A Special Feature of Nonprofit Finance

The United Nations (2003, p. 218) defines nonprofit institutions (NPIs) as:

Mission primacy, protected by a prohibition against distributing any surplus to private persons, makes nonprofit organizations attractive to donors who share goals and objectives similar to the organization. Donors may give without specifying how the recipient should spend their gifts, or they may restrict their gifts to specific projects. Nonprofit organizations have a moral obligation and, in some cases, a legal duty, to honor donors' wishes. This complicates nonprofit financial management because every restricted gift and grant must be accounted for individually. The simplest and surest method of maintaining the integrity of restricted gifts and grants is to deposit them in a special bank account reserved exclusively for restricted cash pending satisfaction of restrictions.

Cash Flow Analysis

Table 21.1 presents a simplified description of cash flow for a hypothetical organization, which would enable a manager to anticipate the amount of cash needed for every month of a fiscal year (abbreviated FY).²

Notes:

^a“Q1” is 1^st quarter of the fiscal year.

^bSum of Q1 through Q4. At the beginning of a fiscal year “Sum” equals “Budget”.

^cCash “released” from restrictions are withdrawals from a bank account reserved for restricted gifts and grants pending satisfaction of restrictions.

^d“Cash In” minus “Cash Out.”

It presents financial information according to the customary practices of finance professionals.

1. Tables should indicate the ending date of the fiscal year.
2. Because numbers change as new information becomes available, tables should always indicate a preparation date.
3. Parenthesis indicates negative numbers.
4. Inflows and outflows are recorded on a gross basis.³

An actual cash flow table would show more income and spending detail and be organized by months. Payments (cash outflow) and receipts (cash inflow) are tabulated when they are expected to occur. Restricted gifts and grants should not be tabulated as cash inflows until restrictions are satisfied (that is, released from restrictions).⁴

Table 21.1 shows a negative net cash flow in the first three quarters but a positive net cash flow in the last quarter and for the fiscal year. The hypothetical organization must begin the year with at least $24,600 cash ($15,000 + $1,300 + $8,300) to avoid a cash shortage before the fourth quarter. Cash could be withdrawn from the special account early to minimize the expected cash flow shortfall but only if the restrictions attached to a $20,000 grant are certain to be satisfied by the fourth quarter of the current year.

Table 21.2 illustrates a revision of Table 21.1 that assumes that two quarters have elapsed since Table 21.1 was created. It replaces estimated numbers for the first and second quarters with a single column of actual data year-to-date (YTD).

• Gifts and grants YTD were $128,000, $6,700 less than anticipated. Fees and charges YTD were $85,000, $5,000 more than anticipated. Total cash inflows were $1,700 less than anticipated.
• Personnel and occupancy costs are unchanged from their initial estimates but “other” costs were $5,000 less. So total cash outflow was $5,000 less than anticipated.
• Actual net cash flow is negative $13,000 instead of negative $16,300 that had been anticipated, representing an improvement of $3,300.

Notes:

^aActual YTD is Actual Year-to-Date data.

^bSum = Actual YTD + Q3 + Q4.

Borrowing would appear as a cash inflow on Tables 21.1 and 21.2.

Optimizing Liquidity

The solution to a cash shortage is to establish a fund consisting of unrestricted cash and cash equivalents that enables an organization to avoid borrowing from banks or other external lenders, that is, a working cash fund.⁵ A popular rule of thumb is that working cash should not be less than an average month's cash outflow. However, a one-size-fits-all rule is unlikely to be optimal for all organizations.

While it is important to have adequate liquidity, too much is wasteful. Managing liquidity is like managing time: it is important to be punctual for every appointment, but being very early wastes time. An organization should find the minimum level of working cash it needs from its own experience. In other words, it should optimize its working cash. The optimal size for this hypothetical organization's working cash fund would be $25,000 (rounded).

In preparation to optimize, an organization should complete the following three-point checklist in Figure 21.1.

A line of credit (LOC) with a commercial bank guarantees ready access to enough cash to deal with a temporary cash shortage. A LOC that is never used is indicative of too much working cash. However, withdrawing from a LOC more than once or twice a year indicates insufficient working cash.

