predicting financial vulnerability in nonprofits roger a. lohmann, ph.d. nancy lohmann, ph.d....

Predicting Financial Predicting Financial Vulnerability in NonprofitsVulnerability in Nonprofits

Roger A. Lohmann, Ph.D.

Nancy Lohmann, Ph.D.

Division of Social Work

School of Applied Social Science

Eberly College of Arts & Sciences

West Virginia University

Age of Financial Uncertainty for Age of Financial Uncertainty for NonprofitsNonprofitsCutbacks of programsMachinations of accountabilityRefusal of many funding sources to

acknowledge need for long term operating support

Situation in WV Getting WorseSituation in WV Getting Worse

NP Crises in Kanawa Valley–Multi-CAP scandal/bankruptcy– Shawnee Hills bankruptcy– Etc.

DHHR De-funding Juvenile RetentionDHHR Contract Terminations– 70 agencies– 5-600 jobs

Is Prediction of Vulnerability Is Prediction of Vulnerability Possible?Possible?No cure for mismanagement–Multi-CAP Officer said: After 26 years in

the business, he’d never heard you couldn’t commingle funds!

– If any of you are in doubt; You can’t!!No present way to predict actions of

others–Will DHHR cancel more contracts?

Some Vulnerability is PredictableSome Vulnerability is Predictable

NP’s are part of a fairly stable political economy – Deliberate introduction of risk–Managers feel vulnerable much of the

time

BackgroundBackground

Small group of accounting researchers working on this problem.– First, in commercial settings– More recently, in nonprofits

Produced and tested a predictive model of estimating financial vulnerability that should be of interest to all nonprofit administrators.

Background: Accounting Background: Accounting StatementsStatementsThree standard nonprofit financial

statements relevant to prediction:– Balance Sheet (Position)– Statement of Income and Expenditures

(Performance Over Time)– Changes in Fund Balance (Changes in

Position Over Time)

Background: Expenditure TypesBackground: Expenditure Types

NASB recognizes three main types of expenditures – Administrative– Fund Raising– Program

Background: Revenue SourcesBackground: Revenue Sources

IRS 990 recognizes five types of revenues– Contracts, gifts and grants– Program revenues (earnings)–Membership dues– Sales of unrelated goods (UBITs)– Investment Income

General Approach: Ratio General Approach: Ratio AnalysisAnalysis Built from standardized information from

financial statements “Ratios” are just Fractions– Numerator and denominator from different

places on financial statements E.g. “current ratio” is – current liabilities / current assets– Normally, 1 or less– Greater than 1 should raise questions about

long-term asset coverage of debt.

Three kinds of Financial Distress Three kinds of Financial Distress ratios:ratios: Seat of the pants (practice- or experience-

based wisdom) Practice wisdom validated by empirical

research– Reliability, validity and generalizability

• Can you trust the measure?• When does it apply?• How widely does it apply?

Published Industry Standards

Defining Financial VulnerabilityDefining Financial Vulnerability

( Beaver, 1966) = financial vulnerability is probability of filing for bankruptcy.– Gilbert, et. Al. (1990) found many

vulnerable companies do not file for bankruptcy.

– Franks & Torous (1989): Companies that file may not be vulnerable (may be due to labor disputes, etc.)

Underlying Idea:Underlying Idea:

Financial Vulnerability = ability to recover from sudden financial shocks.– Sudden and unexpected loss of income– Sudden and uncontrollable increase in

expenditures– Examples

• Loss of a grant/contract• Sudden decrease (or increase) in clients• Discovery by EPA that your building is full of

asbestos

Research Measures of Financial Research Measures of Financial VulnerabilityVulnerabilityActual or anticipated filing for

bankruptcyThree consecutive years of net

losses (negative net income)(Nonprofit) Reduced program

expenses

The Tuckman-Chang ModelThe Tuckman-Chang Model

Financially vulnerable nonprofit: Likely to reduce its program services following a financial shock.– Study of 4,730 501(c)3 organizations

filing IRS 990’s in 1983.

Howard Tuckman and Cyril Chang. A Methodology for Measuring the Financial Vulnerability of Charitable Nonprofit Organizations. Nonprofit and Voluntary Sector Quarterly. Winter, 1991. 445-460

FOR MORE INFO...

