Budgeting Practices To Survive The Recession’s Final Kick
March 14, 2012 Thomas McLaughlin
Rarely a pleasant activity, budgeting for calendar year 2010 is about to become even less fun than usual. The economic downturn of the past two years is now well-entrenched, although recent signs suggest the economy might be turning around.
That’s good news, right?
For many in our economy the answer is an unqualified yes. The same is true for nonprofits — eventually. But to come out of the recession, the sector must first go into it. As was pointed out in the Streetsmart Nonprofit Manager column in the January 1, 2009 issue of The NonProfit Times, the nonprofit sector is recession resistant, but not recession proof. Further, it stated, “red ink will flow in abundance [in 2010].” That prediction might have sounded prematurely pessimistic, but in truth was rooted in mathematics.
Foundations operate in financial slow motion due to the regulations governing them, so it is a simple matter of arithmetic to predict that bad news in philanthropy will lag bad news in the overall economy by as much as a year or two. Only next year will the full effects of the recession be felt, even if the recession is over in the rest of the economy. For different reasons, the same pattern is true of government funding, except that the post-recession picture will be even further strained by historically high borrowing levels and the compounding effect of tax cuts.
A few simple practices and a bit of planning discipline will help most nonprofits avoid the worst of next year. To make these practices more comprehensible, let’s group them in the three major categories that should each have their own budgets: operations; capital; and cash.
Operations Budget – Revenues
The reason revenue comes ahead of expenses in a budget is because revenue should drive expenses (otherwise, “e” comes before “r”). It’s also more important, and is properly the responsibility of the board and the organization’s executives. Furthermore, revenue takes longer to change, especially in a positive direction, whereas most expenses can be changed, up or down within a month or two and perhaps even less. Most revenue streams take a lot longer than that to come to fruition.
Think about your revenue streams by considering broad scenarios. Think about your Base Case — what is most likely to happen? Then, consider the Worst Case. The past year has seen financial events without precedent in the past 70 years. What are the chances that the same kind of downturn will happen again? Don’t rule it out. Yes, it could get worse. Plan for it. Remember that this is the year when foundations and government funding will probably be at an all-time low. Financial train wrecks happen in slow motion.
What about the best case? Leave revenues on an up note. Suppose the stock market swings all the way back, government finances improve at all levels, and unemployment trends downward? Sound improbable? Remember that the end of calendar year 2010 is still further away from today than we are from the “improbable” Crash of Fall 2008.
The point of developing revenue scenarios is to deconstruct them to understand the key drivers that will achieve or avoid them. You already know that foundation funding and government dollars constitute a major part of the nonprofit funding base. But, each will behave differently and have very different effects depending on the underlying assumptions. A secondary purpose of the scenario process is to make an organization’s executives more comfortable with the kind of revenue variability that we’ve seen during the past year.
Operations Budget – Expenses
Once you have three revenue scenarios, experiment with the implications of each one by shaping your expenses to fit the scenarios. If it’s not too unrealistic, include a bit of profit rather than budgeting to break even. This exercise will extend what you learned from revenues to your expenses by forcing you to consider constructive reactions to the good or bad news brought by your revenue streams.
How will you react to good news (Best Case)? What is your most likely response to bad news (Worst Case)? What are the most likely choices you’ll make for spending your revenue (Base Case)? Again, the value of this exercise is that you will have to work through decisions before you actually need to make them. Do-overs cost nothing and you’ll feel more confident about your decision-making ability in the face of uncertainty. Eventually you will develop a sense of mastery about the key drivers of your upcoming budget.
Every year you have to invest money in your capital assets such as buildings, vehicles, and information technology. Those in capital-intensive services, such as higher education and hospitals, need to constantly refresh buildings, campuses, and equipment. Museums, zoos, residential service providers and low-income housing managers also must keep their assets up to date, as does any nonprofit that uses information technology as part of providing its services. This means putting cold cash into equipment purchases, building renovations, and so on.
Many organizations have no official capital reinvestment policy, preferring to buy equipment and do renovations ad hoc. This is understandable but it almost always leads to steady erosion in the capital asset base, which in turn leads to higher replacement costs. Capital assets are best managed by steady investments in renewal and replacement, which is exactly what gets threatened in a recession. So, take this opportunity to consciously and explicitly develop a budget for your capital investments if you don’t already have one.
In 2010, virtually every nonprofit will be tempted to cut back on their investments in capital assets (regular maintenance is an operating cost, not technically an investment). The truth is that you can go easy on capital investments this coming year and you don’t need to feel guilty about it. This is a hallmark of a recession as people and organizations pull back on a massive scale.
There are two caveats here. First, if you are already shorting your capital investment plan, you won’t do yourself any favors by cutting back some more. The shabbiness creeps up quickly, and it won’t be long before functionality — and therefore program effectiveness — is impaired. Second, if you do cut back on capital assets in 2010 you will have to spend as much as twice the regular amount in 2011 to recover the pre-2010 pace.
Cash is a resource as valuable as capital assets or revenue and it needs to be managed with the same kind of even-handedness. For cash flow, timing is everything. One smart move that conserves cash can be worth a great deal. Regular cash flow projections are a good way to ensure that an organization stays liquid enough to meet all reasonably likely demands in the short term.
For the most part, cash flow projections are source-and use-blind. Where the cash comes from doesn’t matter, and what it goes to doesn’t matter unless the donor restricted its use. As with budget scenarios, cash flow planning can illuminate different dimensions of how cash flow behaves. For instance, a cash flow projection might underscore that a low-profit revenue source is still valuable because it pays invoices faster than others. Or, it could identify unrecognized cash drains on the organization.
July 1 is a common start date for state government budgets, and during this past summer many states either had trouble with their own cash flow or failed to achieve legally mandated balanced budgets and had to stop paying their bills temporarily. This decision had a severe impact on cash-thin nonprofits with large amounts of state government funding.
One consequence of this slowdown is that nonprofits turned to short term financing, such as lines of credit. The problem with commercial lines of credit is that they are intended for short-term purposes. But if the capital structure of a nonprofit has been compromised by recession-induced damage, that short-term fix could become a long-term crutch.
Commercial lenders might look the other way when a short-term instrument is used for long-term purposes, but this can leave the nonprofit vulnerable to forced loan restructuring if the lending winds were to change. This happened during the credit crunch of the late 1980’s when banks were forced to call loans that had been intended for short-term purposes but had become part of an organization’s long-term capital structure.
Think of your cash position as a summary comment on your organization’s historic financial management practices. Chronically cash-strapped organizations might need to sell off assets, which is never a wise choice during a recession because it locks in one’s losses at the low point of the asset’s value. In the worst cases, entities might need to consider a merger, although mergers driven solely by cash flow shortages will find the odds stacked against them. Closing down could be the only real choice. It’s better to diagnose the problem and act on it well before the panic stage arrives.
For nonprofits, every recession has a long tail, and 2010 will bring the brunt of it. This is easily the worst systemic threat to many nonprofits in decades. But a sustained and effective response in the three areas of operations, capital budgeting, and cash management will give most organizations the best chance of emerging from this downturn well-positioned to enjoy the inevitable upturn on the other side.
Thomas A. McLaughlin is Director of Consulting Services, at the Nonprofit Finance Fund, and a member of the faculty at the Heller School for Social Policy at Brandeis University. His email is firstname.lastname@example.org