What to Do with Liquid Assets

Restricted gifts and grants and working cash should only be invested short term. The simplest and safest investment opportunity is an interest-bearing checking account at a federally insured commercial bank. The Federal Deposit Insurance Corporation (FDIC) insures accounts up to “$250,000 per depositor, per insured bank, for each account ownership category, including checking accounts, savings accounts, money market deposit accounts, and certificates of deposit [CDs]” (FDIC, 2014). It does not insure other financial products and services that commercial banks may offer. Nor does it insure money market funds at non-bank institutions.

Diagnostic Tests for Liquidity

An organization's liquidity is the total of all of its liquid assets minus donor-restricted funds. Organizations should keep a continuous record of all bills to be paid (that is, accounts payable) and all of its own billings (that is, accounts receivable). On the same date of every month a financial manager should prepare reports of receivables and payables that tally open accounts, indicating the average length of time elapsed since the invoice dates. These reports are called aging reports. Two key rules of thumb for receivables and payables are

• Receivables should not exceed sixty days. Extra effort should be made to collect past due receivables. An increase in receivables indicates worsening liquidity; a decrease indicates improving liquidity.
• Payables should not exceed sixty days. Payables should not be allowed to become past due because they accrue late fees and interest. It would be cheaper to borrow the necessary cash.

Definitions

A budget is an annual financial plan. There are two categories: operating budgets and capital budgets. When the word “budget” is used without a modifier it refers to an operating budget. Budgets are usually organized by line items, which are the categories of goods and services an organization plans to buy during the year. Once a board adopts a budget, the spending lines are called appropriations. Debt is the cumulative result of borrowing; long-term debt consists of loans an organization must pay off (that is, retire) more than one year hence.

An organization's budget is intimately related to its accounting system. Nonprofits use either of two types of accounting systems: cash-basis accounting or accrual-basis accounting. Cash-basis accounting enters a transaction into the record (that is, it recognizes it) only when cash changes hands. Accrual-basis accounting recognizes a transaction whenever it creates a financial obligation, regardless of when cash changes hands (which could be years into the future). Accrual-basis accounting rules in the United States are known as “generally accepted accounting principles” (GAAP), and they are promulgated by the Financial Accounting Standards Board. Other countries use a variant of “international financial reporting standards” (IFRS) promulgated by the International Accounting Standards Board.

Regardless of the accounting system, bookkeepers identify every financial transaction with a code number identifying the source of funds and purpose of spending. The set of such codes constitutes what is called a chart of accounts.

Recommended Budgeting Practices

Boards should adopt a budget policy to provide consistency in budget preparation from year to year. Supplements A and B of this Handbook's website provide a sample budget policy and a sample budget, respectively, reflecting my recommendations for budgeting practices that are applicable to all organizations in all circumstances.

1. A budget should be adopted before the next fiscal year begins. A budget cannot effectively control spending when it is adopted after a new fiscal year begins. Maximum effectiveness requires that the board adopt it in advance. However, advance preparation requires estimating income and spending for the current year (see Recommendation 7, as follows).

2. The operating budget should be separate from the capital budget. An operating budget is a plan for mobilizing resources (income) to spend on services and goods that have a useful life of one year or less, in other words, “spending on operations.” In general, the goods and services included in an operating budget are purchased every year, which are the result of an organization's ongoing commitments.

   A capital budget is a plan for mobilizing resources (restricted gifts and grants, loans, allocation of current income from operating accounts) to spend on capital assets, which are assets having useful lives exceeding one year.⁶ Capital assets are expensive as compared to most items in an operating budget, and items in a capital budget are not purchased every year.

   An organization should not merge operating and capital budgets because year-to-year comparisons of total income and total spending would be meaningless due to fluctuations in capital spending. However, capital assets that cost less than a minor amount—the capitalization threshold—are included in an operating budget without ill effect.⁷ Supplement C on the book's website offers a typical organizational policy regarding capital assets.

