Tips on Assessing the Financial Health of Your Grantee Organizations

Tips on Assessing the Financial Health of Your Grantee Organizations

As a grantmaker, you can significantly impact the organizations you support. With so many worthwhile causes, how do you know which is the most viable for your donation? Grantmakers must strengthen their relationships and understand the questions to ask to invest in viable, sustainable organizations.

There are four main questions you need to understand:

  1. What are the types of audits and audit reports?
  2. What do you need to look for on the organization's audited financial statements?
  3. How do you assess the grantee's financial viability?
  4. What are the top financial health indicators of the organization?

Let's get started with some details on each of these topics.

1. What Are the Types of Audits and Audit Reports?

An audit is a systematic examination of the books and records performed to verify and report on the facts of the organization's financial operations. The goal of auditing is to verify the accounting data by determining the accuracy and reliability of the accounting statements and reports. The purpose of a financial statement audit is to add credibility to an organization's reported financial position and performance.

Financial Statement Audits

These audits are performed in accordance with generally accepted government auditing standards (GAGAS) when required by law, regulation, contract, agreement, or policy.

are-you-ready-for-your-financial-statement-auditRELATED eGUIDE: Are You Ready For Your Financial Statement Audit?

Compliance/Single Audits

These audits are required for organizations that expend $750,000 or more of federal awards, either received directly from the federal government or passed through state/local governments or other nonprofit entities. The audit is required in accordance with Subpart F of the OMB Uniform Guidance (2 CFR 200) and is subject to generally accepted auditing standards (GAAS) and GAGAS, often referred to as a single audit. The audit requires an opinion on compliance over significant programs.

The audit findings are presented in the Schedule of Fundings and Questioned Costs and indicate:

  • Significant deficiencies
  • Material weaknesses
  • Noncompliance or other matters identified by the auditor
  • An understanding of the causes and actions that should be taken to resolve the issue

Once the audit is complete, an audit report will be compiled which "documents reasonable assurance that the organization's financial statements are free from material misstatements."

There are four types of audit reports: Unmodified Opinion, Qualified Opinion, Adverse Opinion, and Disclaimer of Opinion. While the Unmodified Opinion is the one you will see most of the time, it is essential to understand them all as the three others are the ones you should be most concerned with.

Unmodified Opinion

This is the most common type of auditor report and is also known as a "clean" opinion (previously known as an unqualified opinion). This report indicates that the auditor could perform the required work with the financial statements provided by management, and the auditor had no reservations concerning the financial statements.

Qualified Opinion

This auditor's report is used when the auditor finds material misstatements, omissions, or inadequate disclosures in the footnotes to the financial statements. It indicates that the deviation(s) from generally accepted accounting principles (GAAP) are not pervasive and do not misstate the organization's financial position as a whole. A qualified opinion can be acceptable to most grantors, donors, and lenders.

Adverse Opinion

This is the most unfavorable opinion and indicates that the financial records are not in accordance with GAAP and contain grossly material and pervasive misstatements. An adverse opinion may be an indicator of fraud. Investors, lenders, and other financial institutions do not typically accept financial statements with adverse opinions as part of their debt.

Disclaimer of Opinion

This report is issued when the auditor cannot complete the audit report due to the absence of financial records or insufficient cooperation from management. Also referred to as a scope limitation, it indicates that no opinion over the financial statements was able to be determined.

In 2022, the auditor's report will significantly change. These changes will include how the auditor will present their findings to the organizations. The upcoming changes to the auditor's report include:

  • Presentation of the auditor's opinion first followed, by the basis for opinion and statement that the auditor is required to be independent of the entity.
  • An inclusion of the description of the respective responsibilities of management and the auditor for going concern.
  • The inclusion of disclosure when substantial doubt about the entity's ability to continue as a going concern.
  • An expansion of the description of the auditor's responsibilities for the audit.
  • Communications require the auditor to communicate with those charged with governance about the significant risks identified by the auditor during planning.

2. What Do You Need to Look For on the Organization's Audited Financial Statements?

Auditors will review these six statements/schedules when they prepare the audit:

  1. Statement of Financial Position
  2. Statement of Activities
  3. Statement of Functional Expenses
  4. Statement of Cash Flows
  5. Footnotes
  6. Supplementary Schedules

Let's discuss what is included in each of these and the warning signs or red flags to watch out for. This overview will help you understand what the auditors are looking for and what will be in their final audit report.

A. Statement of Financial Position

Presents the assets, liabilities, and net assets of the organization. The statement of financial position provides information about the liquidity of the assets and restrictions on the use of certain assets.

Cash
Operating
Restricted / Board Designated
Cash, investments, or other assets that have donor-imposed restrictions limiting their use for long-term purposes are presented separately from cash or investments that are available for current use.
Receivables
Current / Long-Term
Net Present Value / Collections
Restrictions
Investments / Assets Held in Community Foundations
Current / Long-Term
Net Present Value / Collections
Restrictions
Inventories
Valuation
Sales
Deferred Revenue / Contract Liabilities / Debt
Revenue Recognition
Ability of the Organization to Pay Its Debts When Due
Net Assets
Board Designated
With Donor Restrictions
Without Donor Restrictions (time restriction, use restriction, both)

Warning signs related to the statement of financial position:

  • Current liabilities equal or exceed current assets
  • Excessive amount of debt compared to total assets
  • Net assets are in a deficit position (excess of liabilities over assets)
  • Large receivable balances that have increased year over year (collection issues)

 

B. Statement of Activities

Presents changes in an organization's net assets and includes revenues, expenses, gains, losses, and reclassifications of net assets.

