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Rochester Business Journal Article by Jerry Archibald - July 2002

“If you think about what you ought to do for other people, your character will take care of itself…….”      Woodrow Wilson

Important Trivial Question for Today. What do Charles Schwab, Standard and Poors, Moody’s, Morningstar Advisors and Bonadio have in common?

While you ponder that query, the business community continues to be rocked by daily disclosures of management deception and financial misrepresentation that is giving new meaning to the term “cooking the books”.   Do not think for a nanosecond that this focus on “corporate responsibility” is confined to the for-profit or public company business sectors.  All organizations, including non-profits, must take action now to engage in management and Board discussion regarding the following matters:

  • Clarity and substance of communications between management and the Board on financial matters.

  • Assessment of the quality and frequency of Board interaction with your external auditor

  • Policy of the organization regarding utilization of the audit firm for “non-audit” services commonly referred to as consulting

  • Review and revision, if necessary, of the Board process for performance evaluation and assessment of the CEO of the non-profit.

  • Evaluate current procedures used by the non-profit organization to identify non-compliant activities and the process for corrective action.

  • Complete the implementation of a Regulatory Compliance Plan for your organization, if appropriate.

 

Answer to the Important Trivial Question

Each of these organizations have developed financial assessment models for grading or scoring the overall financial health of an organization.  Bonadio & Co. is the only group focused on providing a financial scoring model for non-profit organizations.  Schwab recently introduced an A through F model for publicly traded companies.  Moody's rates bond quality with their alphabet grading (triple BBB, double AA, etc.)  Standard and Poors has a one to five star assessment and Morningstar provides a one to five performance grade for mutual funds.

Why, you might ask, would Bonadio develop a financial assessment model for non-profits?  For almost thirty years, I have heard and read reports regarding the frustration of non-profit Board members and management inability to comprehend the significance and importance of non-profit financial ratios and operating indicators.  This frustration is most often expressed in the aftermath of a non-profit’s financial failure or bankruptcy.

One of the most frequently asked questions in any business financial crisis is, “Why didn’t we know this was going to happen?” or some variation dealing with the oversights of the past.  The answer is not readily available from a financial statement audit or internal management reports.  What can an organization do to provide this information on a timely basis?

There have been a variety of research projects focused on providing business owners and management with a financial analysis model that can serve as a predictor of financial crisis or, God forbid, the risk of bankruptcy.  My apologies to the Ninth Circuit Court of Appeals for including the Almighty reference in this column.  However, I believe I am within my constitutional rights.

One of the well-known models, known as Z-Score Analysis, was developed by Edward Altman, a professor at New York University.  Professor Altman’s Z-Score Analysis uses financial ratios to develop a score indicating the probability of bankruptcy or financial crisis in a commercial enterprise.  The Z-Score model uses just five financial ratios to develop an overall assessment of financial health.  The ratios are:

  • return on total assets;

  • sales to total assets;

  •  market value of equity to total debt;

  • working capital to total assets; and

  • retained earnings to total assets.

Each of these ratios is assigned a weight in the calculation.  In a fairly quick calculation, the Z-Score provides an indicator on a scale of 0 to 5 whether your company is “heading toward bankruptcy” (score of less than 1.81) or “you’re in good shape” (score of greater than 2.99).

The problem with Z-Score Analysis is that the ratios used are not meaningful or relevant to an analysis of the typical non-profit organization.  As a result, the Z-Score has limited value in analyzing a non-profit organization.  For more information on Z-Score and other financial analysis tools for small businesses, go to JaxWorks.com.

However, fear not.  Professor Archibald and his class of articulate and expert CPAs at Bonadio & Co. have developed a financial analysis model for non-profit organizations.  The model will be available on the Bonadio.com website in August.  We have tested the methodology in our client base to ensure the broad applicability of the model.  With giving appropriate recognition to Professor Altman, we have identified our valuable assessment tool as the A-ScoreSM.

 

  

The A-ScoreSM employs 12 readily available financial ratios to develop a “grade” or “score” as a predictor of financial stability for a non-profit organization.  Each ratio is assigned a weight in the calculation.  The resulting score is based on a 100-point scale.  This assessment tool is most useful on an annual calculation basis.

More important than the absolute score developed for your organization is the development of the score over a five-year trend analysis.  Improvement or deterioration in these ratios over a multiyear trend can be helpful to both agency management and the Board in establishing strategic goals and targets for the organization.

The A-ScoreSM  uses a statistical, multi-tiered weighting methodology for each ratio used.  The impact of each ratio on the overall score is based on three factors, as follows:

  • The relative importance of the ratio to the overall score; high, medium or low;

  • The desirable target level for each ratio,

  • and The deviation of the actual ratio from the desirable target.

The 12 ratios used in developing the A-ScoreSM  and their relative importance are:

Days of cash on hand represents the number of days that operating expenses of the organization could be covered with existing cash reserves.  This ratio is of high value in the A-ScoreSM and carries a desirable target of greater than 30 days.

Days outstanding in accounts receivable represents the number of days revenue for the organization that is tied up in the process of being paid.  This ratio is of high value with a desirable target of less than 55 days.  The target in this case may vary depending upon the payer sources for your agency and their typical payment terms.

Current ratio is a measure of liquidity and represents the relationship between assets that are expected to be converted into cash in the next 12 months (numerator) compared to liabilities that need to be paid in that same time frame (denominator).  This ratio is of high value with a target level of greater than one-to-one.

Debt service ratio is commonly referred to as “banker’s cash flow”.  This ratio calculates the ability of the entity to generate sufficient cash flow to pay principal and interest on its debt obligations.  The desirable target is greater than 1.20 and has a high value in the A-ScoreSM calculation.

Ratio of net surplus to total revenue is the last of the five high value ratios in the A-ScoreSM.  The ability to generate surplus in the non-profit sector is the lifeblood of financial stability.  The federal government is the only business enterprise that has demonstrated the ability to survive decades of continuous deficits.  However, the government also has the advantage of being able to print money.  The desirable target for the ratio is between 1 percent and 3 percent of surplus for every dollar of revenue.  Every industry has its own targets for surplus in relation to revenue as well as components of the non-profit industry (e.g., education vs. health care).

 

In addition to the five high-value ratios, there are five ratios that are given medium weight in the A-ScoreSM.  They are:

  • days outstanding in accounts payable,total liabilities as a percentage of net assets,

  • line-of-credit balance as a percentage of total current assets,percentage of total revenue received from the largest single payer source,

  • and revenue as a percentage of total assets.

The final two ratios given the lowest weight in the A-ScoreSM rating are:

  • administrative expense as a percentage of total expenses,

  • and fund raising revenue as a percentage of total revenue.

The first step in assessing your organizational financial stability is asking how many of these 12 ratios you currently monitor and report to your Board.  If the answer is “none” or “few”, please consider the value of including the information in your monthly management reports.  The second step would be to address the changes necessary to improve the organization’s financial position.  There is wide variation in the nature and scope of non-profit organizations.  The ratios most important to your organization may be different from those discussed in this column.  Depending upon your program service areas or type of service, there may be modifications to the individual ratios that you assess for your organization.

Gerald J. Archibald, a CPA, is a partner in the regional accounting firm of Bonadio & Co., LLP.  He is active professionally and personally in an array of non-profit organizations.  He can be contacted at garchibald@bonadio.com.