   Ideally, an operating budget should show allocations of current income to the capital budget based on specific financing needs. Some nonprofit organizations include depreciation in their budget. However, depreciation is a number that accounts for the fact that capital assets wear out. Depreciation is a cost, yet it is not paid out to anybody. Practically speaking, including depreciation in a budget is functionally equivalent to saving, and it allows the organization to set aside money that will help replace capital goods when they wear out. However, the amount listed for depreciation is based on original cost. When capital goods must be replaced, they will be more expensive than their original cost. Thus, allocations of current income to the capital budget should be based on specific financing needs that reflect current prices.

3. An operating budget must be balanced without borrowing, whereas borrowing is an acceptable method for financing a capital budget. Organizations should balance their operating budgets. By definition a balanced operating budget may show a surplus but never should show a deficit. Figure 21.2 presents the operating budget equation; it displays sources of funds on the left and uses of funds on the right.

   

   Because operating budgets embody ongoing commitments, deficits (that is, negative surpluses) are unsustainable. Number 2 on a recently published list of “10 ways to kill your nonprofit” is “operate in the red” (Hager and Searing, 2014, p. 67).⁸ A small surplus in the budget is useful because it provides a cushion against external shocks and internal stresses.

   Borrowing is an acceptable method of financing capital assets, provided: (1) the repayment period does not exceed the useful life of the items being financed and (2) there is sufficient cash flow to retire the debt on schedule. Interest on the debt should be in an operating budget, not in a capital budget. Figure 21.3 presents the capital budget equation. It shows sources of funds on the left and uses of funds on the right.

   

4. The line items in an operating budget should correspond to the accounting system's chart of accounts. A budget cannot effectively be used to control spending when it is organized into income and spending categories that are different from the categories used by the accounting system, namely the chart of accounts. Also, using accounting software with budgeting functionality is preferable to preparing a budget on a spreadsheet. When using one system for both, it ensures that income and spending categories will be the same in both the accounting reports and the budget document.
5. An operating budget should not include restricted income, unless restrictions are expected to be satisfied during the fiscal year that the budget is in effect. Organizations have a moral obligation to honor donors' restrictions and, in the United States, they have a legal obligation to do so as well. Therefore, an organization should not include a restricted gift in a budget unless it will be able to satisfy a donor's restrictions in the same year. Conversely, if an organization that received a restricted gift or grant in a prior year with restrictions it was unable to satisfy at the time and it now can satisfy them in the new year, this should be shown in the budget with the statement that it is “released” from restrictions.
6. An operating budget should include no more than a small amount of non-recurring income. Examples of non-recurring income are bequests and proceeds from asset sales. Because most line items in an operating budget recur every year, it is risky to rely on non-recurring income to balance an operating budget. It is wise for an organization to establish a policy limiting the amount of non-recurring income that will be included in its annual operating budget. Whenever a bequest exceeds this amount, the organization should spend it on capital or other non-recurring needs or designate it for a reserve fund.
7. An operating budget for a new year should be based on the current year's estimated income and spending—not the current year's budget. Some financial managers take the easy way out and use the current budget as the starting point for preparing the next year's budget. This habit is not only lazy, but it is also inefficient and unwise. The purpose of a budget is to provide just enough financial resources—not too much and not too little—to buy needed items. Assuming that an organization does not allow its employees to spend more than the appropriated amount for any particular line item (an important requirement), there may be appropriations (funds) left at year's end for many line items. These are lapsed appropriations that may reflect inaccuracies in that budget. Thus, if a financial manager bases the next year's budget on the previous budget instead of on the actual spending for the year, he or she will be incorporating past errors into the next budget.
8. A narrative is an integral part of a budget. A budget is a plan based on assumptions about future events. It is meaningless without an accompanying narrative that explains key assumptions. During the implementation phase, an organization will be able to move quickly to respond to assumptions that are no longer valid even before an operating deficit becomes evident, if they have been made clear. In addition, a good budget narrative reviews the successes and failures of the current year and sets quantified goals and objectives for the upcoming year.

