Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Red Flag, Yellow Flag Numberless Financial Analysis for Nonprofits

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Introduction This presentation will help you analyze your own organization's financial statements based on the easy-to-master Red Flag, Yellow Flag method of financial analysis. Note: This list may not identify all possible trouble spots for every organization. It is meant to be illustrative only.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Definitions Yellow flag — a yellow flag means "slow down — ask questions to be sure there's no danger." Upon investigation, a yellow flag may turn out to be nothing — or it may warrant more study. Red flag — a red flag means "STOP — ask very sharp, probing questions before going any further." Red flags often mean danger ahead.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin How to use this presentation Take out your organization's audited financial statements and follow along. If you spot a red flag or a yellow flag in those statements as described in the presentation, make a note and follow it up with your financial advisors as appropriate.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Opinion letter

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin First sentence "We have compiled or reviewed the financial statements...” An audit is the highest level of assurance possible. All but the smallest of nonprofits should have a yearly audit. A review or compilation does not offer a proper degree of accountability.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Third paragraph or later "Except..." Auditors expect their opinion to hold true for the entire set of financial statements. If they exclude a part by a phrase beginning in this way, they are alerting you to an area of the document that is not as reliable as the rest.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Third paragraph or later "... question its ability to continue as a going concern." Auditors and financial personnel always assume that an entity will continue to exist indefinitely. But if serious financial problems raise doubt for them, they will note this in the opinion letter. STOP! Get solid answers to your questions before proceeding.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Elapsed time between dates The difference between the end of the fiscal year and the date of the opinion letter is more than 90 days (up to 120 days). The agency may not have been ready for its yearly audit due to mild internal disorganization in its accounting or other functions.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Elapsed time between dates The difference between the end of the fiscal year and the date of the opinion letter is more than 120 days. The agency almost surely had such organizational problems that it could not prepare for an audit on time. The results are out of date as soon as they are released.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin "Balance Sheet"

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Largest asset Find the largest single asset on the balance sheet. Learn who in the organization controls that asset. Controlling the largest single asset in any organization gives a person or department a great deal of influence over the future of the organization.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Largest asset is accounts receivable If the largest asset is accounts receivable, the organization's future financial health is dangerously concentrated in an outside entity. If that entity does not eventually pay all of the receivables, the agency will experience financial problems.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Significant tax liability The organization shows a significant tax liability (look under under current liabilities). Any organization showing a significant liability for payroll taxes (more than 1% of yearly payroll) may have missed a payroll tax payment and therefore owes the IRS money. This may indicate a chronic cash flow shortage.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Negative net assets Negative total net assets (a number in parentheses) Negative total net assets means the organization is close to bankruptcy. This indicator should be taken seriously.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin "Revenue and Expenses"

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Statement of revenue and expenses A negative change in net assets means that the organization lost money that year. A change in net assets of less than about - 5% should prompt further investigation of the organization, its programs and services, its funders, and its stability.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Statement of revenue and expenses A change in net assets of more than about - 5% should prompt serious investigation of the organization and its future stability. Such significant losses cannot be sustained indefinitely.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin "Footnotes"

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Footnotes Note 1 -- Accounting policies – "modified accrual basis" or "modified cash basis" of accounting. The accounting method should be accrual- based. Anything else falls short of acceptable financial practices.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Related party transactions While not illegal, related party transactions often create a perception of illicit financial activity. If you see a disclosure of a related party transaction, you may want to understand the reasons behind the relationship before becoming involved with the organization.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Long-term debt balloon Because of the mathematics involved, long-term debt will always decline for each succeeding year. If long-term debt increases, it means a "balloon" payment is due. Balloon payments in the future long-term debt schedule are not a problem if management is aware of them and has a plan for dealing with them.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Short-term borrowing practices Interest rates higher than 1 to 1¼% above prime interest rate Lines of credit are issued by banks for short term, cash flow purposes and are usually linked to the prime interest rate. High rates suggest that the bank feels the borrower is a high risk.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Short-term borrowing practices Line of credit is at maximum level. When a line of credit has been fully drawn on, the organization may be experiencing cash flow difficulties. Pay careful attention to the cash balance and to the future prospects for better cash flow.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Lawsuits pending Any lawsuit is a potential threat to a nonprofit agency. Of course, lawsuits are a reality of today's world. The larger the agency, the more likely it will face at least one lawsuit at all times. Evaluate the lawsuit's potential as part of your review. Management's assessment is usually stated.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Extraordinary transactions Sometimes a one-of-a-kind financial transaction occurred during the fiscal year. If so, auditors will generally mention it. Extraordinary transactions are not necessarily bad. Some can be positive, while others can't be assessed right away. Investigate to learn the implications of any such transaction you see.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Pending adjustments In complex environments such as health care organizations, nonprofits may be subject to adjustments in rates that take years to be finalized. Similar to extraordinary transactions, pending adjustments may be positive or negative, or they may have no effect at all.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Comment about uncertainty of funding sources Occasionally auditors will feel it necessary to comment about an unusually high percentage of revenue coming from a particular funder. Such comments may be a precursor to a going concern opinion, or they may be a routine comment on the realities of depending on a single source of government or foundation funding.

Streetsmart Financial Basics for Nonprofit Managers Copyright 2002 Thomas A. McLaughlin Subsequent events On occasion a major event takes place after the financial statements were completed. Again, the event may be positive or negative. Be sure to understand what happened and why, and make your own judgment about its meaning.