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The Financial Management in Nonprofit Organizations

Executive Summary

This paper focuses on financial management in nonprofit organizations. It starts by providing an overview of financial management as a whole before embarking on shedding light on differences and similarities in the way finances are managed in both investor-owned and nonprofit firms. The author recognizes many similarities in the management finances in both nonprofit and profit-making organizations. However, a number of differences have also been identified and discussed in detail. In comparing  these two sectors, the paper looked at the cost of capital estimation, capital structure, capital formation, capital structure and capital budgeting. It also discussed the issue of financial analysis, planning and forecasting, governance and long-term financing decision in these organizations. The evolving concept of performance management and the use of debts were not left out. The cost of capital for the nonprofit corporation is estimated and tied to the cost of capital of a similar profit-making corporation. Firms with adequate funding are able to operate at optimal capital structure, and this minimizes capital costs, and where financing is weak, nonprofit firms tend to borrow in excess resulting in higher capital costs. Despite many temptations to leave out risk analysis, the author emphasizes the need to analyze risks for incorporation into decision-making process in nonprofit organization. Governance in nonprofit sector are not as enhanced as in  case with profit-making companies, but there are measures to check monitor and safeguard these organizations from frauds and financial impropriety. 


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Financial Management in Nonprofit Organizations

There are many similarities in the management of finances in nonprofit and profit-making organizations. However, there are certain variations that shift the focus of financial managers in the not-for-profit organizations. Unlike profit-making firms whose main goal is to make profit and increase shareholders’ wealth, nonprofit organizations aim at providing socially desirable needs on an ongoing basis. A nonprofit organization depends on resource providers for funding; however, these providers are not engaged in the exchange transaction. These firms therefore lack the financial flexibility when compared to profit-making enterprises. Resources of nonprofit organizations are used to provide goods and services to the clients but not resource provider. In regard to this, these firms are expected to demonstrate stewardship of donated resources and ensure that funds are used for intended purposes and projects (Anheier, 2005). The purposes of funding are either determined by the donor or implied from the mission of the organization.

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Comparing Financial Management in Nonprofit and Profit Organization

There are notable differences in goals and objectives of these two types of business, and this leads to some interesting differences in their financial management. The main goal of a profitmaking firm is to maximize the wealth of shareholders. On the other hand, nonprofit organizations do not have stockholders, and their goal is not to maximize the value of shareholders but meet the mission of the organization. Not-for-profit organizations employ millions of employees and thus require the financial management skills just like those in the investor-owned organizations. Financial reports must also reflect whether or not the funds were used as directed by the donor. Cash and budget management areas of much importance in financial management require a very close attention within nonprofit organizations. Cash flow is challenging and difficult to predict because resource providers are not the beneficiary of service being provided. It is also hard to project in a reliable manner the contribution revenue from year to year. Therefore, the control of expenses is of paramount importance since budgeting is critical for these organizations. The firm should remain financially strong in order to realize its mission statement, and this requires excellent financial management skills and policies (Jody, 1996).

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Cost of Capital Estimation

The cost of capital is usually a blend of the costs of different types of capital the company uses.Estimating the cost of capital in nonprofits is similar to that in investor-owned firms albeit two differences exist between them. First, they do not pay taxes,  therefore there are no tax effects associated with debt-financing. Investor-owned firms raise their capital through the sale of stocks and from retained earnings. The fund or equity capital of a nonprofit are realized through earned profits, grants from government bodies, and through individual and corporate contributions. Since the cost of capital is used for calculating capital budgeting, the opportunity cost of fund capital becomes controversial to estimate in not-for-profit organizations. The cost of fund capital for any nonprofit corporation is estimated and tied to the cost of capital of a similar profit-making corporation. For instance, estimating the cost of capital for a nonprofit making hospital is based to that of profit making hospital. This means that the principle of opportunity cost is applied in estimating the cost of fund capital. This cost should be equal to that of retained earnings in a similar profit-making firm. However, contributions restricted for specific projects and purposes have zero cost since there is no chance to invest in them.

