Using Effective Ratio Analysis at Nonprofits

By Sibi B. Thomas  |  May 29, 2018

Analyzing key ratios in your nonprofit’s financial statements can be a very useful tool for gaining deeper insight into the organization’s financial condition and evaluating its overall performance, even at the programmatic level. Effective ratio analysis can be used to analyze trends over a period of time, plan for future strategies and measure current financial health.

Since each nonprofit is unique and certain ratios can be more meaningful to some than others, it is important to identify which ratios are more relevant to your organization – and why. In this article we will discuss some effective ratio analysis tools that nonprofits should consider.

DAYS OUTSTANDING ON ACCOUNTS RECEIVABLE

This is an effective ratio used in the for-profit sector to calculate the average number of days it takes for customers to pay invoices. In the nonprofit sector, this ratio can be used to measure the average length of time it takes to collect cash from governmental agencies or other third-party payers after services are provided and billed. This ratio can be used to understand the timing of cashflow coming in to the organization and also identify any large old receivables that need to be written off or investigated further. The average number of days it takes to collect the cash can vary from organization to organization and also by program. It is important to understand the industry average to benchmark your organization’s days outstanding number.

The ratio is calculated as follows: Accounts Receivable / (Annual Revenue / 365 Days)

PAYROLL AND FRINGE BENEFITS ANALYSIS

Two key ratios that analyze payroll and fringe benefits are: Salary Expense Ratio (SER) by Program/Function and Fringe Benefits Ratio (FBR) by Program/Function. SER measures salary and fringe benefits in relation to total expenses. FBR measures fringe benefits (including payroll tax) in relation to total salaries. It is important to calculate ratios at the program level, as well as for the agency as a whole, and compare the ratios to prior years and peer agencies to ensure the organization is within the expected range. Organizations with a highly unionized workforce may have a higher FBR than others.

The ratios are calculated as follows:

SER – Total Salaries + Fringe Benefits / Total Operating Costs

FBR – Total Fringe Benefits / Total Salaries

 

PRIMARY RESERVE RATIO (PRR)

PRR measures the financial strength of an organization by considering the expendable resources within the context of the organization’s operations. PRR is calculated as follows: expendable net assets / total expenses. Expendable net assets generally include all net assets except permanently restricted net assets and those invested in property and equipment. PRR should be calculated in months or years. Generally, a PRR of three to six months on average is a reasonable number. Of course, the higher the ratio, the better. Organizations with less than three months of reserve must consider focusing on strategies to build the expendable net assets or reduction of expenses for better financial strength.

VIABILITY RATIO

Viability ratio is a direct measure of the amount of net assets available to cover the debt. It is measured as follows: expendable net assets / long-term debt. The recommended range of the ratio is between 1.25X and 2.00X. However, the ‘right’ ratio is organization-specific and varies by an organization’s debt policies. Keep in mind when calculating this ratio that any long-term debt that will be paid off by future rate reimbursements should be excluded from the calculation. This is a common occurrence for organizations that operate residential programs funded by the government.

DEBT SERVICE COVERAGE RATIO (DSCR)

DSCR measures the income available to service debt payments. It is calculated as follows: adjusted change in net assets / debt service. The adjusted change in net assets equals the change in net assets, plus interest and depreciation expenses. Debt service consists of principal and interest payments. The higher the ratio, the better; however, certain banks require a minimum level to meet the financial covenants for outstanding debt.

FUNDRAISING RATIO

This ratio measures the percentage of fundraising costs compared to contribution revenues. The important point to remember here is that fundraising costs incurred in one period may result in contributions that will be received in future periods, so considering a three-year

average is more meaningful. The lower the number, the better; however, anything over 35% is considered high.

The ratio is calculated as follows:

Fundraising Expense / Contribution Revenue.

OTHER COMMON RATIOS

Current Ratio is calculated by Current Assets / Current Liabilities

It measures the ratio of current assets to current liabilities. The higher the ratio, the better.

Debt Equity Ratio is the ratio of total liabilities to net assets. It is calculated by Total Liabilities / Total Net Assets, and the lower the ratio, the better.

Program Expense Ratio is the ratio of program expenses to total expenses. It is calculated as follows: Program Expenses / Total Expenses.

Administrative Ratio equals Administrative Expenses / Total Expenses. It calculates the ratio of management and administration as a percentage of total expenses.

Effective ratio analysis provides useful information that can be compared across industries and sectors. The analysis can be built into your dashboard reporting tool for presentation to both internal management and your board, and it can greatly aid in the decision-making process when developing your nonprofit’s long term strategic goals.

 

About Sibi B. Thomas