Revenue
Contributions without donor restrictions
Contributions with donor restrictions
Membership dues, sales, special events - revenue recognition
Gains and losses - investments, sales of assets, etc.
Expenses
Program
Management and general
Fundraising

Warning signs related to the statement of activities:

  • Sustained pattern of annual decreases in net assets
  • Positive or negative swings in sources of revenue
  • Significant and unbudgeted fluctuations in revenues or expenses, especially decreases in revenue or increases in expenses

 

C. Statement of Functional Expenses

Presents the functional and natural classification of expenses.

Functional Classification
Program, management and general, and fundraising
Natural Classification
Salaries and wages, supplies, interest expense, rent, depreciation, etc.

Warning signs related to the statement of functional expenses:

  • High percentage of total expenses included in supporting services when compared to organizations of similar size and mission
  • Investment in effective supporting services is critical to the success of nonprofit organizations, however, organizations should strive to be as efficient as possible
  • Unbudgeted large fluctuations in expenses (either natural or functional expenses), especially increases

 

D. Statement of Cash Flows

Details the changes in an organization's cash during the year, based on sources and uses.

Cash Flow
Operating, investing, and financing activities
Non-cash transactions that affect the financial position of the organization are also disclosed

Warning signs related to the statement of cash flows:

  • Sustained negative cash flows from operations
  • Persistent decreases in total cash
  • Financing activities such as borrowing funds that the organization may have difficulty paying back
  • Significant amounts of interest paid

 

E. Footnotes

The footnotes to the financial statement are additional information that helps explain how a company arrived at its financial statement figures. They also help explain any irregularities or perceived inconsistencies in year-to-year account methodologies. Below are some examples of footnotes often used:

  • Adoption of new accounting standards
  • Beneficial interest in assets held by others
  • Notes payable/lines of credit
  • Revenue concentration
  • Leases
  • Uncertainties
  • Going concern
  • Prior period adjustments
  • Contingent liabilities
    • Expenses that may be incurred depending on the outcome of an uncertain future event
    • Lawsuits, pending investigations, etc.
    • May or may not be recorded as a liability in the financial statements
  • Pledges receivable
  • Fair value disclosures
  • Net assets
  • Related party transactions
  • Liquidity/availability of financial assets
  • COVID relief funding
  • Subsequent events
  • Commitments
    • Contractual obligations for future goods or services that had not been received as of the end of the year
    • Construction contract commitment is a common example
    • Long-term leases with required payments for several years, and the lease terms and future payments are typically disclosed in a separate footnote

F. Supplementary Schedules

These are not required for a fair presentation in accordance with GAAP, but an organization may elect to include additional information or grantors may require it.

  • Consolidated entities and inter-organizational eliminations
  • Schedule of expenditures of federal awards that details the federal awards expended, categorized by the federal program

3. How Do You Assess the Grantee's Financial Viability?

Financial sustainability is the hallmark of a healthy nonprofit. When the nonprofit is financially sustainable, it can maintain operations, grow resources to weather challenges, and accomplish its mission in the long run. Financial sustainability requires clear objectives, strategies, and action plans.

What are the Most Common Challenges to Financial Sustainability?

Challenges to financial sustainability are varied, so watch out for these concerns with the organization's funding issues.

  • Dependence on external sources of funding: Government and foundation grants and private donations can be unreliable due to changes in funding priorities, withdrawal of support, or the government program funding may fall short due to budget concerns.
  • Unsuccessful branding or marketing: If potential funders aren't aware of your nonprofit's contribution or don't see your mission in action, they may be unlikely to offer support.
  • Inadequate fiscal and operational reporting: Sloppy record-keeping might indicate a lack of concern over finances.
  • Apparent duplication of the mission: If your mission or initiatives seem too similar to a more established organization, donors might expect you to partner or even consolidate to increase efficiency.
  • Economic changes: Decreased demand for services or tighter competition may erode financial sustainability. A change in operating costs, such as increases in goods or services, may pose a threat.