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Capital Structure Decisions

Two issues are of concern when making capital structure for nonprofit businesses. First, the issue is whether or not the theory of capital structure applies to nonprofit business. Secondly, there is a need to assess if there are any characteristics preventing not-for-profit businesses from following the guidance stipulated in the theory.  The fund capital for these firms has a nearly equal opportunity cost to the equity of investor-owned firms with a similar risk. Therefore, the cost of fund capital expands with debt financing just like in profit-making firms. They are subject to financial distress and agency costs similar to  profit-making firms,  therefore the trade-off theory could be applied. Such businesses have optimal capital structures defined as trade-offs between debt and the costs and benefits of debt financing. In cases where nonprofit firms are forced into using more than the optimal level amount of debt financing, managers should reduce the level of debt as soon as the situation permits, since this tends to increase the cost of capital. Firms with adequate funding are able to operate using  optimal capital structure, which minimizes capital costs. Where financing is weak, nonprofit firms tend to borrow in excess, which results in higher capital costs, since weakening financial condition may prevent the firm from acquiring necessary capital equipment.

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Capital Budgeting

In nonprofit capital budgeting, we look at the goal of project analysis, estimation of cash flow, and risk analysis. Capital budgeting in these firms incorporates many other factors besides profitability of project. These factors include the wellbeing of the community that could outweigh financial considerations. Nonetheless, decisions should ensure future financial viability to avoid the closure of the organizations. For instance investing in unprofitable projects without corresponding profitable projects could deteriorate financial condition of the organization, and it is quite obvious that bankrupt organization cannot provide community services.

Cash flow estimation for a nonprofit is similar to investor-owned organizations, but with two differences. First, project analysis in nonprofit should consider social value alongside cash flow or financial value. The net present value has two components, one for cash flow streaming and the other for net present social value for the project. A project is deemed viable if the total net present value is greater than zero.  If the sum of NPVs for all projects in the planning period is less than zero, the social value could eventually displace financial value making the situation unsustainable as the firm cannot continue providing social value without maintaining financial integrity.

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The second element is determining the discount rate for calculation of  annual social value stream for NPSV projects. Nevertheless, this could be looked at in the perspective of nonprofit firm in a portfolio of marketable securities whose proceeds were used to purchase the same services from a similar investor-owned firm for people who cannot afford them. This could be used to argue that providers require return on social value that is equal to return for equity investment within similar profit making organizations (Larkin & DiTommaso, 2006).

There are three types of risks, namely, a stand-alone risk, which views project risk in isolation, corporate risk and market risk. The market risk views the risk from the perspective of the stockholder with diversified stock portfolio, and this is the most relevant risk for the profit-making firms. The stand-alone risk could be relevant for the not-for profit organization running just one project. However, most nonprofit firms offer a myriad of products and services and can be thought of as having numerous projects. Hence the stand-alone risk may not be very appropriate. The corporate risk, which views the risk in the context of the organization’s portfolio projects, is thus relevant in risk analysis of these organizations. Just like in investor-owned firms, it is very difficult to have an accurate assessment of the corporate risk in the majority of not-for profit projects (Finkler, 2005). Most managers thus assess project’s stand-alone risk which they combine with subjective notion on how it fits into other operations of the firm. The projects being considered ought to be in the same line of business with other projects of the firm or division in order to qualify the stand-alone risk as a good measure of corporate risk. Finally, nonprofit capital budgeting decisions require a blend of objective and subjective factors to analyze the risk, social value, profitability, and impacts of debt capacity as well as overall acceptability (Finkler, 2005). The process is however complicated, and the temptations to ignore project risk analysis are high, as they are so imprecise. Nonetheless, the analysis of risks should be assessed and incorporated into the decision-making process of the nonprofit organization.

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Financial Analysis, Planning and Forecasting

Financial analysis, planning and forecasting applies to both investor-owned and nonprofit organizations. However, there are differences in accounting procedures and hence the financial statements. Typically, the accounting procedures for not-for-profit firms follow the generally accepted accounting procedures (GAAP), hence their financial statements are similar to those of investor-owned firms in many respects, with slight variations. The fund capital in not-for-profit firms is equivalent to equity in commercial firms but serves the same function. Balance sheets are built over time from contributions and retentions but are reduced by operating losses (Larkin & DiTommaso, 2006).