Tuckman-Chang RatiosTuckman-Chang Ratios

Inadequate Equity Balances Revenue Concentration Low Administrative Costs Low Operating Margins

Inadequate Equity BalancesInadequate Equity Balances

Ratio of total equity (fund balances) to total revenues– Lower ratio means less able to replace lost revenues

following a financial shock– Lower ratio = greater vulnerability

• Negative ratio unlikely (Neg. total revenues means real trouble!)

Revenue ConcentrationRevenue Concentration

Sum of revenue sources / total revenues squared– (24/328,000) = .000073– .000073*.000073 = .0000000053

Organizations with fewer revenue sources are more vulnerable to financial shocks in any one of them

Fewer sources = greater vulnerability

Low Administrative CostsLow Administrative Costs Ratio of Administrative Expenses/Total Revenues Contrary to conventional wisdom: Lower ratios = greater vulnerability Lower administrative costs almost always translate into decreased flexibility.

– Diminished ability to reduce administrative costs in a crisis– More limited management problem solving capabilities– E.g., fewer mgrs., supervisors or support personnel to draft to 1)solve problem or 2)

provide services in meantime. Reminder: Conclusion based on random sample study of 4,730 nonprofits!

Low Operating MarginsLow Operating Margins

Ratio of (total revenues less total expenses) / Total Revenues Lower ratios = greater vulnerability

– $300,000 in revenues and $200,000 in expenses• 30-20 = 10• 10/30 = .33

– $500,000 in revenues and $200,000 in expenses• 50-20 = 30• 30/50 = .60

Tuchman and Chang standardsTuchman and Chang standards

Any score in second quintile “at risk” Lowest quintile on all four variables “severely at risk”

– Quintile ratios for four measures• Equity Balances• Revenue Concentration• Administrative Cost• Operating Margins

Tuchman and Chang ‘Insights’Tuchman and Chang ‘Insights’

Inverse relationship --> revenues and risk Low equity levels an indicator of risk Higher long-term debt to long-term assets

ratios another sign of trouble Vulnerable nonprofits are less liquid

(current ratios) Higher program service reliance -->

greater vulnerability

Two Major Research ProblemsTwo Major Research Problems

Extent of Program Services not fully captured by accounting system.

Difficult to determine independently which nonprofits experience financial shocks

Prediction EquationPrediction Equation

Greenlee and Trussel (2001) develop a prediction equation – Useful for exact estimation of financial vulnerability

within a set of norms for interpreting it.– Useful for comparing vulnerabilities

Greenlee-Trussel EquationGreenlee-Trussel Equation

– Yields the probability of financial vulnerability – Probability greater than 10% is a strong indication of

financial vulnerability– Probability less than 7% is a strong indication of no

vulnerability– Probability between 7-10% are indeterminate.

Greenlee-Trussel EquationGreenlee-Trussel Equation

1/(1+e-z) where Z=Constant (3.0610) + EQUITY + CONCENT +

ADMIN + MARGIN– The four ratios of Tuckman-Chang

Almost Ready for Prime TimeAlmost Ready for Prime Time

In the absence of other information, this approach is solid enough that nonprofit managers might begin to make use of it to test their hunches about the financial vulnerability of their organizations. – Probably not a good idea to rely on totally.– Certainly better than anything else currently existing.

Some general guidelines for more Some general guidelines for more intuitive use of ratiosintuitive use of ratios Greater the body of data you have more meaningful it will be. Year-to-year comparisons are more momentous than month-

to-month Cross-organizational comparisons of programs with similar

names can be very risky. (E.g., All home health programs are not created equal).

Different ApproachesDifferent Approaches

Self-Norming– Compare a single organization at different periods– Pick most secure and most vulnerable periods and compare

Peer-Comparisons– Compare Groups of related organizations

Compare community systems– Information on ranges

Limitations of the Model: ILimitations of the Model: I

Not all nonprofits file 990’s– Risky to generalize about non-filers.

Ratios limited to data IRS 990 collects– E.g., IRS doesn’t collect data on outputs

Limitations of the Model: IILimitations of the Model: II

The Greenlee-Tressel model (GTM) only tested on organizations four or more years old.– Could be that newer organizations (1-3

years old) behave differently. The GTM only tested on charitable

organizations to date. Further research needed using alternative

definitions of financial vulnerability.

predicting financial vulnerability in nonprofits roger a. lohmann, ph.d. nancy lohmann, ph.d....

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