Reporting and Operations

Budgeting for Capital

An organization's financial plans should include budgets for operations and for capital.  Together these comprise what I refer to as an Organizational Budget.  The annual operating budget was discussed in previous sections of this web site.  In this section we will discuss the terms and concepts involved in creating the capital budget.

While an organization's operating budget reflects its planned financial activities for a year, showing how much revenue it expects from which sources and how much it will spend on operations, a capital budget, or capitalization plan, relates more to an organization's financial position: its assets, liabilities, and net assets, setting forth goals and targets for these areas.  Although the concept of capital structure, may seem odd for a small or midsize nonprofit organization to consider, the truth is that all organizations have a capital structure, whether they are conscious of it or not.  Good financial management requires an organization to understand its capital structure and to be conscious and deliberate about setting and reaching its long term financial goals.

These goals as identified in a capital budget might include asset purchases (such as equipment, facility acquisition, or leasehold improvements), asset investments (such as production costs of a product the organization will sell), financial stability targets (such as building an operating reserve or eliminating a deficit), or strategic targets (such as building a fund to support program or management initiatives per its strategic plan).  Capital budgets often require a funding plan separate from and in addition to the operating budget.  This funding plan can include a capital campaign as well as other funding strategies.

Setting Capital Structure Targets

Building and maintaining an Operating Reserve is a top priority.

Operating reserves are essentially the accumulation of unrestricted surpluses that are liquid (as opposed to invested in fixed assets) and thus available for use at the discretion of an organization's board.  The presence of an operating reserve increases an organization's ability to take mission-related risks and to absorb or respond to temporary changes in its environment or circumstances, for example, significant unbudgeted increases in operating expenses or losses in operating revenues.  

Numerous small and midsize nonprofits are founded by entrepreneurial visionaries who are in many ways comparable to their counterpart for-profit business owners.  Nonprofits are in fact businesses whose profits (surpluses) remain with the (nonprofit) corporation rather than going to individuals or shareholders as in the for-profit business model.  Note: "not-for-profit" does not mean "no surplus allowed".  Just as for-profit businesses need working capital to function at peak capacity, so do nonprofits need the equivalent in operating reserves.  Operating reserves or working capital funds create liquidity and financial flexibility for the organization.  Organizations with a strong working capital position can focus beyond day-to-day cash flow needs and more effectively plan for the long-term health of the organization.  

Without an operating reserve, an organization can be thrown into cash flow stress and become distracted from good long-term decision-making or forced to make expensive short-term crisis-based decisions, or worse; it may not have the resources to continue delivery of its programs.  Organizations with limited or negative working capital by necessity focus on the short term and are less likely to engage in responsible long-term planning.  You can see why building operating reserves is a top priority.

In its December 2008 whitepaper "Maintaining Nonprofit Operating Reserves, An Organizational Imperative for Nonprofit Financial Stability" the Nonprofit Operating Reserves Initiative (NORI) Workgroup recommends that most small and midsized nonprofits should maintain a minimum liquid operating reserve representing 25% of its annual operating expenses.  Your organization's capital budget should include figuring out how much your organization needs for its reserve (target amount), how many years it will take to reach the target amount, and what funding strategies will be employed for building the reserve.  The NORI Workgroup has created a toolkit to assist organizations in creating a reserve policy to build an operating reserve.

Endowment funds are permanently restricted and the principal cannot be used for operating, cash flow, or other purposes.  For small and midsized organizations, building a board designated operating reserve in addition to other reserves listed below should be undertaken well before considering establishment of endowment.  See FASB 116 for more about endowments.
 

Deficit Reduction is a top priority.

An organization with an accumulated deficit, where a year or more of operating shortfalls have built up to where unrestricted net assets are negative, will find it difficult or impossible to build an operating reserve before reducing or eliminating the deficit.  In such a case, deficit reduction needs to be top priority.  The organization should set a deficit reduction schedule and funding strategies in its budget.  Repeated operating deficits may be the result of poor budgeting and may indicate that the budget vetting process should be more vigorous.
 

Good Debt, Bad Debt

It is an admirable goal for small and midsized nonprofits to be completely free of debt, but this is not always possible or in some cases advisable.  Good cash flow management may, on occasion, require an organization to access a cash flow loan or a line of credit.  You should pay attention to the balance between your organization's liabilities and net assets, striving to keep net assets positive, and using debt only when it makes good management sense.  "Bad" debt, such as being very far behind on vendor payments or maxed-out on cash flow loans, is not fiscally healthy and should be targeted as a part of deficit reduction.  When utilizing planned borrowing, be sure to factor related interest expense into your expense budget.  Payments to reduce the liability principal are not true expenses, but income to provide the cash required to pay down the liability should be included as an item in the budgeting process as part of the full organizational budget.  

