An important thing to remember about finance is that numbers, any numbers at all, mean absolutely nothing without a context.
For example, if an organization’s profit was $100,000 last year, there's really only one thing known: it didn’t have a deficit. It isn’t known if the business did well or poorly, if it grew or stabilized, if its operation was efficient or not, if it made as much as its competitors or less. In order to know more about what the $100,000 profit means, there must be more context.
Context is provided by other financial information with which comparisons can be made. Comparisons and ratios (the relationship between one number and another) are the way meaning is made. So, if the organization knows that its profit was $100,000 this year and just $25,000 the year before, the $100,000 figure becomes more meaningful.
The more comparisons there are, the more context is available in which to extract more meaning from the numbers. For example, if we also know that three years ago the company made $400,000 and that this year a peer company made $300,000, then we'd really start to understand what the $100,000 number means. We could extrapolate that something happened in the company last year that it may be recovering from, but if it doesn't recover quickly, the competition may outpace it.
Most nonprofits use basic comparisons in their review of financial information: did we make more money this year than last? Did we grow this year (were our numbers overall bigger than they were last year)? Did we spend less than we made? These are extremely useful questions and comparisons, but clearly address a very specific time period: that of one year’s business. What about shorter or longer time periods? The same questions still apply, but are they the best ones to ask?
Unfortunately, many organizations miss some of the most meaningful questions in relation to their finances: those that make comparisons to other similar organizations - similar in size, in geographical location, and in program of work (mission). Comparing the organization with others of a similar nature enables the organization to see if it's operating within the industry standards, which, by the way, is what major funders do when considering support for the organization.
One way to compare with others in the same industry is to look at the relationships between line items in the budget, or the ratios. Ratios are the relationship between two numbers. There are standard ratios operating in the nonprofit’s industry that its leadership may or may not be aware of. For example, a nonprofit’s general and administrative costs (G&A) should be approximately 20 percent of total expenses, as compared to program costs, which make up the remaining 80 percent. This ratio demonstrates that there is enough capacity to support the program. Deviating much from this ratio isn't a good idea for the organization’s fiscal health. If G&A moves above the 20 percent, it can indicate that the organization is inefficient and/or is not putting the appropriate emphasis on mission-specific activities. On the other hand, if G&A dips too far below the 20 percent, it can indicate that it is overburdening its staff and/or cutting corners that may jeopardize the organization's future.
Knowing the ratios that are standard to the nonprofit industry as a whole, but also to the organization’s particular business (ballet company, private school, dental clinic, land trust, etc.) is part of learning how to evaluate its financial health. When a nonprofit business considers ratios, it will want to consider both the nonprofit industry standards, as well as those of the particular industry it works within. An opera company is both a nonprofit and an arts organization; a dental clinic is a nonprofit but is in the health industry as opposed to the arts and will have different ratios as a result. Other factors to consider in evaluating ratios include geography (cost of living varies greatly and will impact ratios), organizational size and maturity, among others.
A problem with leaving analysis of your nonprofit's financials to those without industry-specific knowledge (for example, the treasurer of a ballet company is a CPA, but works only with banks and mortgage companies) is that they may be evaluating your business using standards from another industry. And not only is it a good idea for the nonprofit's finance professionals to become aware of the organization's standards, this also holds true for the board. Too many boards give cursory review of the financial statements, looking only at the bottom line and performance against last year.
So, how do you determine what standards will be useful in evaluating your nonprofit's financials? Both associations and funding organizations (such as foundations) are usually well-versed in this area. Setting up a meeting with your local nonprofit association, your mission-specific association, and/or a foundation can be very instructive. There are also national organizations (such as GuideStar) that offer excellent resources on this.
The questions that are asked by the nonprofit about its finances and the comparisons that are made—in other words, the context—are the key to making meaning out of the numbers. This too turns the financials into a powerful tool for the effective management of the nonprofit organization. There is no fixed answer applicable to all organizations when evaluating financials. But becoming aware of the complexity of the context and learning what standards and factors are most relevant to your nonprofit is a mark of institutional maturity and stability.
Nonprofit-KnowHow addresses key concepts on finance in the nonprofit world.