Predicting Financial Vulnerability in NonprofitsRoger A. Lohmann, Ph.D.Nancy Lohmann, Ph.D.Division of Social WorkSchool of Applied Social ScienceEberly College of Arts & SciencesWest Virginia University

Age of Financial Uncertainty for NonprofitsCutbacks of programsMachinations of accountabilityRefusal of many funding sources to acknowledge need for long term operating support

Situation in WV Getting WorseNP Crises in Kanawa ValleyMulti-CAP scandal/bankruptcyShawnee Hills bankruptcyEtc.DHHR De-funding Juvenile RetentionDHHR Contract Terminations70 agencies5-600 jobs

Is Prediction of Vulnerability Possible?No cure for mismanagementMulti-CAP Officer said: After 26 years in the business, hed never heard you couldnt commingle funds!If any of you are in doubt; You cant!!No present way to predict actions of othersWill DHHR cancel more contracts?

Some Vulnerability is PredictableNPs are part of a fairly stable political economy Deliberate introduction of riskManagers feel vulnerable much of the time

BackgroundSmall group of accounting researchers working on this problem.First, in commercial settingsMore recently, in nonprofitsProduced and tested a predictive model of estimating financial vulnerability that should be of interest to all nonprofit administrators.

Background: Accounting StatementsThree standard nonprofit financial statements relevant to prediction:Balance Sheet (Position)Statement of Income and Expenditures (Performance Over Time)Changes in Fund Balance (Changes in Position Over Time)

Background: Expenditure TypesNASB recognizes three main types of expenditures AdministrativeFund RaisingProgram

Background: Revenue SourcesIRS 990 recognizes five types of revenuesContracts, gifts and grantsProgram revenues (earnings)Membership duesSales of unrelated goods (UBITs)Investment Income

General Approach: Ratio AnalysisBuilt from standardized information from financial statementsRatios are just FractionsNumerator and denominator from different places on financial statementsE.g. current ratio is current liabilities / current assetsNormally, 1 or lessGreater than 1 should raise questions about long-term asset coverage of debt.

Three kinds of Financial Distress ratios:Seat of the pants (practice- or experience-based wisdom)Practice wisdom validated by empirical researchReliability, validity and generalizability Can you trust the measure?When does it apply?How widely does it apply?Published Industry Standards

Defining Financial Vulnerability ( Beaver, 1966) = financial vulnerability is probability of filing for bankruptcy. Gilbert, et. Al. (1990) found many vulnerable companies do not file for bankruptcy.Franks & Torous (1989): Companies that file may not be vulnerable (may be due to labor disputes, etc.)

Underlying Idea:Financial Vulnerability = ability to recover from sudden financial shocks.Sudden and unexpected loss of incomeSudden and uncontrollable increase in expendituresExamplesLoss of a grant/contractSudden decrease (or increase) in clientsDiscovery by EPA that your building is full of asbestos

Research Measures of Financial VulnerabilityActual or anticipated filing for bankruptcyThree consecutive years of net losses (negative net income)(Nonprofit) Reduced program expenses

The Tuckman-Chang Model Financially vulnerable nonprofit: Likely to reduce its program services following a financial shock.Study of 4,730 501(c)3 organizations filing IRS 990s in 1983.Howard Tuckman and Cyril Chang. A Methodology for Measuring the Financial Vulnerability of Charitable Nonprofit Organizations. Nonprofit and Voluntary Sector Quarterly. Winter, 1991. 445-460FOR MORE INFO...

Tuckman-Chang RatiosInadequate Equity BalancesRevenue ConcentrationLow Administrative CostsLow Operating Margins

Inadequate Equity BalancesRatio of total equity (fund balances) to total revenuesLower ratio means less able to replace lost revenues following a financial shockLower ratio = greater vulnerabilityNegative ratio unlikely (Neg. total revenues means real trouble!)

Tuckman-Chang RatiosInadequate Equity BalancesRevenue ConcentrationLow Administrative CostsLow Operating Margins

Revenue ConcentrationSum of revenue sources / total revenues squared(24/328,000) = .000073.000073*.000073 = .0000000053Organizations with fewer revenue sources are more vulnerable to financial shocks in any one of themFewer sources = greater vulnerability

Tuckman-Chang RatiosInadequate Equity BalancesRevenue ConcentrationLow Administrative CostsLow Operating Margins

Low Administrative CostsRatio of Administrative Expenses/Total RevenuesContrary to conventional wisdom: Lower ratios = greater vulnerabilityLower administrative costs almost always translate into decreased flexibility. Diminished ability to reduce administrative costs in a crisisMore limited management problem solving capabilitiesE.g., fewer mgrs., supervisors or support personnel to draft to 1)solve problem or 2) provide services in meantime.Reminder: Conclusion based on random sample study of 4,730 nonprofits!

Tuckman-Chang RatiosInadequate Equity BalancesRevenue ConcentrationLow Administrative CostsLow Operating Margins

Low Operating MarginsRatio of (total revenues less total expenses) / Total RevenuesLower ratios = greater vulnerability$300,000 in revenues and $200,000 in expenses30-20 = 1010/30 = .33$500,000 in revenues and $200,000 in expenses50-20 = 3030/50 = .60

Tuchman and Chang standardsAny score in second quintile at riskLowest quintile on all four variables severely at riskQuintile ratios for four measuresEquity BalancesRevenue ConcentrationAdministrative CostOperating Margins

Tuchman and Chang InsightsInverse relationship --> revenues and riskLow equity levels an indicator of riskHigher long-term debt to long-term assets ratios another sign of troubleVulnerable nonprofits are less liquid (current ratios)Higher program service reliance --> greater vulnerability

Two Major Research ProblemsExtent of Program Services not fully captured by accounting system.Difficult to determine independently which nonprofits experience financial shocks

Prediction EquationGreenlee and Trussel (2001) develop a prediction equation Useful for exact estimation of financial vulnerability within a set of norms for interpreting it.Useful for comparing vulnerabilities

Greenlee-Trussel EquationYields the probability of financial vulnerability Probability greater than 10% is a strong indication of financial vulnerabilityProbability less than 7% is a strong indication of no vulnerabilityProbability between 7-10% are indeterminate.

Greenlee-Trussel Equation1/(1+e-z) whereZ=Constant (3.0610) + EQUITY + CONCENT + ADMIN + MARGINThe four ratios of Tuckman-Chang

Almost Ready for Prime TimeIn the absence of other information, this approach is solid enough that nonprofit managers might begin to make use of it to test their hunches about the financial vulnerability of their organizations. Probably not a good idea to rely on totally.Certainly better than anything else currently existing.

Some general guidelines for more intuitive use of ratiosGreater the body of data you have more meaningful it will be.Year-to-year comparisons are more momentous than month-to-monthCross-organizational comparisons of programs with similar names can be very risky. (E.g., All home health programs are not created equal).

Different ApproachesSelf-NormingCompare a single organization at different periodsPick most secure and most vulnerable periods and comparePeer-ComparisonsCompare Groups of related organizationsCompare community systemsInformation on ranges

Limitations of the Model: INot all nonprofits file 990sRisky to generalize about non-filers.Ratios limited to data IRS 990 collectsE.g., IRS doesnt collect data on outputs

Limitations of the Model: IIThe Greenlee-Tressel model (GTM) only tested on organizations four or more years old.Could be that newer organizations (1-3 years old) behave differently. The GTM only tested on charitable organizations to date.Further research needed using alternative definitions of financial vulnerability.