Budgeting Decisions

The preceding discussion features recommended practices that apply to every organization, large or small, located in this country or that. The following section highlights matters that are organization-specific and contingent on circumstances.

The Goal for Surplus

The label nonprofit does not mean that an organization generates zero profit. It merely connotes that an organization has a purpose that transcends making a profit. Nonprofit organizations often eschew the term profit, preferring to talk in terms of surplus or net income. (The equivalent organizational label, not-for-profit, is more evocative but not as popular.) Every nonprofit organization must generate a surplus to keep its capital assets in good condition and to grow.

Financial performance of a nonprofit organization is measured by the excess of unrestricted income over spending on operations, usually known as an operating surplus. (A negative surplus is called a deficit.) Calculation of operating surplus depends on which accounting rules an organization follows—cash or accrual, GAAP or IFRS. The following definitions of operating surplus are comparable measures for nonprofit organizations in the United States:

• The cash-basis operating surplus is the sum of (1) net unrestricted cash inflow, including cash released from restrictions and (2) spending to acquire capital assets.
• The accrual-basis operating surplus is change in unrestricted net assets plus depreciation and minus pledges. The calculation of this differs outside the United States.¹²

To avoid compromising its ability to deliver service, a nonprofit organization must maintain its assets at current market prices (that is, replacement cost), which naturally increase with inflation. Ideally, a U.S. organization that uses GAAP should have a minimum annual operating surplus equal to the product of the value of its assets (excluding land) and the long run rate of inflation of 3.4 percent.¹³ Thus, an organization having capital assets of greater value than its spending on operations (for example, a museum) will need to have an operating surplus that exceeds the long-run rate of inflation (Bowman, 2011). Conversely, an organization having capital assets with a value that is less than spending on operations (for example, a legal services clinic) can survive comfortably with a surplus that is less than the long-run rate of inflation. Organizations with repeated annual surpluses that are less than the prescribed amount will find it necessary to conduct periodic capital campaigns to address the conditions created by deferred maintenance.

Exercising Control

Early every month, an organization's financial managers should search for areas of weakness in financial performance by comparing, line by line, actual income and spending to budgetary expectations. Variances should be calculated. A positive difference is favorable and a negative difference is unfavorable.

Table 21.5 combines information from Tables 1 and 2 in a variance analysis to show how each item in the budget performed relative to expectations. It reports an unfavorable variance in gifts and grants but a favorable variance in fees, charges, and “other” costs. Gifts, grants, and “other costs” are both lower than budgeted, but one variance is negative whereas the other variance is positive. The net difference is projected to be $3,300 higher than budgeted, which is favorable.

Notes:

^aVariance = Actual Income YTD minus Budgeted Income YTD.

^bVariance = Budgeted Spending YTD minus Actual Spending YTD.

Early intervention in response to an incipient operating deficit can avert catastrophe. To illustrate: an actual operating deficit of 2 percent at the end of the first quarter may not seem like much, but it is worthy of immediate corrective action. Reducing spending by 2 percent for an entire year requires cutting quarterly spending by 2.67 percent to obtain the necessary savings over the three remaining quarters. If a financial manager waits until the last quarter to eliminate a projected 2 percent annual operating deficit, the total cuts will have to constitute 8 percent of projected spending.¹⁴

Reserves

Operating deficits are not sustainable. When confronted with an operating deficit, an organization can (1) cut expenses, (2) find new sources of income, or (3) wait until its economic situation improves. Assuming that it does not want to hurt its clientele by cutting expenses, the organization is left with two choices, but both tactics take time to implement. To buy the time it needs to supplement weak income, an organization must have a pool of unrestricted assets that can be converted into cash with little or no loss in value and without significant transaction costs (such as early withdrawal penalties). In other words, it needs an operating reserve. An operating reserve is similar to a working cash fund, except that its assets are slightly less liquid. An operating reserve should never be invested in stocks of individual corporations or in stock mutual funds.

