Ears Ringing From Financial Alarms

July 16, 2012       Thomas McLaughlin      

The title of this piece should be the sound you hear in your mind if you see parentheses in the “Net Assets” line of your balance sheet. This sound should be loud enough to get your attention and persistent enough to impel you to action.

Here’s why that is the case. When a nonprofit shows negative net assets, it is considered insolvent. This means that it is unable to meet its financial obligations as they come due. Other terminology would describe it as having more liabilities than assets.

In plain English, the organization owes more than it owns. Technically, insolvency is not the same thing as bankruptcy because bankruptcy is a status only a court can confer. It’s close, though.

The Signs

A balance sheet with such an imbalance is sending a strong warning signal. Some nonprofit leaders and board members seem to pay little attention to the dinging their balance sheet makes. Why this occurs is probably because the balance sheet is an abstraction, once removed from the realities of management. It offers important indicators only if you’ve been inducted into the club of balance sheet readers.

This club membership does not automatically come from being on a board of directors or in the senior management ranks. One does not learn how to read a balance sheet just by joining a board or by turning great accomplishments as a program director or fundraiser into a senior executive position. More important, repeatedly hearing financial reports does not confer reliable knowledge. Watch the faces of non-financial board members during the financial report. That distant look is not serenity.

So how do you get the message to non-readers without inflicting a mini-course in bookkeeping on them? Tell them to look for other signals. Insolvency impacts many aspects of a nonprofit’s operations. It turns out that when this happens it’s not only the balance sheet that’s dinging. Here is a short course in warning signals that don’t require balance sheet knowledge.

Inadequate Cash on Hand: Insolvent organizations almost certainly will have chronic cash shortages. Low cash shows up in many different ways. The balance sheet sign is a low cash balance in the top one or two lines on the asset side, but the practical effects are multiple. A missed payroll is proof positive that the slump in net assets has practical implications.

Chronically Late Payments: Late payment of bills is usually inevitable too. The choice is stark for managers caught in this situation: Do we put off paying our vendors or our staff? The question usually answers itself. They pay the staff because the staff is closer and more immediately necessary for continuing services.

Vendors who are owed money quickly catch on to the dire financial situation. They call the bill payers and ask when they can expect to be paid. Eventually, they call frequently. They then stop providing products and services — which becomes another marker of financial difficulty.

Unpaid Bills Pile Up: Those unpaid bills add up quickly. An abrupt shift in a major vendor or supplier, such as an insurance company or an administrative services firm, can be a sign that both parties have decided to part company due to the cash shortage. Suppliers of commodity services are often the easiest to change quickly. This can lead to disruptions in administrative matters, especially if the wary new supplier insists on being paid in advance.

Unexpected borrowing: Has your organization suddenly begun borrowing money for short-term purposes? This is yet another ding-ding-ding. This kind of borrowing will only be short term, often through a line of credit. There’s nothing inherently wrong with short-term borrowing or lines of credit, but it might be a sign of financial stress if the entity begins doing this when some of the above signals are present.

Lines of credit have a big speed bump for the unwary: borrowers are required by federal regulation to leave the line of credit unused for at least 30 consecutive days each fiscal year.

Lower Amounts Owed to the Organization: There is an irony in this one. Bills the organization has sent out that are waiting to be paid are perfectly normal. Most organizations that provide services for a fee always have some level of outstanding accounts. This is a balance sheet indicator, and in a financial crisis the amount of these outstanding bills waiting to be paid often goes down. This should be good news, and in a short-term sense it is. The negative aspect is that these amounts decline because the organization is so desperate for cash that it puts unusual time and effort into collecting what in the past it might have let slide a bit longer.

Selling Investments: If the organization was lucky enough to have built up an endowment, financial trouble might prompt the sale of those assets. This is a fast way to restore a sagging cash flow, but it amounts to eating this winter the seeds you were going to plant next spring. Selling certain investments can bring additional problems. A nonprofit with investments is said to have an endowment. Often the donors who created the endowment intended those funds to last forever. These restricted funds technically can’t be used for any purpose other than what the donor intended and this is highlighted by explicit, publicly acknowledged restrictions on the use of the funds. Selling investments can force an organization’s endowment “under water,” which means that the dollar that was originally donated years ago is now worth, say, 70 cents. Law permits no further reduction of the remaining amount until those lost 30 cents are restored.

Selling the wrong investments can be a legal matter and it can also result in bad publicity. One university after the 2008 stock market crash planned to sell some long-held assets but had to abandon that plan after a public outcry and the threat of legal action.

Selling Buildings: The last resort is usually putting one or more buildings on the auction block. Unless a building is held strictly for investment purposes, its sale is almost certain to have programmatic ramifications. That can result in revenue reductions and reduced cash flow, which starts the cycle all over again.

Missed Payrolls: The nuclear option for financially stressed organizations is missing a payroll. It might sound odd, but this desperate measure really is a “choice,” albeit the choice of last resort. For those looking for dings, this is more like a bang.

Financially pressed organizations must make increasingly serious choices in an attempt to stop the decline. Evidence of that decline is most readily seen in the balance sheet. But not all smart, accomplished, responsible people know how to read a balance sheet so this evidence may go unnoticed. No problem. Look for easy-to-spot alternative signals. Ding-ding-ding can be heard in many ways.

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Thomas A. McLaughlin is the founder of the consulting firm McLaughlin & Associates and a faculty member at the Heller School for Social Policy at Brandeis University. He is the author of “Streetsmart Financial Basics for Nonprofit Managers” (3rd edition), published by Wiley & Sons. His email address is tamclaughlin@comcast.net