Financial management in nonprofits is becoming increasingly complex. Managers are coping with numerous challenges, including the continuous balancing of multiple revenue sources (each with its own restrictions and reporting systems) and increasing competition both from other nonprofits and from the business sector. At the same time, they face a growing tendency among donors and the public to equate financial efficiency with organizational effectiveness. In this issue of the Nonprofit Quarterly we tackle these and other trends, conundrums and controversies inherent in managing our financial systems.

It is important to understand that most nonprofits have market relationships that are different from those of most businesses. Nonprofits often must “sell” to institutions or individual donors a service or benefit that will be delivered to and consumed by someone completely different. This complicates nonprofit accountability as well as financial and programmatic decision-making within the sector. The articles published here are intended to help managers who are struggling to make sense of their short- and longer-term financial pictures.

The poor economy and the government’s response to the September 11 attacks have undermined the sector’s funding. Government money is tight. Corporations have been experiencing record declines in earnings. Foundations face shrunken endowments, and this has translated into substantially reduced contributions. Individual giving is also expected to suffer due to job and stock market uncertainty. It all adds up to what Emil Angelica refers to in his article as a “perfect storm” environment.

Complicating this financial crunch is the fact that it was preceded by a “boom economy.” This encouraged program expansion as well as a good deal of activity and funding around capacity building. Also mixed into this environment was a trend toward increased scrutiny and accountability—some focused on program effectiveness and some on financial efficiency. With the dramatic shift from a boom era to a bust, many organizations were caught in the midst of expansion–building state-of-the art information technology systems, fundraising for buildings or endowments, or taking great ideas “to scale.”

Now nonprofit managers are confronting serious questions about the liquidity, or lack thereof, of their assets. Managers are faced with having to cut overhead costs to bring them into the right ratio with program costs. In such an environment, most nonprofits will face multiple challenges in trying to assess their financial health and viability, even for their own internal management and decision-making purposes. But now others may be scrutinizing them more intensely as well.

Many nonprofits, of course, have been subjected for years to the ratio requirements of the United Way and other workplace campaigns. They are used to having to bring their fundraising and overhead numbers in below certain ceilings when seeking government contracts. Most managers are skilled at doing so, but they often do so in conversation with the funder.

But now, thanks to the online database GuideStar, donors, the media and others can readily access financial information from the IRS Form 990s filed by most charitable nonprofits. These stakeholders often lack a relationship with or knowledge of the details of how the organization is run, so they don’t know how to interpret the data they obtain. The IRS itself admits the information on 990s is error-prone, and it often defies interpretation–both for individual organizations and collectively—without further scrutiny. A multi-layered study now being conducted by the Center on Philanthropy at Indiana University and the Center on Nonprofits and Philanthropy at the Urban Institute represents a major step forward in understanding the sector’s finances. You will read more about this in the articles by Mark Hager, Tom Pollak and Patrick Rooney.

The public availability of 990s may actually be stimulating additional reporting problems. Several groups have emerged as watchdogs or quasi-rating agencies for the sector. These new data brokers aim to increase accountability and transparency. However, as with most well-intended initiatives, the ratings revolution has had some unforeseen consequences. Jenn Lammers’ article addresses these issues.

These well-meaning clearinghouses have succeeded in exposing nonprofits to new market pressure to paint a favorable financial portrait. Overall, we worry that emphasizing the use of financial data as tools to judge nonprofits has shifted the balance of attention away from the sometimes ambiguous, long-term and difficult-to-measure concept of effectiveness to the more tangible but less profound concept of efficiency. Scandals at the Red Cross, and more recently at the United Way, seemed to catalyze a more single-minded focus on financial measurements. Some nonprofits will respond by getting more clever and aggressive in manipulating their financial reporting. Fewer nonprofits will now file 990s that make them look administratively inefficient, particularly when it comes to fundraising and administration ratios.

We have faith that nonprofits now attending to an ever more complex and challenging bottom line will still find innovative ways to maintain both their integrity and their viability. But we think trends in the financial realities of the sector will have at least four profound effects on the sector in the years ahead.

First, when it comes to human resources, nonprofits may need to rethink qualifications for the next generation of nonprofit managers. Understanding and developing an adequate capital structure for the long term is becoming an increasingly important part of nonprofit leadership. Recruitment patterns will reflect the need for these skills, and business experience will likely become even more accepted as useful preparation for nonprofit work.

The second effect of the current emphasis on finances is that the development of meaningful and useful performance measurement may be slowed. Due to the heightened financial pressures, managers are reducing their focus on programmatic achievement and on social impact. Financial statements may be useful to nonprofits in building legitimacy and support from donors and stakeholders, but they are not particularly helpful in determining effectiveness or developing and improving programs.

Third, the current trends require higher levels of financial tracking and reporting, which favors larger, established organizations over smaller, less sophisticated nonprofits. As numbers and ratios are posted on the Internet, and as financial facts are scrutinized more thoroughly by the public, organizations with the ability to manage this public relations challenge will surely have an advantage. The sector already is very heavily skewed with a few large institutions holding the bulk of the sectors’ assets and attracting a disproportionate share of government and institutional funding. New financial pressures will make these imbalances even more profound. The gap between the rich and poor will likely widen as financial strength takes on greater importance.

The last major consequence of these trends is the most consequential. As nonprofits are encouraged to look more to their financials, and as funding becomes tighter, it may become increasingly difficult for nonprofits to take programmatic risks and deliver innovative solutions to community problems. Free from the demands of shareholders and unencumbered by the call of voters, nonprofits occupy a special position in society, one that gives them both a substantial amount of autonomy and a subsidy in the form of tax-exemption. In exchange, we expect nonprofits to deliver important alternative visions of how to advance the public good. Looking too long at just the numbers has the potential to dumb down the nonprofit sector and dampen creativity.

So, how can nonprofits begin to confront and address some of the emerging financial challenges that now characterize the landscape? The answer is simple. When it comes to building a competent financial structure and system, nonprofits need to remind themselves of what they already know, namely that finances must always be understood as a tool, albeit a relatively essential and powerful tool, in the overall pursuit of mission. Anyone who takes the numbers game more seriously than that is on the wrong track. Getting really good with numbers must be a strategic part of getting really good with mission accomplishment.

We hope the articles in this issue will help managers think more clearly about many of these challenges.

Peter Frumkin is an associate professor of public policy at Harvard’s Kennedy School of Government and a senior fellow of the New American Foundation. He is the author of On Being Nonprofit (Harvard University Press, 2002). Elizabeth K. Keating is an assistant professor of public policy at Harvard’s Kennedy School of Government and a certified public accountant.