Some executives do not want an operating reserve. Some say, “I can either serve one hundred more clients or have a reserve” (Sloan, Grizzle, and Kim, 2014), but this is wrong-headed. The purpose of a reserve is to continue service to current clients when income suddenly and unexpectedly becomes insufficient for an extended period of time. An operating reserve provides relief until circumstances improve or until managers find a new source of continuous funding. Once it is established, maintaining it at a constant level does not deduct from net income until replenishing it occurs.

Many organizations establish a target level for their operating reserve based on a rule of thumb, such as a minimum of three months of spending on operations (Nonprofit Operating Reserve Initiative, 2008). However, a one-size-fits-all rule is unlikely to be optimal. An organization can determine the minimum necessary reserve (that is, the optimum reserve) by learning from its own experience (that is, optimizing).

An organization with a history of conservative budgeting will need a smaller reserve than one with frequent unexpected operating deficits. To calculate the optimum reserve, subtract spending from unrestricted income in each of the past five years. Only the negative numbers (deficits) are cause for concern. After adjusting calculated deficits for inflation, add them. (Supplement E in the book's website shows how to adjust historical data for inflation.) Division by last year's spending on operations and multiplication by twelve converts this number to months of spending.

Whenever an organization withdraws funds from its operating reserve to finance an operating deficit, it should replenish the reserve in the first upcoming budget. If the organization cannot replenish the entire amount in one year, it should develop a plan to replenish it within a maximum of three years.

Investing Reserve Funds

Bills and notes issued by the U.S. government are an alternative to bank deposits for all reserve funds.¹⁵ Individuals and nonprofit organizations can purchase these securities electronically at the most recent auction price through Treasury Direct (U.S. Department of the Treasury, 2014a, 2014b). Bank-issued certificates of deposit (CDs) are a higher-earning option. Table 21.6 shows the difference between market interest rates (“yields”) at various maturities. Maturities should be staggered (“laddered”) so some bills and notes mature every month. See Supplement F of this book's resource website for a sample investment policy.

Note: APR is Annual Percentage Rate. Source: US Department of the Treasury (2014b). The bank is not identified to avoid the appearance of product endorsement.

Diagnostic Tests for Resiliency

Nonprofit organizations should consistently have surpluses. The method of calculating an operating deficit depends on an organization's basis of accounting. Comparable metrics were given in the discussion of financial performance, discussed earlier in this chapter. For organizations in the United States that use GAAP, the annual surplus should be no less than 3.4 percent multiplied by total assets, excluding land.

The Income Portfolio

Commercial business firms derive nearly all of their income from sales of goods and services (that is, they have earned income). In addition to earned income, nonprofit income may include gifts, grants, and investment income.¹⁶ Each type of income has advantages and disadvantages (Froelich, 1999). Conventional wisdom urges nonprofit organizations to diversify their income portfolios but Dennis Young's Benefits Theory of nonprofit income argues that every organization faces natural constraints on possibilities for exploiting diversification. The key to growth is finding the right combination of income sources. In Chapter Nineteen of this Handbook, Young and Jung-In Soh discuss a wide range of nonprofit funding sources. Benefits Theory posits “Sources of income should correspond with the nature of benefits conferred on, or of interest to, the providers of those resources” (Young, 2007, p. 341).

• Private benefits accrue from individuals who are willing to pay for the goods and services. Private benefits generate earned income (examples: ticket sales, tuition). Ideally, the market price of these goods and services covers their cost of production. If mission dictates that price should be below cost, the producing organizations must seek cross-subsidy, gifts, or endowment income.
• Group benefits benefit a subgroup of society to which donors belong or benefit a group that donors care about (examples: art lovers, homeless persons). The chief source of income to cover the cost of production is gifts.
• Public benefits accruing to a sufficiently large segment of the general public stimulate political support that can result in government funding (examples: libraries, privately owned historic sites). There may be overlapping interests with subgroups, such as assistance for homeless persons.
• Trade benefits are goods and services purchased by institutions or groups in commercial relationship with the producing nonprofit organization (examples: ads in trade publications and program booklets). Trade benefits also generate earned income.

