Good financial management is an essential ingredient for service delivery in the not-for-profit community. An important aspect of effective financial management is creating and maintaining a financial cushion sufficient to weather stormy periods of financial uncertainty and dwindling financial resources.
In this article we will outline how you can determine what your financial cushion is, what is an appropriate level of financial cushion for the organization and, finally, examine some strategies for building, maintaining and, where necessary, reducing your financial cushion.
Determining your financial cushion
For purposes of this article, when we talk about a financial cushion we refer to assets of an organization that are likely to turn into cash within one year, less liabilities of the organization that will have to be paid within one year. This net amount represents the financial cushion that is actually available to the Board of Directors if funds are required for a financial emergency. The concept of financial cushion is often referred to as Net Assets, Accumulated Surplus or Fund Balance in a statement of financial position.
Net assets in the following example are $50,000. This is the amount that assets exceed liabilities. That is not to say that the organization has $50,000 to spend in the event of a financial emergency. You will notice that $40,000 of net assets is made up of capital assets.
These assets could be furniture and equipment, leasehold improvements, or a playground. They are not usually easily convertible into cash in the event of a financial crisis.
In this example, the truly useable financial cushion is the excess of current assets over current liabilities, in this case, $10,000.
An additional wrinkle must be added. Certain assets may have restrictions placed on them by private donors or government funders. Examples are donations given for specific projects such as research and an endowment fund to be held in perpetuity. In this case the true financial cushion available for day-to-day use in an emergency may well be less than the total of current assets over current liabilities. You should review your organization’s financial statements to determine the actual amount of net assets that are unrestricted and available to your organization.
Appropriate levels for a financial cushion
There is a common misconception in the not-for-profit sector that organizations are not allowed to have a financial cushion as they are “not-for-profit”. In this context it is useful to remember that not-for-profit organizations are also “not-for-loss” organizations. An organization cannot sustain losses over the long term without ceasing to operate or going bankrupt. Likewise, it is very challenging to run an organization with next to no financial cushion. Managing funds in this environment becomes very time-consuming and is bound to distract from the organization’s objective of providing service to its community. If you run your car with a close to empty gas tank all the time, you are likely to run out of gas at some point in the year. The same is true if you have too small a financial cushion. At some point you are bound to run out of money.
Having established that a financial cushion is essential, the question becomes, how much should it be? The unwritten guideline in the not-for-profit community in Ontario seems to be that a financial cushion of between one and three month’s expenses is an acceptable range. Organizations in a stable financial environment with secure funding can often function well with a cushion toward the lower end of the range. Organizations operating in an unstable financial environment would be better off operating with a financial cushion toward the upper end or even above that range.
It is important to note that there are relatively few statutory constraints on the level of financial cushion that an organization can maintain. The following is a brief survey of the requirements in legislation applicable to many not-for-profit organizations in Canada:
- a) The Ontario Corporations Act and Canada Corporations Act do not specify lower or upper limits of financial cushion that must or can be held by not-for-profit organizations. The level of cushion is left up to the Board of Directors.
b) Canada Revenue Agency (CRA) requires that all registered charities obtain permission from CRA to “accumulate funds”. There is no definition in the Tax Act as to what constitutes an “accumulation” of funds. Past experience would indicate that a cushion of up to six months expenses would probably not contravene CRA’s guidelines. If your organization is a registered charity accumulating significant funds for a major expenditure such as the purchase of a building, you should obtain CRA’s permission to accumulate the funds prior to undertaking the fundraising project.
c) In the child care field, Toronto Children’s Services has an administrative policy whereby accumulation of net assets (this would appear to include capital assets and restricted funds) in excess of three months of operating expenses may result in a reduction in subsidy per diem rates. In our experience, Toronto Children’s Services bends over backwards to avoid reducing per diem rates and always discusses such a situation with a childcare centre before taking action.
d) Provincial funders such as the Ministry of Health and the Ministry of Housing often have policies whereby any excess of approved revenues over expenditures must be returned to the Ministry on completion of either a funding year or a specific project. In this situation, no accumulation of financial cushion for a Ministry-sponsored project is allowed. Financial cushions must be built from other sources of revenue.
Managing the level of your financial cushion
Managing the level of the financial cushion of your organization is an important part of the financial management process. Prior to managing the cushion, the Finance Committee or its equivalent should first determine what the current level of the financial cushion is and then specify what the ideal level of cushion for the organization should be. Determining the ideal level will require you to take into account the current financial environment as it now exists and future expectations. Once the current level of the cushion is known and the desired level estimated, you can then proceed to achieve the desired objective.
Increasing Your Financial Cushion
Planning to increase a financial cushion is not a complicated concept. You have to focus on generating an excess of revenue over expenses over a given period. In theory that’s easy. As many Boards of not-for-profit organizations know, generating a surplus is usually easier said than done.
Generating an excess of revenue over expenses entails increasing revenue and/or decreasing expenses. Grant revenue is often fixed or increases in grant revenue must be matched by identical increases in expenditures. Consequently, many organizations must turn to fundraising for increasing revenue. For many service-based organizations salaries account for the lion’s share of expenses. Expense reduction most commonly translates into reducing staff costs by either increasing program efficiency (i.e. increasing revenue without a concurrent increase in staff costs) or reducing staff compliment.
Finance Committees should be careful not to try to accumulate too large a surplus all at once. The process should be spread out over a number of years to minimize stress on personnel and ensure that the quality of service provided does not decline significantly during the process.
Reducing Your Financial Cushion
Periodically not-for-profit organizations find themselves in the enviable position of having too large a financial cushion. In our experience planned reduction of a financial cushion can be much more divisive to an organization than increasing the cushion. Reducing a cushion involves spending more that your organization takes in over a period of time. People often have strong and differing views on how this should be done, if at all. To reduce internal conflict we recommend that you discuss and approve at the Board level the ideal amount of financial cushion and the time frame over which the organization will operate at an annual excess of expenses over revenues until this target is reached. Many Boards of Directors are highly reluctant to operate an organization at a deficit even though it is a “planned” deficit. Consequently, agreement must be reached at the Board level to avoid misunderstandings when management operates the organization at a loss. In our experience there is no easy way to reduce a financial cushion in the absence of clear, honest and frequent discussions between management and the Board of Directors.
In summary, not-for-profit organizations should have, as a guideline, a financial cushion of between one and three months of expenses. This cushion should exclude capital assets, related long-term liabilities and funds restricted as to use by donors. It is important for an organization to determine the level of its current financial cushion and set a desirable target. Once the target has been met the organization should plan a course to increase, maintain or decrease the financial cushion as appropriate.