Predicting Financial Vulnerability in Charitable Organizations

By John Trussel, Janet S. Greenlee, and Thomas Brady

One result of the trend toward privatization of government social services has been a tremendous increase in the number of tax-exempt organizations. According to the Independent Sector, an organization that reports on the state of the tax-exempt sector, the number of such organizations has increased by more than 50% in the past decade. There are now more than one million nonprofit organizations that generate in excess of $600 billion in total revenues and employ close to 7% of the total workforce. As this sector continues to grow, the demand for accounting services by these organizations will increase. One potential service area for CPAs is the evaluation of the financial condition of organizations in this sector.

Auditors are presented with three challenges when trying to evaluate the financial condition of a tax-exempt organization. First, financial measures that have been developed in the business sector are often inappropriate for organizations whose purpose is to maximize service rather than profit. Second, few financial benchmarks allow for comparison with similar organizations. Finally, no method has been developed that can assess the financial vulnerability of tax-exempt organizations to a financial shock, such as a lawsuit, loss of a major funding source, or a sudden downturn in the economy. The for-profit sector, on the other hand, has many methods that use accounting information to determine such vulnerability.

Sources of funding for charitable organizations are constantly evolving. Despite the widespread belief that charitable organizations depend primarily on government grants or contracts, this is generally not the case for the sector as a whole. During the past 10 years, reliance on governmental funding has decreased substantially. Currently, more than 70% of charitable revenue is generated from nongovernmental sources (i.e., fees and private giving).

Indeed, charitable organizations operate in an atmosphere of increasing governmental regulation and public scrutiny. Since 1994, 14 states have either instituted or increased nonprofit regulation and reporting requirements, and the 1996 Taxpayers Bill of Rights required significantly increased nonprofit disclosure. Nonprofit organizations are now required not only to supply a copy of their informational tax returns (Form 990) to any requesting party, but also to make these returns “widely available.” Further, the National Center for Charitable Statistics (www.nccs.urban.org), an arm of the nonprofit think tank the Urban Institute, has placed Form 990 information from more than one million tax-exempt organizations on the Internet.

With these attributes in mind, we extracted certain financial measures from the framework originally set forth by nonprofit research economists Howard Tuckman and Cyril Chang. These measures focus on the ability of a charity to continue to carry out the mission of the organization if faced with one or more financial shocks:

Debt ratio (DEBT). A charity with a higher proportion of debt in its capital structure will be more limited in its ability to replace these lost revenues, when faced with a financial shock, than one with a lower proportion of debt. Conversely, a charity with less debt in its capital structure is more likely to be able to leverage its borrowing power, under similar circumstances. Thus, the higher the debt ratio, the more likely the organization is to be financially vulnerable.

Revenue concentration index (CONCEN). Charities derive revenue from gifts, grants, program services, membership dues, sales of inventories, and investments. Charities with fewer revenue sources are more vulnerable to financial shock than those with multiple revenue sources, because a charity with multiple sources may be able to rely on alternative sources of funding and thus avoid reducing services. A charity that receives all of its revenue from one source has a ”revenue concentration index” of one. A charity with multiple sources of revenue will have an index approaching zero.

Administrative cost ratio (ADMIN). Charities with relatively low administrative costs are more financially vulnerable than are those with relatively high administrative costs. Charities devoting a higher proportion of revenue to administration may be able to reduce discretionary costs before having to reduce services.

Surplus margin (MARGIN). Charities with a low surplus (i.e., excess of revenues over expenses) are more vulnerable than are those with high surpluses, because a high-surplus charity could operate with a reduced surplus before it needs to reduce services. Thus, the lower the surplus margin, the greater the financial vulnerability of the organization.

We also used two additional measures. We included organizational size (SIZE), because larger charities may be less vulnerable than smaller ones. We also included industry (INDUSTRY), because the charitable sector is similar to the business sector in that it is extremely diverse. The National Taxonomy Exempt Entities (NTEE) defines 10 major categories of charities, but five categories have relatively few organizations in them. We merged the organizations in these five categories into one “Other” category.

The measures described below can be used as performance benchmarks and as indicators of financial vulnerability. Many of the methods that the for-profit sector uses to measure financial vulnerability focus on bankruptcy prediction. Financial vulnerability in charitable organizations must be defined more broadly, however, because the purpose of the sector is not to generate profits for investors, but to provide services. Thus, we defined a financially vulnerable charity as one with an overall reduction in its fund balance (i.e., net assets) during a period of three consecutive years. Such an occurrence will lead to a reduction in services and eventually result in the organization’s inability to carry out its mission. Calculating these measures is the first step in predicting the financial vulnerability of a charity. The calculated results must then be compared to the industry-wide benchmarks. These benchmarks, presented in Exhibit 3, were computed with information provided using the IRS’s Statistics of Income (SOI) database. This database includes extensive financial information for all (approximately 8,000) charities reporting more than $10 million in assets and a random sample of approximately 2,000 other, smaller charitable organizations.

Predicting Financial Vulnerability

While models that are commonly used to predict financial vulnerability in businesses are not fully applicable to charities, the process undertaken to develop such models is similar:

Our technique was developed using the process described above. According to the parameters of our model, we defined a financially vulnerable charity as one that sustained an overall reduction in its equity balance (i.e., net assets) for a period of three consecutive years. The resulting equation, presented at the bottom of Exhibit 3, can be used to determine the financial vulnerability of a charitable organization.

How to Determine Financial Vulnerability

Step 1. Compute financial indicators (from Exhibit 1) for the last five years to highlight any trends.

Step 2. Choose the subsector (from Exhibit 2) to which the charity belongs.

Step 3. Compare the most recent year’s financial indicators to sub-sector benchmarks (from Exhibit 3).

Step 4. Compute the Financial Vulnerability Index (FVI) using the equation in Exhibit 3. The FVI is a composite measure of financial vulnerability that integrates the other ratios using logistical regression analysis. Generally, the higher the FVI, the greater the likelihood that the organization will have financial problems.

Step 5. Employ the following decision rule to determine whether the charity is vulnerable to financial shock. A FVI greater than .20 is a strong indication that a charity is financially vulnerable. A FVI less than 10 indicates that the organization is not financially vulnerable. A FVI between these two numbers is inconclusive. A blank worksheet to assist in computing the financial vulnerability of a real charity and an example of this method applied to a fictional organization are presented in Exhibit 4 and Exhibit 5.

It is important to remember that this model is merely one possible way of measuring financial risk for nonprofits. Other financial and nonfinancial information should also be considered when evaluating any organization.

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