Table 21.7 shows the composition of income portfolios of major nonprofit subsectors. Nonprofit organizations should diversify their income portfolios to the extent possible, recognizing that their efforts to develop new income sources are constrained by whom they benefit and who is interested in seeing that its beneficiaries are well-served.

Note: Rows may not add to 100 percent due to rounding. Source: Roeger, Blackwood, and Pettijohn, 2012, Tables 5.19–5.25.

Every nonprofit organization should occasionally compare the composition of its income portfolio to a relevant peer group. According to Benefits Theory, their income portfolios should be similar. Marked differences should raise questions. For example, if an inquiring organization's peers have income from government sources but it does not, there may be possibilities for it to obtain public funding. A peer analysis proceeds in three steps.

• Identify peers. All U.S. tax-exempt organizations' Internal Revenue Service (IRS) Form 990 reports are publicly available on the Internet (GuideStar, 2014). An inquiring organization should look up its own report and find its National Taxonomy of Exempt Entities (NTEE) code number, then search for other organizations with the same NTEE code number, in the same geographic region, in the same size category, using the same basis of accounting (cash or accrual).
• Calculate the percent of total income (“revenue” on the form) by income category. The information is found on the IRS 990 form (page 9, part VIII, column A). Substitute zero for net gain from sales of assets other than inventory (page 9, line 7d) and all negative numbers. Calculate total income reflecting all substitutions. The sum of calculated percentages must be 100 percent, plus or minus rounding error.
• Compare percentages in each category with the corresponding percentages of peers. If the peer organization is able to derive substantially more support from a particular source than has been the case for the inquiring organization, Benefits Theory predicts that it should be able to improve its support from the same source or type of source.

Financing Deficit Centers Long Term

It is possible to finance deficit centers with surpluses from high market value programs (that is, cross-subsidy), but competition is likely to negate this tactic in the long run. A more reliable alternative than cross-subsidy for long-term financing of chronic deficit centers is an endowment which, in this context, means a portfolio of long-term investments that generate a cash flow of constant purchasing power in perpetuity.¹⁷ A common misperception is that only interest and dividend income may be spent. In fact, the increase in market value also may be converted into cash for current spending.¹⁸

Long-term investments may have attractive returns but they are inherently riskier than short-term investments used to manage reserves. Return is the sum of an investment's interest, dividends, and capital gain. Risk is variability in return.¹⁹ Table 21.8 shows three of the many ways to measure it: (1) return in the best year minus return in the worst year, (2) the worst annual return alone, and (3) the number of years returns were negative.

Source: Vanguard, https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations (accessed December 2014).

The goal of investing is to assemble an efficient portfolio—a collection of investments that maximizes return at an acceptable risk or, conversely, minimizes risk for an acceptable return. Efficiency is achieved by diversification, which is a process of investing in stocks and bonds with different returns and risks.²⁰

A portfolio of long-term investments should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating investments among stocks, bonds, cash equivalents, and possibly other asset categories, diversify within each asset category (that is, do not place all of your assets with one single investment). The SEC offers the following warning with regard to the use of mutual funds as an investment vehicle

Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That's a lot of diversification for one investment!…Be aware, however, that a mutual fund investment doesn't necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. Investing in more than one mutual fund may be necessary to get the desired extent of diversification. (U.S. Securities and Exchange Commission, 2014, n.p.)

State law governs long-term investing and spending, usually modeled on the Uniform Prudent Management of Institutional Funds Act (UPMIFA). The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act requires charities to register with the U.S. Commodities Futures Trading Commission if they co-manage funds for private investors.

Most endowed organizations spend a fixed fraction of the average of the most recent three to five years of the market value of their endowment's portfolio. An alternative method, which sets a cap and a floor on the spending rate, is growing in popularity because it is less volatile and provides more predictability to operating budgets (Sedlacek and Jarvis, 2010). For example, Yale University uses a 6.0 percent cap and a 4.5 percent floor (Yale University, 2010).

