Explanation of Financial Ratio Analysis in Not-For-Profit Accounting

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Businesses of all types use financial ratios to grasp an idea of financial performance during a specific period or in comparison to previous periods. Although there are numerous financial ratios to choose from, not all apply to nonprofit organizations. Nonprofit organizations either wholly or partly generate revenue from donations, government contracts and government grants. Therefore, financial ratios used to measure their performance should focus specifically on these revenue sources. Examples of financial ratios for nonprofit organizations are reliance on sources of income, benefit expense rate, fund-raising efficiency and current ratio.

Reliance on Sources of Income

Nonprofit organizations receive significant portions of their income from one or several major sources. When this happens, the organization may be dependent on such sources to survive. The reliance on sources of income ratio reflects an organization’s financial position if a major source of income decreases or stops and is calculated by dividing the largest source of income by the total income. For example, if ABC Company generated $1 million in revenue in 2010 and sales to DEF Incorporated represented $255,000 of the income received, the reliance of sources of income would be 0.255 ($255,000/$1,000,000). This means ABC would lose more than 25 percent of its annual revenue if income from DEF Incorporated is eliminated.

Benefit Expense Rate

The benefit expense rate reflects employee benefits in proportion to employee salaries and wages and is determined by dividing company-paid benefits (insurance and fringe benefits) divided by total salaries and wages. If ABC Company paid $376,000 in salaries in 2010 and $170,000 of that amount was for health insurance, vacation time and various other benefits, the benefit expense rate would be 0.45. Consequently, 45 percent of the salaries and wages are allocated to employee benefits ($170,000 / $376,000).

Fund-Raising Efficiency

Nonprofit organizations such as the American Heart Association and March for Dimes receive portions of their revenue through fund-raising activities. The fund-raising efficiency ratio is a reflection of an organization's return on the amount spent on fund-raising expenses. Contribution income divided by fund-raising expenses yields the fund-raising efficiency. For example, if ABC Company receives $345,000 in contributed income and spent $250,000 on fund-raising expenses, its fund-raising efficiency ratio is 1.38 ($345,000/$250,000). A fund-raising efficiency of 1.38 means ABC receives $1.38 for every dollar invested in fund-raising expenses.

Current Ratio

The current ratio reflects an organization’s ability to pay off short-term debt. Current ratios are the result of current assets divided by current liabilities. For example, if ABC Company has current assets of $335,500 and current liabilities of $275,000, its current ratio is 1.22 ($335,000/$275,000). Thus, the company has $1.22 in current assets for every dollar in current liabilities. Creditors prefer that companies have a current ratio of at least 1, which is an indication of their ability to liquidate all current assets to pay off all current liabilities

Significance

Financial ratios are indicators of organizations’ ability to manage assets and survive in various economic environments. However, the significance of financial ratios depends on the industry and previous years’ performance.

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