the balance

sheet) using the formula

Current assets

Current ratio =

Current liabilities

The purpose of the current ratio is to assess a private nonprofit human service

agency’s liquidity. Liquidity means the extent to which the agency has cash

and other assets readily convertible into cash to cover current operating expenses.

As noted in Chapter 4, current (short-term) assets are generally composed of cash

and accounts receivable, short-term investments, and any other asset that can be

converted into cash within one year. Current (short-term) liabilities are expenses

that are currently due or will come due in one year or less.

In terms of interpretation, the current ratio should be at least 1.0, but in general

the higher the ratio the better. If the current ratio is less than 1.0, the human service

agency may be facing liquidity problems.

The Long-Term Solvency Ratio

The long-term solvency ratio is also developed from the statement of financial

position (or the balance sheet), but uses a different formula:

Total assets

Long-term solvency ratio =

Total liabilities

The purpose of the long-term solvency ratio is to assess the ability of a private

nonprofit human service agency to pay annual expenses as they come due. Another

way of phrasing this is to say that the long-term solvency ratio, as its name implies,

assesses the long-range financial solvency of a private nonprofit human service

agency. Total assets include both current (short-term) assets and noncurrent (longterm)

assets; total liabilities include both current (short-term) liabilities and noncurrent

(long-term) liabilities.

In terms of interpretation, the long-term solvency ratio should be at least 1.0;

but as a general rule, the higher the ratio the better. If the long-term solvency ratio

of a human service agency is significantly less than 1.0, the financial viability of the

organization may be in question.

The question might well be asked, Why does an agency need to compute

both the current ratio and the long-term solvency ratio? Don’t these two ratios say

essentially the same thing?

The answer is not really. A private nonprofit human service agency can be

asset rich and cash poor or cash rich and asset poor. For example, an agency could

have significant current assets (as measured by a current ratio greater than 1.0), but

have more total liabilities than total assets (as measured by a long-term solvency

ratio of less than 1.0). Vice versa, a private nonprofit human service agency could

also have more total assets than total liabilities (as measured by a long-term solvency

ratio greater than 1.0), but have real liquidity problems (as measured by a

current ratio of less than 1.0). In this latter case, a long-term investment (e.g., a

long-term certificate of deposit) might have to be converted to cash in order to

meet the cash flow needs of the agency. The combination of the current ratio and

the long-term solvency ratio provide complementary short-term and long-term

views of the financial condition of a private nonprofit human service agency.

The Contribution Ratio

The contribution ratio is developed from the statement of activities (or the profit

and loss summary) using the formula

Largest revenue source

Contribution ratio =

Total revenues

The purpose of the contribution ratio is to assess the agency’s dependency on

its major revenue source. Revenue from the agency’s largest revenue source is

divided by total revenues to determine the proportion of agency revenues that

come from this one source.

As a general rule, the more revenue sources a private nonprofit human service

agency has (the more diversified it is) the better, because the agency is not

overly dependent on any one particular revenue source. Consequently, in terms of

interpretation, the lower the contribution ratio the better. If the contribution ratio

of a human service agency is .5 or greater, the agency is disproportionately dependent

upon that one revenue source. If anything happens to that one revenue source

(e.g., a government contract is canceled or a foundation grant is not renewed), the

financial viability of the agency may be in serious question.

The Programs/Expense Ratio

The programs/expense ratio is developed from the statement of activities using

the formula

Total program expenses

Programs/Expense ratio =

Total expenses

The programs/expense ratio is one of several standards adopted by the

National Charities Information Bureau (NCIB, 1998). The purpose of the NCIB’s

standards is to provide information about private nonprofit organizations that

can be used by donors to make more informed decisions. The NCIB certifies nonprofit

organizations as either “meeting” or “not meeting” its standards. The NCIB

standard for the programs/expense ratio is a minimum ratio of .6. In terms of

interpretation, the programs/expense ratio standard means that a private nonprofit

human service agency should spend a minimum of 60 percent of its total

 

expenses for programs. The NCIB adds the caveat that “greater flexibility” should

be demonstrated in applying this standard to private nonprofit organizations that

are less than three years old or that have total annual expenses of less than $100,000.

The General and Management/Expense Ratio

The general and management/expense ratio is also developed from the statement

of activities using the formula

Total general and

management expenses

General and management/Expense ratio =

Total expenses

The purpose of the general and management/expense ratio is to determine

the proportion of agency expenses that go toward the administration of a private

nonprofit human service agency. Every dollar that goes for administration means

that one dollar less is available for programs and to provide services to clients.

In terms of interpretation, the general and management/expense ratio can be

thought of as a measure of the management efficiency of a human service agency.

Borrowing on a similar ratio standard suggested by Dalsimer (1995:17), a general

and management/expense ratio greater than .35 should be cause for some concern.

Aprivate nonprofit human service agency with a general and management/expense

ratio greater than .35 should probably start thinking about ways of reducing administrative

costs.

The Fund-Raising/Expense Ratio

The fund-raising/expense ratio is likewise developed from the statement of activities

using the formula

Total fund-raising expenses

Fund-raising/Expense ratio =

Total expenses

The purpose of the fund-raising/expense ratio is to determine the proportion

of agency expenses that go toward the various fund-raising activities conducted by

a private nonprofit human service agency. As is the case with general and management

expenses, every dollar that goes toward fund-raising means that one dollar

less is available for programs and to serve clients.

In terms of interpretation, the fund-raising/expense ratio can be thought of

as a measure of the efficiency of agency fund-raising activities. Again, borrowing

on a similar ratio standard suggested by Dalsimer (1995:17), a fund-raising/

expense ratio greater than .15 should be cause for some concern. If the fundraising/

expense ratio is greater than .15, the human service agency might want to

consider changing its approach to fund-raising. Adifferent approach might generate

more funds while also lowering fund-raising costs.