An organization should optimize its working cash and operating reserve before establishing an endowment. Using cash flow from annual operating surpluses to form the nucleus of an endowment is difficult and/or time-consuming. The usual method of endowment building involves a combination of major gifts and a host of smaller ones. Common experience is for 10 percent of donors to account for 90 percent of gifts. Chapter Eighteen of this book offers an extensive discussion of the practices associated with fundraising and philanthropy.

Borrowing and Long-Term Debt

Organizations that do not invest in themselves do not grow. Capital assets (buildings and equipment) are productive resources. If they are allowed to deteriorate, the inevitable result will be less output or lower quality services. Because nearly everything becomes more expensive over time, average annual spending on capital should be equal to the long-term inflation rate (3.4 percent) multiplied by the value of existing assets. Growth requires greater spending on capital.

There are two ways to pay for capital projects—equity and debt. Equity in this context refers to major gifts and grants. The gift aspect of equity is appealing, but its downside is the cost of fundraising and the time it takes to accumulate enough equity to begin a project.²¹ Debt is appealing because it can be acquired quickly, but it saddles an organization with ironclad financial obligations for years into the future.²² At the top of a recently published list of “10 ways to kill your nonprofit” is to “overwhelm it with liabilities”—in other words, create a heavy debt load (Hager and Searing, 2014, p. 67). Capital project financing is a complex balancing act.

There are many good reasons for owning rather than renting, and they all are either a cause or an effect of growth:

• When a nonprofit organization needs more space for specialized activities (for example, laboratories, theatrical productions, museums), it faces a decision to spend its resources to improve its landlord's property or to acquire its own. Acquisition is preferable, provided it is cost-effective.
• Renters are vulnerable to losing their leases or being forced out when landlords raise rents to unaffordable levels. If doing business at a particular location is important, acquisition is preferable to renting, provided it is cost-effective.
• When the scale of a nonprofit's operations reaches a certain point it will be unable to rent sufficient space at a single location. If it is important that staff or consumers have face-to-face communication with all departments, then it becomes necessary to create a campus and acquisition is likely to be cost-effective.

The qualifier in every case is cost-effectiveness. Property acquisition, unlike renting, involves large initial costs and operating costs that may have been shared with neighbors in leased space. The economics of every project is different and each must be evaluated on its own merits.²³ There are some certainties, however: (1) only liquid and resilient organizations should consider borrowing and (2) estimates of fundraising and borrowing capacities should be realistic. It should be unnecessary to stress the last point, but the following cautionary tales suggest otherwise.

• When the Field Museum of Natural History in Chicago raised less money than the project budget required, it borrowed. The result was a crisis in its operating budget that forced the museum to cut deeply into its research program (Gillers and Grotto, 2013).
• The initial plan for creating a new August Wilson Performing Arts Center in Pittsburgh called for donations of $2 million. Cost overruns were $11 million, so the board amended the plan to increase the donation requirement. The original estimate of $2 million was a realistic fundraising goal, but $11 million was not. It defaulted and its creditors now have possession of the property (Bloom, 2014).

During a project's concept phase (that is, pre-planning), an organization should assess its capacity to fundraise and to borrow. Financing decisions determine the scale of a project, which is not easily changed after work commences. A project's budget should utilize as much equity as possible to minimize borrowing. As noted earlier, a general rule is that 10 percent of donors contribute 90 percent of the money (counting pledges) to a capital campaign. Before an organization decides on the scale of a project, it should canvass a large sample of the most generous 10 percent of likely donors to determine the depth of philanthropic support.

As a general rule, current cash flow must be sufficient to retire a long-term debt because estimates of future income growth for nonprofit organizations are notoriously unreliable. A commonly used test of ability to retire a debt is the debt service ratio—the average annual surplus before interest and depreciation divided by projected annual debt service payments.²⁴ Supplement G in this book's resource website offers more detail on this topic.

Diagnostic Tests for Robustness

There is no simple test to assess the robustness of an income portfolio; peer analysis is recommended instead. Average annual spending on capital should be equal to the long-term inflation rate multiplied by the value of existing assets. Growth requires greater spending. Total debt should not exceed 50 percent of total assets.