Financial management in nonprofits: basics
The purpose of nonprofit organizations and social enterprises is to solve a social problem, not to make profits. But without financial means, they cannot operate either.
Unlike business corporations, nonprofits cannot generate all their financial resources through the production of products and services. Instead, they are dependent of financial support from other sources, such as states, foundations, or private donors. This has implications for the financial management of nonprofits. In the following, we will take a look at the aims of financial management and categories of financial sources.
Aims of financial management: effectiveness and liquidity
In business corporations, the aims of financial management are profitability and liquidity (von Schnurbein, 2017). Profitability means that the financial resources generate a maximum return on investment, and liquidity is the ability to stay operative. Since nonprofits do not aim for profit maximization, profitability is not a justifiable aim. Instead, we select effectiveness. Thus, financial management should enable the organization to use its financial resources in the most effective way. The second aim, liquidity, is highly important for nonprofits. Nonprofits usually cannot apply easily for external finance, but they have to assure constant cash flow. The two aims of financial management lead to a trade-off dilemma: high cash assets secure liquidity, but at the same time reduce the effective use of financial means for the mission.
Categories of financial resources
Usually, the financial sources of nonprofits are separated into three groups: state subsidies, private donations, and own revenues (Bowman, 2011). The three groups differ especially in terms of logic of the exchange of service and return service. A major part of nonprofit financial resources is based on non-conclusive exchanges. Thus, the one paying is not the one receiving the service. In the following, we take a closer look at the three different groups of financial sources. As figures from the Johns Hopkins Comparative Nonprofit Sector Project show, state subsidies and own revenues are much more important than private donations. However, for the single organization the situation might be very different.
State funding is an important financial source in areas that are closely linked to public service provision such as health and social services or research and education. Public support can take the form of subsidies, loans, debt guarantees, service contracts, project-based support, or (indirectly) tax deductions. As a consequence of new public management, today subsidies are less common and public support is mostly based on service contracts. One advantage of public funding is the longer periods of support, for example a contract period over several years. Additionally, public support often means a quasi-monopoly as other nonprofits without the public support cannot offer the same service at same conditions. A disadvantage of state funding is that you have to follow many restrictions and deliver a detailed reporting. For example, if there is a surplus at the end, the means cannot be used for other purposes.
Often ignored, tax deductions are an important way of public support for nonprofits. On the one hand, private donors receive a tax deduction for their donations to charitable organizations, on the other hand, nonprofits profit from tax exemptions for specific taxes. The regulations can vary considerably from country to country. In the US, for instance, tax deductions of up to 40% are an important factor, whereas in most European countries, tax deductions are much lower, but the higher direct subsidies compensate the difference.
Private donations are collected from individuals, foundations, and other nonprofits, as well as corporations. Nonprofits use fundraising activities to generate private donations. Possible forms are direct mail, mobile fundraising, legacies, grants, loans, and many others. Usually, there is no direct return service, but the donor can include an appropriation. For example, a grant-making foundation supports a nonprofit in the field of education, but only for children until a certain age. The nonprofits are obliged to follow these conditions. Donor advised funds have become very popular in many countries, but from the perspective of the nonprofits, non-earmarked funds are much more important, especially to fund general operations. A major issue in public debate is the costs of fundraising. Mass market fundraising through direct mail or street activities have become very cost intensive and there is low accordance that donated money is used to finance fundraising specialists. However, returns from direct mails are still the most important source in individual giving.
Own revenues from service or product sales, membership fees or from financial investments are the final category of financial sources. The major advantage is that own revenues are not earmarked and surpluses can be used for any task within the organization’s mission. Thus, own revenues are best for investments and core costs. However, own revenues come with an entrepreneurial risk. Therefore, good financial planning of costs and future returns is necessary to avoid negative results that would have to be compensated through private donations. Generally, own revenues offer very good cost control. Returns from running services or membership fees are easy to budget and, thus, offer stability for financial planning. Generally, own revenues have had the highest growth rates in the past years, emphasizing the need for nonprofits, to verify opportunities for own revenues in the future.
If a nonprofit has unrestricted assets, it might invest these resources in order to gain more profits. Especially in connection with financial investments, liquidity is a major issue. Depending on the kind of investment, liquidity is reduced or restricted and if the nonprofit has to access the money anyway, it is connected to high costs. Additionally, the volatility of the financial markets has to be taken into account. However, the most important aspect of financial investments today is the alignment with the organization’s values. Even socially responsible investment rules might not be strict enough to cover the ethical expectations in that sense.
Thus, financial management in nonprofits has to offer answers to the following two questions:
- What are the financial requirements of the organization?
- Which financial sources suit best the needs of the organization?
von Schnurbein, G. (2017). Nonprofit Financial Growth and Path Dependency. CEPS Working Paper Series, No. 12, Basel: CEPS.
© University of Basel