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

2. Streetsmart Financial Basics for Nonprofit Managers
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

3. Streetsmart Financial Basics for Nonprofit Managers
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

4. 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 up with your financial advisors as appropriate.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

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

6. Streetsmart Financial Basics for Nonprofit Managers
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

7. 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 which is not as reliable as the rest.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

8. 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 in 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

9. Elapsed time between dates
The difference between the end of the fiscal year and the date of the opinion letter is more than 90–120 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

10. 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

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

12. Streetsmart Financial Basics for Nonprofit Managers
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

13. 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

14. Significant tax liability
The organization shows a significant tax liability (look 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

15. Streetsmart Financial Basics for Nonprofit Managers
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

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

17. 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

18. 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

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

20. Streetsmart Financial Basics for Nonprofit Managers
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

21. 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 scrutinize the reasons behind the relationship before becoming involved with the organization.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

22. 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 as long as management is aware of them and has a plan for dealing with them.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

23. Short-term borrowing practices
Interest rates higher than 1–1¼% above the 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

24. 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

25. Streetsmart Financial Basics for Nonprofit Managers
Lawsuits pending
Any lawsuit is a potential threat to a nonprofit agency.
Of course, lawsuits are a reality in today's world. The larger the agency, the more likely it will face at least one lawsuit at any time. 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

26. 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

27. Streetsmart Financial Basics for Nonprofit Managers
Pending adjustments
In complex environments such as health care organizations, nonprofits may be subject to adjustments in rates which 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

28. 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

29. Streetsmart Financial Basics for Nonprofit Managers
Subsequent events
On occasion a major event takes place after the financial statements are 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.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin