NPQ is breaking with its own traditions to print a full publication by a collaborative comprising GuideStar, Oliver Wyman, and SeaChange Capital Partners. We found this publication to be unusually useful in that, though focused on Philadelphia, it provides a window into challenges that face nonprofits everywhere.
This report, The Financial Health of Philadelphia-Area Nonprofits, was commissioned earlier this year by The Philadelphia Foundation with the intention of presenting actionable information for nonprofit organizations, their leaders, funders, policymakers and the general public. This report follows a 2010 nonprofit study commissioned by The Philadelphia Foundation.
Residents of the five Pennsylvania counties of Greater Philadelphia rely on nonprofit organizations in many facets of everyday life and community. As nonprofits go, so go the services and amenities that impact quality of life, often health and safety. It is with this latter point in mind that The Philadelphia Foundation has focused much of its efforts over the last decade on “organizational effectiveness”—examining, promoting and funding sound fiscal, governance and leadership practices, especially among organizations serving the most vulnerable.
This report demonstrates that there is much more work to be done to strengthen nonprofit organizations in our area. Moving from “getting by” to “getting strong” requires that more attention and talent be dedicated to financial resilience by executives, boards and funders. Approximately 40 percent of organizations are not generating positive operating margins and will therefore find it difficult to focus on improving service outcomes. Seven percent of nonprofits are technically insolvent, yet neither the organizations themselves nor the wider community have a clear understanding of what it would meant for them to fail, or the implications of that failure for the populations they serve.
The authors, as experienced consultants, suggest sound approaches for addressing financial risks within organizations. They also suggest that funders self-critically examine the extent to which their restrictions on “overhead” or “administration” are contributing to the fragility of nonprofits. The groundwork is also set for more segmented or granular examinations of the region’s nonprofits, as others may wish to pursue in response to this study. This report is a good start.
We want to thank the authors and Nadya K. Shmavonian, the Director of the Nonprofit Repositioning Fund, for all they did to bring this report to fruition.
—Pedro A. Ramos, President & CEO, The Philadelphia Foundation
As nonprofit organizations in the five Pennsylvania counties of Greater Philadelphia (Bucks, Chester, Delaware, Montgomery, and Philadelphia) emerge from the financial crisis of the last decade and head into a very different and hard-to-forecast political and economic environment in the future, financial discipline, smart growth and strong governance are more important than ever. Accordingly, many nonprofit executives and governing boards are asking new questions about the organizations they govern. What risks do we face?1 How risky are we in relation to our peers? Are we doing the right things to understand and mitigate our risks? How should we balance financial risk against programmatic reward? What should we do to reduce the potential hardships from financial distress?
Unfortunately, very few nonprofits have processes in place to address these issues of financial risk management. However, our research suggests that this can and must change.
- Nonprofits in the Philadelphia five county area are fragile: roughly seven percent are technically insolvent (i.e. liabilities exceed assets); over 20 percent have less than one month of cash reserves (i.e. virtually no margin for error); and over 40 percent have net operating margins of zero or less. In aggregate, we believe that fewer than 40 percent of nonprofits can be characterized as financially strong. Yet our experience in other geographies suggests that many executives and governing boards don’t fully understand the financial condition of their organizations or how they compare to peers.
- Practices such as scenario planning, benchmarking and self-rating, as well as setting explicit financial stability targets, can improve risk management. While we have seen a few organizations already doing these things, most are not.
- Distressed nonprofits have very limited ways to recover, so executives and governing boards must do all they can to reduce the risk that their organization becomes distressed in the first place. And they must take prompt, decisive action if it does.
In what promises to be a continuously volatile market for nonprofit organizations, we believe that executives and governing boards must make dramatic improvements in financial risk management over the next few years in order to bring more stability to vital programs and the communities they serve.
