Understanding Nonprofit Finance

Introduction

Nonprofit financial management is one of the most critical aspects of a board’s responsibilities. Ensuring the financial health of an organization is essential for long-term sustainability, fulfilling the mission, and providing valuable services to the community.

Nonprofits are Businesses Too

While nonprofits differ from for-profit businesses in their mission, they still operate within a business framework. Just like a business, nonprofits must generate more revenue than expenses to sustain themselves. In nonprofit accounting, the term "net assets" is used instead of "surplus" to describe the funds that remain after expenses are subtracted from revenue. Building net assets is critical for:

• Growing the organization and keeping facilities and equipment updated,

• Appropriately compensating staff to attract and retain talent,

• Being nimble and ready to seize new opportunities as they arise.

A healthy financial position allows leadership to focus on mission-critical programs instead of spending excessive time on fundraising or worrying about cash flow.

Nonprofit Board Members: Serious Responsibilities for Volunteers

It’s important to remember that nonprofit board members are volunteers—they are not paid. However, even volunteer service comes with serious (and sometimes very technical) responsibilities. Board members must understand that nonprofit tax status is not an invitation to run deficits. Nonprofits, like any other organization, cannot spend money they don’t have.

Being on a nonprofit board requires more than just attending meetings; it requires courage to make tough decisions, navigate financial challenges, and ensure that the organization adapts and evolves. Even historically significant or prestigious organizations must not rest on their laurels—they need to continuously innovate to remain relevant and impactful.

Key Nonprofit Financial Statements

Nonprofit financial statements use different terminology than those in the for-profit sector. Understanding these key documents is essential for effective oversight:

• Statement of Financial Position (equivalent to a balance sheet): This provides an overview of assets, liabilities, and net assets (equity).

• Statement of Activities (equivalent to an income statement): It shows revenue, expenses, and changes in net assets over a specific period.

• Statement of Cash Flows (equivalent to a cash flow statement): This tracks how cash moves in and out of the organization.

These documents help board members assess the organization’s financial health and identify potential risks.

Diversifying Revenue Streams

A core principle of finance, whether for nonprofit or for-profit organizations, is diversification. Relying on a single funding source can leave an organization vulnerable to unexpected changes. By diversifying revenue streams, organizations can mitigate risk and ensure a more stable financial foundation. In a nonprofit, these revenue sources may include:

• Donations from individuals, foundations, and corporations,

• Grants from government sources,

• Program and service fees, and

• Income from endowments or investments.

This variety of revenue streams ensures that the organization is not overly reliant on any one source of income, thereby increasing financial resilience.

Budgeting and Financial Planning

Effective budgeting is a key aspect of nonprofit financial management. The budget is not just a projection of income and expenses, but a tool that ensures the organization is using its resources in alignment with its mission.

Budgeting for depreciation is particularly important but often overlooked. Nonprofits should set aside funds for the depreciation of assets such as buildings and equipment to maintain their facilities. A working capital fund is a typical tool used for this purpose, helping nonprofits ensure they can reinvest in infrastructure without facing the financial strain of deferred maintenance.

Capital Project Pledges: Managing Risk and Timing

Pledges are a critical component of nonprofit fundraising, especially for capital projects, but they come with significant financial management challenges. When a pledge is made, it must be booked as revenue by the nonprofit. However, pledges are often paid over several years—typically 5 to 7 years—and this means that cash isn’t immediately in hand. Managing the timing of pledges versus actual cash flow is essential to avoid financial strain.

During the interim, nonprofits may need to take out loans to cover immediate expenses, such as construction costs or other capital expenditures. This can be risky, as nonprofits rely on the expectation that pledges will be fulfilled over time. If financial markets take a downturn during this period, the organization might face higher borrowing costs, delayed pledge payments, or even defaulted pledges. This mismatch between booked pledges and realized cash can be devastating if not carefully managed.

Nonprofit boards must ensure that rigorous financial planning is in place to account for these risks. It’s vital to avoid overcommitting to projects based solely on pledges, and to have contingency plans in place, such as identifying alternative funding sources or delaying capital expenditures if necessary.

Systems for Third-Party Accountability

Maintaining strong third-party accountability systems is essential for nonprofit transparency and trust. These systems include:

• Form 990 filings: Required by the IRS, Form 990 offers transparency into a nonprofit’s financial activities.

• A-133 Audits: Necessary for nonprofits receiving government grants, this audit ensures proper use of federal funds.

• Bonds reporting and covenant compliance: For organizations using bonds, this helps track adherence to financial agreements.

• Local government regulations: Nonprofits must adhere to various local rules and regulations governing their operations.

In addition to these formal systems, accountability through good governance is critical. Board members are responsible for disclosing conflicts of interest, or even circumstances that could be perceived as such, to avoid any potential bias or inappropriate influence. Transparency in governance builds trust and ensures ethical decision-making within the organization.

These accountability systems not only ensure compliance but also build trust with stakeholders, donors, and the public.

When Tough Decisions Must Be Made: Closing, Merging, or Partnering

Sometimes, a nonprofit may struggle despite best efforts to improve its financial health. In these situations, board members must confront difficult decisions, including closing, merging, or partnering with another organization. This is often hard for nonprofit boards to face, but it’s a necessary part of responsible governance.

A for-profit company that is consistently bleeding money would not be tolerated by its board for long, and the same standard should apply in the nonprofit sector. If a nonprofit cannot sustain its mission, leadership must consider options that protect the organization’s resources and legacy, which may involve merging with a more stable organization, forming strategic partnerships, or even winding down operations.

Solutions Nonprofits Can Use to Achieve Strong Financial Results

To ensure strong financial performance, nonprofits can employ several strategies:

• Effective Use of Budgeting and Financial Tools: By utilizing robust budgeting tools, financial forecasting, and reporting software, nonprofits can more accurately track expenses, revenue, and financial trends. These tools allow organizations to anticipate challenges and adjust their strategies proactively.

• More Comprehensive Understanding of Finance Operations: Nonprofit leaders and board members should deepen their understanding of financial operations. This includes knowing how funds are allocated, understanding key financial metrics, and having clear policies around financial governance. This ensures that financial decisions are informed and aligned with the organization's mission.

• Strengthen Collaborative Relationships: Building strong relationships between departments—especially finance, program, and development teams—ensures that everyone is aligned on financial goals. Collaboration leads to better decision-making and ensures that resources are allocated in ways that support both short-term needs and long-term sustainability.

Final Thoughts

Board members play a vital role in the financial health of nonprofits. From ensuring a diverse revenue base to understanding financial statements, making tough decisions about sustainability, and maintaining third-party accountability, board members must actively engage in overseeing the organization’s financial activities. By implementing effective budgeting tools, deepening financial understanding, and fostering collaboration, nonprofits can achieve strong financial results and remain mission-driven for the long term.