nonprofit functional expense ratio
In this month’s Social Velocity blog interview, we’re talking with Kate Barr, Executive Director of Nonprofits Assistance Fund, whose mission is to foster community development and vitality by building financially healthy nonprofit organizations. Kate has led the organization’s growth as a premier resource for training, strategic financial counsel, and financing for nonprofit organizations in Minnesota. Kate enjoys helping nonprofits consider the relationship between their mission and program goals and their financial and organizational strategy. She frequently writes and speaks on nonprofit financial and strategy and is lead blogger for Balancing the Mission Checkbook.
You can read past interviews in our Social Innovation Interview Series here.
Nell: Nonprofits Assistance Fund is all about helping nonprofit leaders become more financially savvy. Why do you think strategic financial management is so important for nonprofit leaders and what holds some nonprofit leaders back from achieving it?
Kate: I think about it this way: if strategic direction in general is important for nonprofit organizations, then strategic financial management is equally important as a component of that direction and vision. When a nonprofit develops a strategic plan they are also adopting a financial strategy. Too often, though, that financial strategy is underdeveloped because the vision and strategic goals don’t incorporate the business model that’s required to support the plan. At Nonprofits Assistance Fund we unpack the financial aspect of a nonprofit business model into four inter-connected components: revenue mix; cost of effective programs; infrastructure; and capital structure. I see the biggest obstacle to understanding financial strategy is the singular focus that many nonprofit leaders place on revenue, revenue, revenue. If we could just raise enough money, they think, it will all work out. In reality the business model is more complex than that. The extreme revenue pressures that many nonprofits have faced over the last few years have uncovered the vulnerability of business models. Fortunately, savvy leaders are stepping back to understand the strengths and weaknesses of their financial strategy and being more intentional about identifying and creating a business model that can work.
Nell: A few months ago you wrote a rebuttal to the Center of Philanthropy’s recent survey that claimed nonprofit managers lack solid financial knowledge. What would you say is the actual extent of financial knowledge among the leaders of the nonprofit sector? And what can we do to improve it?
Kate: Yes, I was critical of the study because the findings were based on an extremely narrow test of knowledge to define financial literacy. As we said in the column, the report did not make a connection between the “lack of financial knowledge” based on the survey and the health and vitality of the nonprofits and their missions in the community. Frankly, the fact that so many nonprofits have been able to respond to huge increases in demand for service without going over the cliff is testament to some pretty remarkable financial skills. The direct answer to the question, though, is that the financial knowledge is mixed. Anyone with financial management responsibility needs to understand the terminology of nonprofit finance and know how to read and make use of financial information. Leaders of nonprofits need to have both technical knowledge – what I would categorize as financial management skills – and leadership capacity to navigate changes to their business models. There has been a lot of progress in building financial management skills as the field has become more professionalized. There are many training opportunities for skill building, both in person workshop and online learning (including Nonprofits Assistance Fund’s training workshops and webinars). Financial leadership capacity requires more than a few classes. It takes experience, knowledge, and guts to align mission, strategic plan, and financial structure in a way that build sustainable community impact. I think the ideal nonprofit leader combines passion for the mission with excitement for the business challenge.
Nell: There is a phenomenon in the nonprofit sector that when business people join a nonprofit board they often leave their financial and business acumen at the door fearing it could muddy the charitable work of the organization. Why do you think this is and what can we do to overcome that tendency?
Kate: I’ve seen two different dynamics when this happens with board members: wishful thinking and misunderstanding. The wishful thinking problem arises when board members believe that nonprofits operate outside of the market and that their good work can be performed with minimal cost and simple revenue streams. The misunderstanding is just another version of the “nonprofits should operate more like businesses” myth. Nonprofits are businesses. This “advice” underestimates the complexity of nonprofits as business enterprises. Board members can’t be effective unless they understand how the enterprise works and what the board’s role is in planning and governing. Overcoming this tendency starts with board leadership and carries through recruiting, orientation, and ongoing board development. The executive director or CEO has an important role to work with the board chair or governance committee to prepare and support board members’ ability to understand and build the business.
Nell: One of the most exciting developments in the last year or so is the growing interest in and experimentation with social impact bonds, or pay for success bonds, a public/private funding vehicle for nonprofits based on outcomes. Minnesota has already begun to experiment with a $10 million pilot. What, if anything, has Minnesota learned so far and what do you see as the future for this new financial vehicle?
Kate: There is a lot going on in efforts to develop models and financial structures to pay for results, including social impact bonds, pay for success contracting, and the Minnesota pay for performance pilot. The Minnesota state legislature approved a $10 million state appropriation bond to test a pay for performance approach for some state funded programs. The Minnesota pilot is the first experiment to use an actual bond offering as the financial structure. The advisory committee started meeting early this year and has just issued a Request for Information for nonprofit service providers in workforce development and supportive housing. What we’ve learned so far in developing the Minnesota pilot is that every question leads to three more questions. Part of the complexity stems from the goals. In each of the models in development there are actually multiple goals: identifying program designs that work; saving the state money; attracting new funds; and sharing or transferring financial risk. Any one of these goals requires capacity to deliver and appropriate measures for success. Combining all four goals, as most of the models do, creates something of a bear to design and evaluate. Some of the open questions in Minnesota include: the methodology for the economic measure of success; the role of evaluator; the time-frame for measuring and valuing ROI to the state; access to the data that will be used for monitoring; the market for the bonds; and the appropriate level of risk for nonprofits to bear. The Minnesota pilot does not transfer the financial risk to the bondholders in the same way as the SIB model so there is also a working capital gap for the service providers. We are assessing what will be needed for our loan fund to help with that. As for the future, while there is great enthusiasm for these ideas and pilot projects we have to keep in mind that this is all still early stage with lots of lessons to be learned before we even know if these can attract significant new funds.
Nell: One of the big debates in the nonprofit sector centers around a distinction between program and administrative (or “overhead”) expenses. Rating agencies are just starting to realize that this distinction is damaging to the nonprofit sector. But how do we really move beyond this and get a majority of funders, regulators and others to recognize the danger of evaluating nonprofits based on how they spend money versus how they achieve results?
Kate: Is this even really a debate anymore? There’s pretty universal agreement that the functional expense ratio doesn’t measure nonprofit effectiveness, efficiency, or accountability. The challenge now is communication and education. This one ratio has so dominated every nonprofit financial measurement that we are forced to try and undo decades of practice. Nonprofits bought into the ratio, too, and reinforced it with pie charts and donor messages about how “every dollar goes to program”. Is it any surprise that donors listened and believed us? It took years to create the “standard” that expense ratio is the most useful measure for nonprofit financial results. Unfortunately it’s going to take time to re-educate. We have to start within the nonprofit field itself. There are still many nonprofits that promote their low overhead ratio in fundraising because, they claim, it helps them to attract and retain donors. It’s easy to calculate and communicate. Rather than battle the monster that we helped to create, I think we need to change gears, replace the ratio with more meaningful information about impact and financial health, and raise expectations for results. I really appreciate that Financial Scan, the new product from Guidestar and Nonprofit Finance Fund, doesn’t even include the functional expense ratio on the financial health dashboard or accompanying analysis reports. None of the other ratios – that are much more useful – are quite as simple, though. We’re going to be having this “debate” for some time to come.
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