5 Strategies to Maintain Financial Sustainability:

To offset the challenges to financial sustainability, the organization should have a plan to maintain and grow their financial position. This can be done in many ways, but here are a few to consider:

  1. Fundraising: Maintaining a diverse donor base and balancing grants and gifts with other funding sources will help achieve the goals. Using creative fundraising techniques will appeal to unconventional or nontraditional donors. The organization could consider crowdfunding, giving circles, or special events to bolster the fundraising efforts. Look at how they fundraise, how flexible they are to meet the demands of their donors, and the economic challenges that could affect fundraising efforts.
  2. Branding and Marketing: Clarity and consistency of mission are essential. The more specific the mission, the more likely it is to be perceived as achievable and practical. Look for organizations that raise the brand profile by tapping into social networks and reaching out to key influencers.
  3. Alliances: Does the organization collaborate with similar organizations, which can prevent duplication of mission while helping to deliver maximum impact in the community? This is a crucial strategy to build capacity and scale efforts within and across communities.
  4. Precise Fiscal Reporting: Transparent reporting practices demonstrate accountability and value to stakeholders. Watch that funds are accounted for and appropriately allocated.
  5. Culture of Commitment: Look for consistency in staffing and board members as that will contribute to long-term financial sustainability. Roles and expectations should be as transparent as possible, with a plan for leadership transitions and succession planning.

4. What Are the Top Financial Health Indicators of the Organization?

Select ratios to analyze based on the organization's operations, sources of revenue, and mission. Compare ratios to benchmarks based on the financial information of organizations of similar size and mission. While many ratios can be used, here are a few we recommend starting with and how to calculate them.

Liquidity Ratios
Current Ratio - Can the organization pay its current liabilities with current assets? Total current assets / total current liabilities = looking for a factor of 1 or higher
Quick Ratio - Based on liquid current assets (excludes inventory) used to pay current liabilities. (Cash + accounts receivable + other easily liquidated assets) / current liabilities = looking for a factor of 1 or higher

Safety Ratios

Safety is defined as whether an organization has increased exposure due to debt.

EBIT / Interest Ratio - Defines whether the organization can meet its interest payments and take on more debt. The higher the ratio, the better it can meet its interest payments and take on more debt. EBIT / Interest = earnings before interest & taxes / interest expense
The higher the Debt-to-Equity Ratio, the greater the risk to a current and future creditor of default. However, if the ratio is too low, your organization is acting too conservatively. Debt to Equity = total liabilities / total equity
The cash flow to the current maturity of the long-term debt ratio indicates whether the organization can pay its principal debt payment over the next 12 months. Cash flow to current maturity of long-term debt = (net profit + non-cash expenses (i.e., depreciation, amortization)) current portion of long-term debt

Efficiency Ratios

Efficiency measures how well an organization effectively employs its assets.  The ratios below are standard efficiency measures.

Accounts Receivable Turnover measures how fast the organization is collecting its receivables.  Therefore, the higher the turnover, the faster the organization collects its receivables and thereby the more cash the organization has on hand. Accounts Receivable Turnover = total net sales / accounts receivable
Days in Accounts Receivable indicates how many days it takes for the organization to collect all accounts receivable.  The goal is to have fewer days, which suggests that the organization quickly collects its accounts. Days in Accounts Receivable = 365 days / accounts receivable turnover
Accounts Payable Turnover measures how fast the organization is paying its creditors.  The higher the number could indicate that the organization is managing its creditors and thereby holding on to its money longer. On the contrary, the organization is having difficulty paying its creditors due to cash liquidity issues.  Understanding the reason for the higher turnover is critical to determining if a major problem requires alternative resolutions. Accounts Payable Turnover = cost of goods sold / accounts payable
Days in Accounts Payable indicate how many days it takes for the organization to pay all accounts payable.  Make sure your organization takes advantage of vendor discounts. Days in Accounts Payable = 365 days / accounts payable turnover
Inventory Turnover indicates how many times an organization sells its inventory in one accounting period.  This is an important measure to understand whether improvement is required to correct obsolete and/or under/overstocking inventory issues.  A positive trend is showing faster turnover results in improved cash flow and more robust inventory control. Inventory Turnover = cost of goods sold / inventory
Days in Inventory indicates the average length of days it takes to turn over an organization's inventory. Days in Inventory = 365 days inventory turnover
Sales to Total Assets measures the organization's efficiency in generating sales on each dollar of assets. Sales to Total Assets = Total sales / total assets
The Debt Coverage Ratio indicates an organization's ability to satisfy its debt obligations and its capacity to take on additional debt. Debt Coverage = (net profit + any non-cash expenses) / principal on debt
The Cost to Raise a Dollar Ratio evaluates the efficiency of the fundraising channel or program. Variation of $1.00 to $1.60 is very acceptable for a direct mail acquisition, while $0.20 is considered an average acceptable CRD for an entire fundraising program. Charity watchdog groups use this as a rating variable which is one reason it is essential. Cost to Raise a Dollar (CRD) = cost of fundraising / amount raised

 

Summary

As you can see, there is a lot to review when you assess your grantee organizations' financial health. This article is designed to give you insights into what auditors look at and how their reports are generated. By gaining a basic understanding of these findings, you will be equipped with ways to assess before you gift funds to an organization.

If you have any questions or are looking for more information on this topic, reach out to SVA. We are here to help.

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Biz Tip Topic Expert: Kirsten Houghton, CPA, MBA

Kirsten Houghton, CPA, MBA

Kirsten is a Principal with SVA Certified Public Accountants and her expertise includes the nonprofit and real estate industries. In addition to providing audit, accounting, and tax services, Kirsten also provides review, compilation, and management advisory services.

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