58

 

The Revenue/Expense Ratio

The revenue/expense ratio is developed from the statement of activities (or the

profit and loss summary) using the formula

Total revenues

Revenue/Expense ratio =

Total expenses

The purpose of the revenue/expense ratio is to determine if a human service

agency is breaking even, making money, or losing money. The revenue/expense

ratio can be thought of as the agency’s “profit margin.” As was discussed earlier,

private nonprofit agencies are not in business to make a profit; neither, however,

are they in business to lose money. Aprivate nonprofit human service agency that

loses money over several years may wind up ceasing to exist. Some financial management

experts suggest that all private nonprofit organizations should strive to

make a profit (to have an excess of revenue over expense) each year in order to help

replace worn-out equipment, help finance expansion, and protect again unforeseen

future occurrences (e.g., a decline in donations, the loss of a government contract

or foundation grant) (Hertzlinger & Rittenhouse, 1994:152).

In terms of interpretation, the revenue/expense ratio should be at least 1.0,

meaning that revenues and expenses are equal. If we follow the advice of Hertzlinger

and Rittenhouse, the revenue/expense ratio should be greater than 1.0 in

order for a human service agency to develop a contingency fund. While no exact

cutoff point exists, the revenue/expense ratio should not be inordinately high.

While a high revenue/expense ration means that a human service agency has been

successful in putting funds aside for the future, it also means that the agency is not

currently providing as much service or serving as many clients as it could.

Monitoring Ratios over Time

In addition to applying financial analysis to the financial statements of a private

nonprofit human service agency for a particular fiscal year, the financial ratios

themselves can be monitored over time (multiple fiscal years). By doing so, changes

in the financial condition of a private nonprofit human service agency can be

observed. In looking at the financial ratios over time, the objective is to discern the

relative status of each individual financial ratio (is it improving, deteriorating, or

staying the same?) as well as the overall financial condition of the agency (is it

improving, deteriorating, or staying the same?).

Table 5.1 presents financial ratio data developed from the financial statements

of the Denver Child Guidance Center for five fiscal years. Let’s look at what

the financial ratios can tell us about the overall financial condition of the agency.

All of the financial ratios depicted in Table 5.1 are moving in the preferred

directions. Liquidity, as measured by the current ratio (current assets/current liabilities)

has steadily improved. In FY00 the current ratio is .9, meaning that the

 

 

60 C H A P T E R 5

TABLE 5.1 Denver Child Guidance Center

Comparative Financial Ratios

Fiscal Years (FY) 2000–2004

 

FY00

FY01

FY02

FY03

Current ratio

.90

1.00

1.10

1.15

Long-Term Solvency ratio

1.20

1.24

1.28

1.30

Contribution ratio

.70

.60

.50

.47

Programs/expense ratio

.50

.55

.59

.62

General and management/ expense ratio

.30

.27

.26

.24

Funding-raising / expense ratio

.20

.18

.15

.14

Revenue / expense ration

1.05

1.02

1.10

.95

 

 

agency has more current liabilities than current assets. Fortunately in FY00, the

agency has sufficient other assets to handle its liquidity problems (i.e., the longterm

solvency ratio for FY00 is 1.20). The long-term solvency ratio is greater than

1.0 in all years and has steadily increased to a healthy 1.31 in FY04. The contribution

ratio (revenues from the largest funding source/total revenues) is .70 is FY00,

meaning that the agency is overly dependent on one particular funding source.

The contribution ratio, however, declines over the five-year period, which indicates

that agency management is taking positive steps to diversify its revenue base.

The programs/expense ratio is low in FY00 at .50 and violates the minimum

standard of .6 set by the National Charities Information Bureau. Agency management,

however, is taking aggressive steps to improve the situation so the programs/

expense ratio increases to an acceptable level of .62 in FY03 and rises still further to

.65 in FY04. Since the sum of the programs/expense ratio, the general and management/

expense ratio, and the fund-raising/expense ratio for any given year equals

1.0, an increase in the programs/expense ratio means that one or both of the other

two ratios are declining. In FY00, both the general and management/expense ratio

and the fund-raising/expense ratio are high; the later ratio (.20) being greater than

the standard of .15. Again, however, agency management is taking aggressive steps

to bring their administrative costs and fund-raising costs under control as evidenced

by the gradual decline in the general and managment/expense ratio to .22 in FY04

and a commensurate decline in the fund-raising/expense ratio to .13 in FY04.

 

The revenue/expense ratio jumps around somewhat as might be expected. In

FY00, FY01, FY02, and FY04 the revenue/expense ratio is greater than 1.0, meaning

the agency made a “profit.” However, in FY03, the ratio is .95, which means that

the agency had more expenses than income and might indicate that some of the

preceding years’ profit had to be put back into current operations.

The Denver Child Guidance Center represents a situation in which a private

nonprofit human service agency has serious financial problems that are highlighted

by financial analysis. Because the agency’s financial problems are

highlighted, agency management was able to take corrective action.

Summary

In this chapter, we looked at the use of financial analysis as a tool in the assessment

of the financial condition of private nonprofit human service agencies. Seven different

ratios were introduced and discussed. The suggestion was made that the use

of these seven ratios provides a good basic overview of a human services agency’s

financial condition. The suggestion was also made that the monitoring of these

seven ratios over time provides a method of assessing the direction and degree of

change in the financial condition of private nonprofit human service agencies.

 

 

 

Financial Management for Human Services Administrators, by Lawrence, L. Martin. Pulished by Allyn & Bacon. Copy right 2001 by Allyn & Bacon.

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