Financial ratios and benchmarks can be used to assess the financial health of your nonprofit. These ratios and benchmarks can help management make decisions regarding organizational strategy and budgeting and, ultimately, help your nonprofit manage its resources. This financial data can also help donors or grantors determine whether to support your nonprofit.
Although there are many financial ratios and benchmarks that can be used to evaluate financial health, we’re going to focus on three important ratios your nonprofit must know.
Please note that these are just a few financial ratios and benchmarks, which should be used in conjunction with other indicators for a complete financial analysis of your nonprofit. It is worth noting that there is a new accounting standard that changes how net assets are categorized. The new standard replaces “unrestricted net assets” with “net assets without donor restrictions.”
1. Operating Reserve Ratio
One of the most widely used benchmarks is the operating reserve ratio. The operating reserve ratio is an organizational security and liquidity ratio. It essentially indicates how long an entity can continue its operations without any revenue coming in to fund the operations. It can be stated in a percentage or in number of months. A common way to calculate the operating reserve ratio is as follows:
Net assets without restrictions or i.e. unrestricted net assets - (fixed assets - debt related to fixed assets)
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Annual expenses - depreciation and amortization
In order to convert the operating reserve ratio into the number of months that the entity can sustain operations without any revenue, simply multiply the result by 12 months. A high operating reserve ratio (for example, maybe a ratio of 100% or 12 months for an organization funded by a reliable source of revenue) may indicate that the organization is in good financial shape. However, a high operating reserve ratio could also indicate that the organization may be losing other opportunities to further its mission.
2. Program Expense Ratio
The program expense ratio provides information on how much of an organization’s expenses are being spent on programs versus supporting services, such as management, general or fundraising expenses. This ratio is affected by numerous factors for each organization, such as revenue sources, cost allocation methodologies, locations, size and activities. The program expense ratio is calculated as follows:
Total program expenses
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Total expenses
Many charity watchdogs use this ratio. While you would think a high program expense ratio would be great (for example, maybe 90% for some organizations that are not administered by volunteers) – since the nonprofit is putting many resources into its programs – it can indicate that an organization may not be investing in its infrastructure to help sustain itself, handle growth or attract the resources to continue investing in its mission and programs at the same rate in the future.
3. Profit Margin Ratio
In the nonprofit world, making a “profit” is essentially the process of increasing net assets without donor restrictions (or increase in unrestricted net assets). The profit margin is a ratio that can be used to measure this. It essentially indicates whether the organization is earning or receiving more than it is spending on operations. The ratio is calculated as follows:
Change in net assets without donor restrictions or change in unrestricted net assets
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Total revenue and support without donor restrictions or total unrestricted revenue and support
The target profit margin would depend greatly on the organization’s nature, size, and goals and is generally determined during the organization’s budget process. Generally, an organization would want a positive profit margin, which most likely indicates the organization is doing well, generating revenues and cash flow, adding to its reserves or using its resources appropriately.
An excessively high profit margin may indicate to members that dues are too high and could be lowered or may discourage donors from giving because the organization “has too much money.” An example may be an organization with a large endowment that funds about 75% of its operations. If the profit margin of the organization is 50%, donors may direct their contributions to other organizations to support because it may not appear that this organization would need or even use their contribution. A negative “profit” margin in a nonprofit is also generally not good. Despite this, there are cases where an organization may plan on a negative profit margin, depending on the organization’s strategy.
An organization may have planned to use some of its reserves for a project it has been saving for, to correct reserves that the nonprofit has determined are too high, or even an emergency, such as a natural disaster. These are all cases where an organization may have a negative change in net assets without donor restrictions (i.e., change in unrestricted net assets) where it is in line with the organization’s strategy and mission.
Financial Benchmarks
Now that we have discussed some common financial ratios, you’re probably wondering what the benchmarks are for these ratios. The answer is that it depends on your individual organization.
Every organization is different and has different needs. For example, if your organization depends on contributions from individuals and is highly susceptible to changes in the economy, the operating reserve ratio target or benchmark would probably be higher than an organization funded by membership dues with a steady membership. A 501(c)(3) organization may be more concerned with your program expense ratio than a 501(c)(6) organization.
In addition, the source of revenue could impact the target ratio. For example, a 501(c)(3) organization funded with individual contributions may have more fundraising expenses and a different target or benchmark than a 501(c)(3) organization funded primarily through government grants.
Although a higher operating reserve ratio, program expense ratio and “profit” margin are generally good goals and preferred, it is not always the case (and if it is the case, the organization may want to explain its strategy in its reports). If your organization is efficiently and effectively balancing its resources, it will most likely maximize how it furthers its mission and would generally be considered a healthy nonprofit.
A good goal for your nonprofit would be to identify a target range for each ratio and periodically reassess the target range to maximize how resources are used. To determine your organization’s target benchmark or goal, use a risk assessment, trend analysis or benchmarking with comparable organizations.
What Else Can I Do to Keep My Nonprofit Healthy?
If you need help determining target benchmarks or ranges for your organization, we’re happy to help. You can contact us online here.
