Nonprofit Enterprise: Criteria For Financial Planning

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

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

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

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.

Criteria for financial planning

Decision-making in nonprofit financial management is not only about money. It has to include many different aspects in order to meet the expectations of constituents and to be mission aligned. The following five criteria should be respected.

Governance/ethics

The reliance of nonprofits on private or public donors has an impact on their governance system. As Ostrander and Schervish (1990) show, the relationship tends to become donor dominant, which might entail mission drift. Additionally, the nonprofit board of directors itself is subject to influences of financial management. It must secure oversight and mission orientation. Brown (2005) finds that strategic contributions from the board are more sound in organizations with higher financial performance. Finally, ethical considerations cannot be left aside. Currently, nonprofits find themselves under constant scrutiny. Concerning financial sources, ethical norms apply to disclosure, conflict of interest, and the coherence of a revenue source with the organization’s mission.

Competence

The general business experience and knowledge of executives in nonprofit fields are significantly related to financial performance. Furthermore, the effective use of every revenue source depends on a different set of competencies. Maintaining a revenue source requires internal expertise. Fundraising has become a profession of its own, and for state funding, nonprofits require considerable knowledge on submission requirements and processes. Bowman (2011) highlights the fact that accumulated equity raises the financial capacity of nonprofits, and Calabrese (2012) seconds that nonprofits reduce their financial vulnerability through unrestricted net assets.

Efficiency

Each revenue source has different costs of control and transaction costs (Mayer et al., 2014). The more revenue sources are included in the portfolio; the more different cost structures must be managed. Hence, a highly diversified revenue portfolio might signal stability but simultaneously reduce income due to a loss in efficiency. Another vital aspect of efficiency is to cover core costs. As both the public and rating organizations focus on administrative costs as a measure of nonprofit success, raising unrestricted revenues to cover core costs offers leeway in strategic decision-making.

Volatility

Nonprofits are highly reliant on revenue stability to manage their liability. The exposure to volatility varies between the revenue sources. While earned income might change quickly following market developments, state funding is rather stable. However, a change in legislation might cause a shock, and lead to state income dissolving at once. As Mayer et al. (2014) show, reducing volatility does not simply mean balancing investments, earned income, and donations. Instead, nonprofit leaders have to find the right mixture of revenue sources for their organization in relation to their mission.

Interdependencies

There have always been discussions about the interdependencies between different revenue sources. Does, for example, government support reduce private donations? One can find studies for the one or the other answer. But it is necessary that nonprofits pay attention to this issue before they invest into a new financial source.

References

Bowman, W. (2011). Finance Fundamentals for Nonprofits: Building Capacity and Sustainability. Hoboken, New Jersey: Wiley.

Brown, W. A. (2005). Exploring the Association between Board and Organizational Performance in Nonprofit Organizations. In Nonprofit Management and Leadership 15(3), 317-39.

Calabrese, T. D. (2012). The Accumulation of Nonprofit Profits: A Dynamic Analysis. In Nonprofit and Voluntary Sector Quarterly 41(2), 300-24.

Mayer, W. J., H. Wang, J. Egginton, and H. S. Flint (2014). The Impact of Revenue Diversification on Expected Revenue and Volatility for Nonprofit Organizations. In Nonprofit and Voluntary Sector Quarterly 43(2), 374-92.

Ostrander, S. A., and P. G. Schervish (1990). Giving and Getting: Philanthropy as a Social Relation. In Critical Issues in American Philanthropy: Strengthening Theory and Practice, edited by J. Van Til. San Francisco: Jossey-Bass.