National concerns about risk and financial stability among nonprofits have been increasing recently, motivated by some high-profile nonprofit failures, the potential impact of rising interest rates, regulatory changes to health and human services systems, and rising real estate costs, to name a few factors. These concerns have only sharpened since the 2016 election, as nonprofits grapple with increased uncertainty around government funding levels and sources, and the possibility that tax code changes will reduce incentives for philanthropic funding. While planned dissolutions can be a responsible decision for some organizations to make, we can all agree that unanticipated closures in bankruptcy do not represent adequate fiscal stewardship of nonprofit organizations.
This report introduces important fiduciary steps that organizations can take to manage their financial health and their financial risks better. These recommendations build upon a similar 2016 study on how to adapt private sector risk practices to New York nonprofits that was conducted by SeaChange Capital Partners, Oliver Wyman, and GuideStar. We have attempted to identify actions that will be high-impact and potentially transformative over time, but that are also practical and can be implemented now. We believe that the opportunity to create stronger, more stable nonprofits is real—but also that the risks of inaction are real, and substantial. Organizations that do not adopt risk management practices may find themselves in an increasingly precarious situation.
THE SCALE OF THE CHALLENGE: HOW “RISKY” IS THE ENVIRONMENT FOR GREATER PHILADELPHIA’S NONPROFITS?
Our analysis of the financial results of Philadelphia-area nonprofits illustrates just how fragile many nonprofits are. It should provide useful context for nonprofit executives and board members to understand their organizations’ absolute and relative risk profile. It should also help funders to better understand the challenging dynamics facing the region’s nonprofits. An important point of context must be added: this report is based upon 2014 IRS Form 990 data that pre-dated the 2015 Pennsylvania budget impasse, a difficult passage from which many executives in hard-hit fields (i.e., health and human services) suggest their organizations have not fully recovered.
The last time the Philadelphia five-county region was studied, in a 2010 study conducted by The Philadelphia Foundation,2 there were over 15,000 nonprofits in the region, with 242,000 reported employees and more than $11 billion in annual wages, providing critical services to a large number of area residents. Of the 15,000, roughly half file tax returns in some form (with others exempted due to factors such as religious status), and of the filers, roughly 20 percent file full 990 tax forms. This paper is based on the analysis of the data from Form 990, captured in the GuideStar database.
The analysis excludes organizations categorized as educational institutions and hospitals & care organizations (as indicated by NTEE codes beginning with “B” or “E” codes) since the operating models for these entities are different than direct service organizations—which are the focus of this report. Educational institutions and hospitals tend to generate revenues on a fee-for-service basis, and as a result, may have greater access to funding from capital markets and contingent funding sources. In aggregate, in 2014, the 990 filers included in the analysis had revenues of slightly over $16 billion, and operated with a positive net income margin of roughly 11 percent (when including revenues from asset sales and investment income.) Margins have been stable to improving; the equivalent figure in 2010 was only three percent.
The “balance sheet” of these nonprofits also looks reasonably healthy—in aggregate. There are three important measures of a nonprofit’s risk-bearing capacity that executives and governing boards should keep in mind: 1) Cash to cover immediate needs; 2) Unrestricted net assets as the best measure of a nonprofit’s “equity” that is available to bear losses or make investments; and 3) Operating reserves (the portion of the equity that is available in the short term, calculated as net unrestricted assets less fixed assets.). On average, Greater Philadelphia nonprofits don’t look too bad on these metrics. The median nonprofit in the region, for example, has over three months of cash in the bank. While this ratio is substantially lower than the six-month cash reserve level that many nonprofit experts suggest is appropriate, it at least suggests a modest degree of financial cushion.
In aggregate and on average, then, the picture is relatively positive. However, the health—and riskiness—of the region’s nonprofits are of greater concern when viewed at the individual organizational level. The very different circumstances facing individual organizations (and within different fields) become much clearer when the industry-level data are disaggregated.
• Roughly seven percent of the region’s nonprofits are technically insolvent (i.e., their liabilities exceed their assets), and in fields such as health and human services, the insolvency rate is almost double the overall average. Many of these organizations are limping from payroll to payroll with less than a month of cash, effectively borrowing from vendors (by delaying payment) and/or dipping into restricted funds. These organizations have no capital for investment and no ability to consider a thoughtful wind-down given the lack of resources to fund the associated one-time costs.
