February 2015 Meeting: How to Think about Capitalization for Nonprofits of Every Size
Beth Doreian, Senior Associate at the Boston office of the Nonprofit Finance Fund, gave a presentation on the topic of capitalization. Prior to NFF, Beth was Director of Finance and Administration at Women’s Institute for Housing and Economic Development and Controller at Root Capital. Board members and management toss around terms like operating reserves and cash reserves and there is not always consensus on what is meant. How much is enough? How do you figure out how much is enough? What do you count toward operating reserves, anyway? Are your operating reserves reported on regularly on the balance sheet as a separate item? And for those lucky enough to have this problem, how much is too much?
Beth addressed some of those questions.
Determining what the best level of capitalization for an organization is more of an art than a science. The capital structure of an organization reflects the distribution, and magnitude of your organization’s assets, liabilities, and net assets as evidenced on the balance sheet. Sometimes the capital structure of a company is misaligned. The old way of looking at capitalization was that if you owned your own buildings and had a good endowment fund, you were in great shape. However, the current view is that it is most important to have the cash available necessary for you agency to fund its operations and execute its strategy. There are three major components to an appropriate level of capitalization for your agency. The first one is liquidity – does the organization have adequate cash to meet it operating needs? The second one is adaptability – does the organization have the flexible funds that allow for adjustments? And finally, durability – does the organization have access to funds to address a variety of future needs?
Different types of capital address different needs. Working capital allows an organization to bridge revenue timing gaps. Risk and opportunity capital provides a cushion in case some source of capital doesn’t work out. Change and growth capital funds investments in infrastructure and capacity associated with changes in your company. Capital available for recovery will provide a reserve to allow your agency to recover from some financial mistake. Capital for facilities and equipment supports acquisition, upgrades, and replacements. Investment capital (Board designated) is invested in order to provide operating funds from investment income.
How much capital do you need to have? How much working capital do you need to cover your month to month cash flow needs? How many months of capital do you have on hand to fund your operations if there is some interruption in your expected revenue flow? How much capital do you need to take advantage of an opportunity for growth when it comes up? What are your goals for investment income? And finally, what are your facility and equipment needs over the next five years? You need to answer the questions to determine the appropriate level of capitalization for you organization. Sometimes, incurring short term debt may be appropriate to cover timing gaps in your revenue. However, it is a bad idea to use debt to fund continued operating deficits. Sometimes a planned deficit is okay, but continued deficits will deplete your net assets and threaten the capital structure and operations of your agency.