A Guide to Nonprofit Finance

In the pursuit of community impact, nonprofits face several challenges to their financial stability. Actualizing transformative potential while being asked to do more with less is not easy.

But before diving into nonprofit‑specific financial challenges, we must define the financial vital signs that provide an accurate measurement of your organization's financial health. In other words, let’s take the pulse of your nonprofit’s finance.

While developing A National Imperative: Joining Forces to Strengthen Human Services in America, a groundbreaking report on nonprofits and their impact, the Alliance for Strong Families and Communities and the American Public Human Services Association (APHSA) determined the following factors to be critical financial vital signs for any nonprofit:

• Solvency. This is determined by calculating total liabilities as a percentage of total assets. It indicates your ability to meet long‑term financial obligations. Unfortunately, nearly 1 in 8 community‑based organizations are technically insolvent. 
• Liquidity. More than 40% of community‑based organizations lack the liquidity to meet their immediate obligations, with short‑term liabilities exceeding short‑term assets. This results in delaying payment of other short‑term obligations and dipping into restricted funds to cover their immediate costs.
• Operating margin. Nonprofits must generate and retain financial resources above those required to cover expenses. Nearly 50% of community‑based organizations report a negative three‑year operating margin, with the bottom quarter reporting a three‑year margin of −5% or less.

• Reserves. This refers to the number of months that a nonprofit’s reserves can cover operating expenses, with months of reserves calculated for cash (immediate needs), unrestricted net assets (equity available to bear losses and make investments), and operating reserves (short‑term available equity). According to a leading municipal finance banker, 30% of community‑based organizations have virtually no margin for error with cash reserves that cover less than one month of operating expenses—the absolute minimum required to demonstrate financial health.

After assessing your organization's vital signs, it might be clear that there is room for financial improvement. Fortifying your nonprofit’s reserves takes strategy and time—and sometimes outside assistance—but the first step is simply identifying which challenges are impeding your organization’s financial performance.

Nonprofits vary widely in terms of size, budget, and mission. Yet the financial stressors can be boiled down to four distinct challenges:

• Constraints imposed by government contracts
• Constraints imposed by private philanthropy
• The regulatory and legal environment
• Underdeveloped financial risk management capabilities

Challenge #1: Constraints imposed by government contracts

This obstacle can be manifested in several ways. 

• Some government contracts seem promising at the outset, then fail to cover the cost to deliver the agreed‑upon service, notably those funds needed to cover administrative and overhead functions. 
• Navigating inflexible funds and artificial spending caps can feel like a bureaucratic balancing act that centers your nonprofit budget between expectations from competing government contracts. 
• Many government contracts are reimbursement based, which creates cash flow difficulties for nonprofits with limited budgets. Though some government entities pay in a timely manner, others—particularly states and municipalities—can take over a year to pay.

“We’re stuck between a rock and a hard place,” said the CEO of one community‑based human services organization in Illinois. “The government funds us like a charity but expects us to run like a business. And make no mistake: we are a business. We have a business to run, and we have real costs associated with running our business. If we can’t afford to cover these costs, how does anyone expect us to support our community?”

Challenge #2: Constraints imposed by private philanthropy

Philanthropic funders can become a double‑edged sword when they place restrictions on their donations, designating them for specific projects or outcomes. At times, these restrictions can drastically limit a nonprofit’s impact, even strangling critical projects.

Sometimes restricted gifts are the result of a misconception around nonprofit overhead. Though communication and transparency are improving in general, a lack of understanding and consensus about how much overhead is necessary to run a healthy organization can create issues in dealing with both foundations and individual donors. It is crucial for all donors to realize that overhead costs strengthen the foundation—the launching point—for all missional impact. 

As Dan Pallotta, author of Uncharitable–How Restraints on Nonprofits Undermine Their Potential, explained of individual donors, “Our generation does not want its epitaph to read: ‘We kept charity overhead low.’ We want it to read that we changed the world.”

Fortunately, at least five of America’s major foundations — Ford, Hewlett, MacArthur, Open Society, and Packard — have recently acknowledged the importance of paying for overhead to fuel progress.

Challenge #3: Regulations and requirements

Overlapping or outdated regulations sometimes force nonprofits to accrue unnecessary costs, from redundant program audits for both the state and local regulatory agencies to risking noncompliance with one regulation in order to comply with others. In short, bureaucracy—particularly when experienced from many levels—can be expensive. 

“We get federal, state, and county funding,” said the CEO of one community‑based human services organization. “Each comes with its own set of rules, and at each level, they want a lot of the same information in slightly different ways. We could save a lot of time and money if things were more standardized.” 

Challenge #4: Underdeveloped financial risk management capabilities

In the National Imperative survey, several human services executives noted that nonprofits should be more selective about accepting contracts that aren’t economically viable. Nonprofit leaders often hesitate at negotiating for more economically viable terms beyond what is initially offered because they are eager to provide additional services to their communities, they are reluctant to risk harming established relationships with funders, and they know there is competition with other organizations that may agree to the initial terms if they turn down the contracts. Year by year, contract by contract, this can increase your organization’s financial risk.

It is also possible that many nonprofits absorb more financial risks than advisable because of limited in‑house staff or expertise. When organizations lack sufficient accounting staff, for instance, leadership might not have the resources to evaluate the financial aspects of contracts and funding arrangements. Insufficient staffing and expertise can also lead to problems with financial statements or government audits that make it challenging for the organization to continue receiving funding. 