• Many organizations have virtually no margin for error While the nonprofit community as a whole has slightly more than three months of cash in the bank, roughly a quarter of nonprofits have a month or less of cash. And even this actually overstates the real cushion for weaker organizations, since much of the available cash is restricted to certain purposes. At best, fewer than 40 percent of organizations appear to be financially strong, with more than six months of cash or operating reserves.
• As noted previously, while the total nonprofit community earned an average net income margin of 11 percent, the median nonprofit had a margin of only 2.8 percent. And over 40 percent of nonprofits actually had a zero or negative operating margin—in other words, almost half of area nonprofits are running at a loss or at least producing no surplus.
• Most nonprofits are small but the large ones provide the vast majority of services: 69 percent have operating budgets less than $1 million; 19 percent are between $1 and $5 million; and four percent are between $5 million and $10 million. Only eight percent have budgets of $10 million or above. There are fewer than 50 organizations of more than $50 million in the five counties.
However, the smallest 50 percent of the organizations contributed less than 5 percent of total service provision while the largest 10 percent provided almost 85 percent. And while there is some evidence of economies of scale operating in larger nonprofits (for example, they tend to have slightly lower overhead expenses, expressed as a percentage of revenue), 20 percent to 30 percent of the largest organizations still have negative margins and very limited cash and operating reserve cushions. While these large organizations are, on average, less likely to encounter distress than are small organizations, there are still many large organizations in very precarious positions—and the cost to society of distress at these large organizations, in terms of potential disruption to critical services, is substantial.
• Nonprofits differ greatly in their reliance on philanthropy. The median level of philanthropy is about 18 percent as a percentage of total revenue, but this figure varies greatly by field and size. The median health and human services nonprofit earns only 4.7 percent of revenue from philanthropy, compared with nearly 50 percent for the average environmental and arts, culture and humanities nonprofit. Similarly, the median “very small” (under $1 million) organization receives 24 percent of revenue from philanthropy, the median very large nonprofit less than one percent. The largest organizations, delivering the most services, and particularly focused on health and human services, are least supported by philanthropy, and most supported by earned revenue associated with government contracts.
• The sector is painfully exposed to even modest reductions in government funding. A five percent reduction in government funding (if evenly distributed across the sector) would result in nearly 20 percent of nonprofits that currently earn a surplus moving into deficit. For some of these institutions, the deficits would be modest relative to their available financial resources, but for the 20 percent of those worst-impacted by the reduction (i.e., roughly 20 percent x 20 percent = four percent of current surplus-earning nonprofits) the deficits would lead to insolvency in five years.
• “Overhead” and administrative expense performance also vary widely across different nonprofits. Overhead, typically defined as the sum of all administrative and fundraising (i.e., non-program related) expenses, is a difficult issue for nonprofits. Many funders want to see their dollars directly support program expenses, rather than overhead; at the same time, nonprofits have a legitimate need to spend responsibly to create financial systems, IT infrastructure, HR capabilities, and other “administrative” capabilities necessary to support the organization over time. The data suggests that the median Greater Philadelphia nonprofit allocates about 11 percent of its expenses to administration.
This figure is comparable to what we have observed in other geographies, and has been stable over the last five years. As with other metrics, though, the median does not show that there is considerable variation across institutions. The 30th percentile spends only 5.9 percent on administrative expense, and the 70th percentile spends 18 percent. More remarkably, the bottom 10 percent of nonprofits claim to spend nothing on administration (which is likely an illustration of something we all know to be true—990 data isn’t perfect!), while the top 10 percent allocate 36 percent of expenses to admin. There is no ”right” answer for what overhead spending should be, but new research advocates adopting benchmarking by sector to guide overhead management (for additional discussion on this topic, please see Bridgespan’s 2016 report, “Pay-What-It-Takes Philanthropy”).3 Nonprofit executives and governing boards should be aware of how their organization’s expenses compare to peers, and prepared to argue why their specific level of spending is neither so low as to starve the organization of needed administrative support, nor so high as to represent inefficiency or waste.
