With so much beyond our understanding when it comes to the external economic situation, it can be reassuring to deepen our understanding of the internal financial situation of our own organizations. Equipped with insights regarding how a nonprofit is faring amid economic turmoil, leaders can be better prepared to respond knowledgeably and capably to any emerging financial challenges.

Acquiring a deep level of insight requires accurate and timely financial data. Every month, the management team should review the organization’s balance sheet and statements of operations and cash flow and compare these with the same statements from the prior year, as well as with the current budget. Study these documents to determine whether the organization is meeting its financial goals and to identify key differences and trends.

Financial ratios can be a valuable supplement to this analysis. While variations in accounting practices and operations can create wide differences in financial ratios when comparing one organization to another, they can be very useful when used as internal performance benchmarks to aid in management decision making. While the usefulness of specific ratios also varies from one organization to another, the following ratios can be helpful for many small and mid-size nonprofits struggling to address the impact of the recession on their operations.

Current ratio; current assets ÷ current liabilities

Surviving challenging economic times requires adequate cash. If the current ratio is declining, so too is the organization’s ability to generate cash. This could indicate your nonprofit may have trouble meeting financial obligations in the coming months and should be a signal for the management team to look into the causes of rising short-term debt and/or falling current assets.

Operating margin; (operating revenue – operating expense) ÷ operating revenue

Having a healthy operating margin can provide a nonprofit with some financial flexibility to manage through difficult times. Since low operating margins, on the other hand, may suggest greater vulnerability, it’s helpful to track the operating margin to flag any negative shifts. If the margin is falling, you might want to dig into the root causes of the deterioration. Certain projects or programs, for example, may be underperforming and you can use this as an opportunity to evaluate whether the organization is providing stakeholders with sufficient value.

Income reliance ratio; largest individual sources of income ÷ total income

This ratio can be used to measure an organization’s reliance on its top sources of income such as donations, programs, special events, product/service sales, etc. Generally, the larger the percentage of income from the fewer revenue sources, the greater an organization’s vulnerability to risk.

Calculating this ratio can be particularly helpful during the budgeting process, enabling management to identify major sources of funding and their associated risks, and to identify and quantify potential revenue shortfalls.

Personnel costs ratio; total wages, taxes, benefits ÷ total expenses

Since staffing is the largest expense for most nonprofits, monitoring this ratio can help the organization focus on controlling its highest cost. If personnel costs are rising, you should probe for explanations: does a new project account for the shift? Or is spending disproportionate?

Administrative expense ratio; total administrative expenses ÷ total expenses

Over the years, many prospective donors have tended to look for a low administrative expense ratio when determining a nonprofit’s donation-worthiness. Lower administrative costs, however, can contribute to an organization’s vulnerability since they often translate to fewer people resources with which to effectively operate the organization. And when administrative expenses are already low, there is less flexibility to adapt to financial stress by reducing costs.

It is important, however, to flag any significant changes to ensure your nonprofit has a healthy balance between “overhead” (such as rent and office and general expenses) and the direct costs of running the organization (such as project manager salaries and sub-contractor costs). This ratio can be very different from one nonprofit to another according to the programs they provide. The key to effectively managing these costs is to know the history of this balance and then to assess whether the current balance is healthy for the organization.

Program/service spending ratio; program/service expenses ÷ total expenses

This ratio calculates the amount of funds an organization spends on programs and services to fulfill its mission. While certain programs require more overhead to deliver, generally this ratio increases as an organization becomes more efficient. You should understand the inputs into the ratio and the impact of these inputs. A large new program, for example, could require additional overhead costs or perhaps a shifting of current costs to administer it, which could affect this ratio significantly for a particular period of time.

If the ratio is trending downward, you might consider studying each program individually – review its original budget as well as its effectiveness in achieving its purpose.

Program/service cost ratio; program expense ÷ number of units of service

This ratio measures the cost per unit of service delivered for each program or project, enabling management to identify changes in costs and financial efficiency. A significant increase in this ratio should serve as a trigger to review the viability of the program. For example, an association may evaluate a program on a cost per member basis and if the ratio continually climbs, it may not be practical to continue the program in its current state. Of course, any revenue generated by a program should be factored into your decisions.

Ratio of equity to expenditures; total equity ÷ total expenditures

Organizations with higher fund balances (equity) are less vulnerable to financial volatility. The management team might want to consider setting a specific target for this ratio so you are prepared to act if the ratio trends downward. While the ratio of equity to expenditures tends to vary according to the type of organization, a healthy ratio will enable a nonprofit to weather a sudden, temporary reduction in funding.

Obviously, changing circumstances can impact these ratios, such as building infrastructure, establishing new programs, launching a capital campaign. Thus for ratios to be reliable and helpful, they must be based on timely and complete financial information and should be tracked on a regular basis over time to point out trends, performance and progress.

While no organization is immune from economic volatility, consistent monitoring of financial ratios can help nonprofit leaders respond knowledgeably to financial challenges and allow the team to focus on achieving the organization’s mission.

Bob McMahon, CA, is a partner of BDO Dunwoody LLP. He provides auditing, accounting and advisory services to nonprofit, private and public organizations. You can reach Bob at (905) 270-7700 or bmcmahon@bdo.ca.