 Planned Change in Capital Structure

Furniture, Equipment, and Technology

For an organization not in financial crisis, investing in equipment and software upgrades or replacements is one of the next priority items to consider for a capital budget.  Don't forget ample filing cabinets and decent chairs!  Keeping staff well-equipped can make them more efficient and happier, leading to staff retention and loyalty while improving program outcomes.  It's win-win.  Some foundation and corporate funders and government agencies explicitly support fixed asset acquisition and technology improvements in addition to project and operating funding.  Visit the Foundation Center or TechSoup websites to research funding sources for equipment and technology.  
 

Facilities Part 1 - Maintenance, Repair, & Replacement

Whether your organization owns or rents its space, you may find it necessary to make improvements to the property (leasehold improvements, if renting).  For example you may be responsible for maintenance and repair as the owner, or as part of the conditions of the lease.  Anticipating what repairs or improvements may be necessary, researching and estimating the related costs, determining the target amount needed and the approximate timing of the expenditures are all part of the capital budgeting process, along with developing funding strategies.  These funding strategies could include assignment of funded non-cash depreciation or dedication of certain revenue streams.  In addition, your organization may want to create, budget for, and maintain an emergency fund, for unanticipated repairs.
 

Facilities Part 2 - Building Acquisition and Construction Projects

A classic capital campaign supporting a bricks-and-mortar building project is a familiar scenario.  But this is a huge commitment for a small or midsize organization and should be undertaken only after a great deal of preparation, including an organizational self-examination to ensure that the staff and board infrastructure can sustain the additional work load and fundraising effort, and a thorough feasibility study to ensure that the community can, and is willing to, support the endeavor.  In addition, a multi-year business plan reflecting the financial impact of operating in the new building will need to be developed.  Many organizations find themselves operating in the red for the first one to three years after implementing a facility project, and may also find themselves in debt for construction costs that were in excess of capital campaign income, rendering the organization financially fragile just when it needs to be strongest.  Years of very careful planning, research on financing options, and a great deal of caution are advised.  The Nonprofit Finance Fund offers a Facility Project Planning Guide that describes what a facility project is, and what factors to consider in deciding to embark on one, as well as outlining the dangers and pitfalls of doing so.  The impact of a facility project on small and midsize organizations cannot be underestimated.
 

Special funds

Once adequate operating reserves are in place, your organization may want to consider establishing funds to support special program activities and strategic initiatives.

  • Emergency Program Services - For organizations that serve clients affected by natural disasters or other calamities such as fires or air crashes, special emergency reserves may be appropriate.  United Way Worldwide, admittedly a very large organization, has published guidelines for its member organizations to follow when setting targets for building such reserves to enable them to serve their clients.
  • Strategic Initiatives - Many well written strategic plans sit on the shelf for lack of resources to implement identified initiatives.  Don't let this happen to you.  Research the probable financial impact of strategic initiatives, including the need for additional human resources.  Determine the timing, and availability of funding, for initiatives and a design a fundraising strategy to complement the existing fundraising plan for operations.  Perhaps the plan calls for adding a fundraising staff person, the results of whose efforts will likely not be seen for 12-18 months; with a human resource reserve in place, the payroll costs could be covered without putting the organization in debt.
  • Opportunity Funds - With or without a strategic plan in place, sometimes new program opportunities present themselves unexpectedly and may require start-up funding.  Having a special reserve for an artistic director or program manager to access under such circumstances can allow for program growth and quality enhancements that would cost far more if delayed or could allow an entrepreneurial founder to seize opportunities or act on ideas without putting the organization in financial jeopardy. 

Naturally, building the funds to create the reserves takes careful budgeting and disciplined financial management, and policies must be followed in deciding whether and how to access these funds and replenish them as appropriate.  The Tool Kit [Link: TBA ] developed by the Nonprofit Operating Reserves Initiative Workgroup provides prototype policies and contains a section by Richard Larkin setting forth factors that should be taken into account when determining the right level of reserves for your organization.
 

Other Resources:

 

The Grasshopper or the Ant: A Review of Endowment Giving Policy Optionsby Russell Willis Taylor for the Doris Duke Charitable Foundation Arts Program, 2006
http://www.artstrategies.org/downloads/TheGrasshopperOrTheAnt.pdf

Hidden in Plain Sight: Understanding Nonprofit Capital Structure by Clara Miller, 2003
http://www.nonprofitfinancefund.org/docs/Miller_Capital_Structure.pdf


© 2009 Elizabeth Hamilton Foley