• Sub-fields exhibit very different characteristics. In particular, as noted already, the health and human services field appears weaker than other nonprofits on almost every metric of financial health. To illustrate: the cash on hand ratio for the median Philadelphia-area nonprofit is over three months, at 3.4. The same ratio at the median Philadelphia-area health and human services nonprofit, meanwhile, is half that level, at 1.7. Again, these 2014 data precede the Pennsylvania budget impasse, which disproportionately affected nonprofits working in fields that are particularly dependent on government funding, like health and human services (although larger institutions such as hospitals may have greater access to credit lines, as well as more predictable fee-for-service revenue streams).
• Geographic differences don’t seem to matter as much as we expected. Urban Philadelphia and the suburban and exurban areas of the surrounding four counties obviously have very different economic and demographic characteristics. The data on nonprofit health across the five counties, however, shows remarkably little variation. (We’ve also analyzed the differences among states nationally, and between major urban areas and the rest of the country, and—somewhat surprisingly—have observed relatively little variation in nonprofit health metrics across any of those boundaries.)
We are not suggesting that nonprofit organizations should earn consistently large surpluses. After all, the organizations exist to pursue programs, not to build up internal resources. However, the profound under-capitalization and small scale of most organizations impedes necessary investments and makes prudent risk management all the more important. Yet, greater scale is not a panacea. For example, a large, well-run nonprofit organization with economies of scale might be able to earn a surplus of one percent on revenue in a typical year if it relies principally on government contracts. However, even after five years the resulting retained surplus would amount to less than three weeks of expenses. This is not enough to support appropriate investments in technology or infrastructure or to provide a cushion against unforeseen risks. Larger nonprofits typically have a lower proportion of revenue coming from private philanthropy. They are therefore more reliant on government contracts. Beyond a certain tipping point, even the most efficient organizations will not necessarily have sufficient private funds to offset the deficit from their government funding.
THE TRACK RECORD: HOW NONPROFITS HAVE DEALT WITH RISK
The sector’s overall fragility means that many nonprofits will experience financial distress. In a 2016 study of nonprofits in New York City, SeaChange and Oliver Wyman interviewed executive directors, board members, and funders of nonprofits that had struggled. Some went bankrupt. Others were rescued at the eleventh hour by other organizations. Others “saw the writing on the wall” early enough to enter into an orderly merger or dissolution. Across the discussions, several themes emerged, as did some “worst practices”, themes that will likely resonate for nonprofit executives and funders in the Greater Philadelphia region. Among the factors reported by these distressed organizations (not universally, but frequently):
- The organizations were fragile to begin with. Before the crisis hit they had limited resources and several years of deficits that had eroded whatever resources had once been in place.
- The organizations had a longstanding challenge in recruiting and retaining a strong chief financial officer.
- The crisis was precipitated by an event: the departure of the executive director; the non-renewal of an important funder; a change in government priorities or in the nature of government funding; a very meaningful (25-50 percent-plus) increase in scale; a real estate project that was large compared to the operating budget; or the emergence of a contingent liability (e.g., a Medicaid audit).
- The organizations failed to do explicit scenario planning despite facing inherently uncertain situations. They did not pay enough attention to contingencies and milestones. Organizations were surprised by crises that could have been foreseen.
- Trustees were not made fully aware of important long-term trends in financial performance or the operating environment. Important trends were masked by an exclusive focus on annual budgets, and year-to-date and year-over-year “rearview mirror” comparisons.
- Trustees did not get timely, actionable information at the appropriate level of detail (i.e., by contract, program, or project) before or during the early stages of the crisis.
- Trustees took too long to realize that there was a problem and then delayed taking action even after they had decided it was necessary. Executive directors and trustees suffered from magical thinking, particularly with respect to fundraising.