Long term financing decisions. Not-for-profit firms have access to capital just like investor-owned firms. In terms of long-term debt financing, nonprofit can issue tax exempt debts and municipal bonds (Munis) to finance its activities, but they cannot issue equity. Munis include special tax bonds and general obligation bonds. Shorter maturity municipal bonds are an equivalent of corporate bonds’ sinking fund payments. Municipal issues are not registered with Securities and Exchange Commission as is the case with corporate bonds in profit-making firms.  For profit-making firms, equity is financed from retained earnings and issue of stocks. Equity financing in not-for profit comes from retained earnings and charitable contributions. Raising equity appears easy in profit-making firms, as new stock can be issued at any time and also in any amount. However, the charitable contributions cannot be relied on as most pledges are not fulfilled. The use of these contributions tends to be restricted to a specific project or purpose.     On the contrary, in case with profit-making firms,  proceeds from issued stocks are used for any purpose. Nonetheless, issuing stock in the equity market to raise capital by profit organizations is also restricted by the market conditions and investors’ view of the stock among other issues. Therefore the freedom of managers in profit-making to issue new stocks is somehow restricted to protect the value and price of company stock in the market (Bryce, 2000).

Governance in Nonprofit Organizations

Nonprofit firms are prone to fraud, financial malpractices, and members who are  interested in their financial gains at the expense of their organizations’ missions. These issues are quite disturbing and need to be monitored, regulated, and governed appropriately to safeguard the integrity of the organization. Investor-owned firms are scrutinized by shareholders and government agencies such as Securities and Exchange Commission and the media.

For the biggest  part of history, nonprofit firms have long operated without the public scrutiny. They are obligated to hold public meetings, and media reporting on these organizations is quite limited. These firms are governed by the board of Directors, trustees and volunteers. The board has a legal responsibility of making sure that the mission is met, assets are safeguarded, and it operates in the interest of the public (Anthony & Young, 1994).  Private watchdog groups are used to monitor the performance and behavior of nonprofit firms. State charity regulators are registers and maintain a list of nonprofit organizations. It also investigates cases of fraud and abuse of office whenever they come up. Donors and members can withhold funding when dissatisfied and increase their support when satisfied with operations of these organizations. Internal Revenue Service audits the books of account of nonprofit organizations every year to ensure they comply with requirements for tax exempt status. They can revoke tax exemption and call for intermediate sanctions. The media is the major whistle blower for scandals occurring in these firms. It acts as a watchdog increasing the accountability in the nonprofit sector.

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Performance Management in Nonprofit Organizations

Performance management in the nonprofit sector has gradually developed over the last decade. However, the distinctions between performance reporting, management and measurements were unclear. Today, the distinction between performance reporting and management is getting clearer, with the later being steering tools and the former being accountability tool. The use of balanced score card is commonly used in this sector to enhance the fame of performance management (Kaplan & Norton, 1992). Most organizations in the nonprofit sector have already implemented performance management systems. Despite its role as a steering and accountability tool, it is also used to manage contract relations.

Use of Debts

Debt can be very useful in the nonprofit sector, and borrowing is allowed in some cases. Before borrowing, the organization should estimate recent cash flow projections and conduct analysis of its financial position to know whether or not it will be able to pay the debt. It is important to know how the borrowed fund is to be used, put up a realistic payment plan, and get the approval of the board. The borrowed fund can be used to leverage cash flows, purchase capital for the organization, and  provide essential services to the society. For instance, in the matter of a natural disaster, the firm may not have adequate finance to offer emergency services under its jurisdiction, hence borrowing could help to mitigate financial shortage (Kaplan & Norton, 1992).

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This paper has adequately addressed fundamental issues related to financial management in not-for-profit organizations. The latter play a vital role in the society and are funded with  billions of dollars. They also offer employment opportunities to millions of people and therefore must be protected from any form of financial mismanagement. Given the complexity of their nature, there are clear guidelines on how they should manage their finances in a transparent manner, to ensure their sustainability and efficient use of the finances they receive. Lack of proper management of finances could lead to the collapse of this important sector, and this will definitely deny the community the much needed service they provide.  It is important to note that the level accounting and management of finances in these firms is complicated, and many efforts are still required to improve the management of finances in the nonprofit sector. Governance methods and structure are still weak. The monitoring and governance structure needs to be improved  to safeguard the organization  from financial mismanagement.



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