Further complicating things, all of these nonprofit finance challenges are intertwined—the low investment in expertise is often the result of low overhead cost allowance. In short, risk management is a crucial component of maintaining financial stability, but it requires time, resources, and expertise to be executed properly.

Many of the financial challenges facing nonprofits are addressed by Vu Le in his engaging presentation at the close of the 2019 Alliance for Strong Families and Communities National Conference:

Addressing the unique challenges of nonprofit finance requires new strategies. It also requires reframing the way the public—and sometimes in‑house leaders and board directors—perceive nonprofits. As Alliance CEO Susan Dreyfus and APHSA CEO Tracy Wareing Evans wrote in the Stanford Social Innovation Review, “When we talk about human services, we want to land on the shared values that enable audiences to see a bigger picture, one in which they can see themselves.”

In short: When the perception of nonprofits pivots from “charity” to “strategic community partner,” you are freed to address financial challenges in a strategic, businesslike manner befitting the community as a local economic driver.

As Rehana Absar, director of organizational excellence at the Alliance, recently emphasized in an article in the Nonprofit Business Advisor, nonprofits, while absolutely adaptive and innovative in their own right, can take a page from corporate America’s playbook to better deliver results that are truly transformative.

Consider how the corporate sector is constantly evolving and innovating, focusing on return on investment, using more modern and technology‑enabled ways to offer services, developing strong partnerships and mergers to help it achieve better outcomes faster, and creating cost‑effective approaches to administrative functions.

After identifying your nonprofit’s greatest financial challenges and reframing the perception of your nonprofit operations as a business, what steps can you take to develop new strategies that move your organization from financial stress to financial health and sustainability?

The first step is simply committing to the development of more robust nonprofit financial management and financial risk management policies. The development of clear risk management protocols and contingencies cannot be overemphasized.

Here are several research-backed recommendations for overcoming nonprofit finance challenges:

Learn to say no.

Nonprofits must be more strategic about which contracts and funding streams to accept. This requires clearly defined leadership roles and communication between finance executives who are empowered to make strategic decisions at their organizations.  

Streamline the planning processes.

Now more than ever, scenario planning should be a normal part of your financial planning process. First, develop a list of current financial risks and uncertainties. These could include risks unique to your organization as well as broader, even global challenges such as a pandemic like COVID-19. Then assess the likelihood and potential financial impact of each. Finally, develop contingency plans for reducing the likelihood and impact of each risk. Some scenarios, such as COVID-19, are unavoidable. But nonprofit leaders can still plan for the ways a pandemic or the resulting economic downturn could directly impact your nonprofit.

Your organization should also have formal plans in place for recovery and program continuity in the face of financial disaster or even bankruptcy. These plans should be discussed in advance during stable times with government agencies and partners so that everyone is prepared to act in a crisis.

Create clear financial benchmarks and targets.

Compare your nonprofit’s financial performance to peers on an annual basis using IRS Form 990 data and explore the use of “self-rating” tools to combine financial measures into an overall indicator of organizational health.

Also, develop targets for operating results associated with financial stability. These can include targets for cash, unrestricted net assets, operating reserves, and access to credit.

Consider your board.

The primary purpose of boards of directors is to ensure the health and future of their organizations. It is critical to ensure that they do not get mired in operational issues of the organization, but rather focus on the sector landscape, big-picture trends, and community needs. To participate in intelligent risk management, board directors must also understand important contracts and the associated processes for approval and registration. Make sure to recruit trustees with financial and risk management expertise. 

Diversify funding sources.

Continue and redouble efforts to develop alternative revenue sources and to diversify their funding profiles. GuideStar reports on its blog that developing or fortifying strategic partnerships with corporations can help nonprofits improve public image, attract and retain investors, and potentially bring in “volunteer hours, pro bono services, in-kind gifts, potential individual donors, board members, and honorees.”

Boost back-office awareness.

Assess whether your staff possess adequate financial expertise to properly manage funds and recognize growing financial risks. Whether you employ a dedicated CFO or outsource bookkeeping and accounting through investments in operations support services, it is critical to ensure your organization is equipped to deal with the particular requirements of nonprofit accounting, program and grant accounting, and government contracting. 

Consider outsourcing finance functions.

The Nonprofit Risk Management Center reports, “Fiscal outsourcing can be helpful to a nonprofit that finds itself ill-equipped to manage these and other financial risks alone.” By outsourcing operations, your in-house staff can freely focus on what matters—the mission. 

Outsourcing also gives organizations flexibility so they only have to pay for what they need. For example, a small organization might not need a full-time CFO. With contracted agreements, organizations can ensure the right level of expertise is always on hand, not to mention they never have to deal with staff turnover. 

In some scenarios, getting help with nonprofit finance can greatly expand an organization’s capacity for impact. This is why the Alliance offers back-office operations services specifically designed to efficiently and effectively meet the administrative and financial needs of community-based organizations. Organizations can outsource various financial duties for which internal capacity and resources may be limited, such as accounting, bookkeeping, payroll processing, and risk management. 

The financial challenges facing nonprofits are considerable. When organizations can gain support to manage their finances more effectively, these challenges can become less daunting, and the entire community benefits.