THE CONTEXT: STRUCTURAL CHALLENGES
In order to manage financial risk, nonprofit executives and governing boards should be fully aware of the dynamics that make nonprofits particularly vulnerable to economic challenges, differentiating factors that for-profit executives do not always appreciate before they join a nonprofit board. These include, but are not limited to:
- Tackling the hardest problems: Many nonprofits address economically intractable and politically unappealing problems that are labor intensive and inherently inefficient. Board members may be faced with systemic conditions that can be far more difficult to address than any they have seen before.
- Cost-minus funding: Most nonprofit funding, especially in health and human services, comes in the form of government contracts or restricted grants that virtually guarantee a deficit. Government contracts also create working capital depletion because funding arrives after expenses are paid. These funds are also subject to unpredictable delays in payment.4
- Inflexible funding: In the nonprofit world, a dollar isn’t a dollar—it’s usually a dollar with lots of strings, costs and restrictions attached. Typically, a large portion, or all, of grants and contract revenues are required to be allocated to program expenses. This imposes a huge administrative burden on nonprofits, as every penny of program spending needs to be documented. It also leaves nonprofits scraping to pay for critical functions like IT, finance, and executive management that do not qualify as “program” expenses—but are in fact vital to the health and survival of the institution.
- One-way bets: Nonprofits face contingent liabilities that can swamp them financially. These include government claw-backs for disallowed expenses, after-the-fact audits, and unilateral retroactive rate reductions.
- Zero-sum philanthropy: The total supply of philanthropy is largely fixed.5 Large organizations working in the most difficult issue areas will always be overwhelmingly reliant on government funding. Similarly, arts and culture organizations that are more reliant upon philanthropy, face great competitive challenges. And finally, while philanthropy may be flat—or even decline—when the economy is unpredictable, human need often rises, placing greater demand upon social service agencies.
- Cost disease: Nonprofits often provide face-to-face, labor-intensive services that do not become more efficient with technology—as a result, costs often rise faster than revenue. The real costs of these services have risen substantially over time and are likely to do so in the future.6 There are few, if any, magic bullets in this arena.
- Recruiting and retention: Nonprofits face structural challenges in recruiting and retaining high-quality staff in technical skill areas such as finance, accounting, and technology. Factors driving this situation include the small size of many organizations, the challenge in providing career development, and competition from higher-paying for-profits.
- Gales of creative destruction: Nonprofits operate in a dynamic environment. Challenges include demographics, funding fashions, political priorities, real estate costs, and low working capital. The weak financial position of many nonprofits can make it difficult to anticipate and respond to these and other challenges.
It is no surprise that many nonprofits are always living close to the edge. A common response to these challenges is to attempt to raise more unrestricted private philanthropic dollars. This solution won’t work, at least not for the community as a whole. Experience shows that the amount of available private philanthropy is relatively fixed—it varies little year to year, and has demonstrated no ability to grow at a faster rate than GDP. While individual nonprofits may succeed in their mission of raising more, the sector in aggregate won’t. And it is just as unlikely that public sources of support will increase any time soon. What does this mean for nonprofit leadership and governance, and what can be done to better anticipate and manage risks in this challenging environment?
ONE PATH FORWARD: MORE ROBUST AND SYSTEMATIC RISK MANAGEMENT
Enterprise Risk Management in for-profit companies and our interviews with nonprofit executives suggest a set of best practices for nonprofit risk management. They are in use at several leading nonprofits, and each one can make a real difference to any organization that adopts it. These practices presume a level of staff and board oversight that may present a challenge, particularly to very small organizations. They are introduced here as best practices that can be adopted by nonprofits, because without increased fiscal rigor, many distressed nonprofits will be compromised in their ability to deliver upon their missions.
This material is presented with the hope that nonprofit executives and board members as well as funders can face into fiscal challenges proactively, and manage to them more aggressively. In cases where from a practical standpoint the practices cannot be fully implemented, executive directors and governing boards should apply the mindset behind the practice to the greatest extent possible. Development of these skills will be critical to the nonprofit sector’s success. T