1. Streetsmart Financial Basics for Nonprofit Managers
Red Flag, Yellow Flag
Numberless Financial
Analysis for Nonprofit Organizations
Hello this is Tm and welcome to Red Flag, Yellow Flag: Numberless Financial Analysis for Nonprofit Organizations
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.
This presentation will help you analyze your own organization's financial statements—without doing a single calculation. We'll use my special red-flag, yellow-flag method to make it easy.
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.
In my method, a yellow flag means pretty much what a yellow light means on the highway. Slow down. Be cautious. Pay attention to what comes next. There may not be danger ahead, and there may not be anything at all, but you'll be better prepared if you proceed with caution.
A red flag means what you'd expect it to mean. STOP! There could very well be financial danger ahead, so ask some very good, probing questions. Don't go ahead until you're satisfied with the answers. Often, you won't be able to get the answers just from looking at the financial statements. So that's when you have to find a way to ask the management directly. Be on the alert if you see a red flag.
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
Now it's time to get out your set of financial statements. Have them handy at all times as we go through the material. You won't see all the yellow flags I talk about—and I hope you don't see any red flags—but if you do see some flags the slides will suggest what they might mean, and I'll offer a few thoughts about how to deal with them.
Are you ready? Good—move to the next slide please.
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.
The opinion letter is the first significant piece of paper in a set of financial statements. Not surprisingly, it looks just like a letter. It is addressed to the organization itself and signed by the auditor or audit firm.
Look at the first sentence in the letter. It should say something like "we have audited . . ." If it says “compiled” or “reviewed”—YELLOW FLAG. Why? Because only an audit offers the highest level of assurance and reliability for the outside reader. All but the smallest of nonprofits should have an audit every year. Anything less is not properly accountable.
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.
Now look at the third or fourth paragraph. If you see the word “except” in any sentence, it's a YELLOW FLAG. The reason is that just about any use of the word “except” means that the auditor is trying to signal an area in the financial statements that, for whatever reason, is not as reliable as the rest. Normally an audit offers an unqualified opinion, but the presence of an ”except” sentence or similar caution may mean that the opinion is qualified.
Remember, this is a yellow flag. The exception might turn out to be minor, but you'll need to study it carefully.
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.
Look at the area toward the end of the opinion letter. If there is going to be a RED FLAG in the letter, this is where it'll be. It's where the auditor suggests that the entity might not survive for long. This is called a going concern opinion, and it is a very serious matter indeed. What it means is that the auditor, who has spent some time looking at the organization from the inside out, is worried that it is in such bad financial condition that it might not survive for the next 12 months.
This is one of the most serious RED FLAGS you can find. Think of it as being like a financial fire alarm. Emergency action is necessary when you see a going concern opinion.
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.
Calculate the difference between the end of the fiscal year and the date of the opinion letter. The date of the opinion letter is usually the last day during which the auditor spent a significant amount of time working onsite. If the difference between the two dates is more than about 90–120 days, it's a YELLOW FLAG.
The reason? Any organization should be able to close its books and be ready for an audit within two or three months after the fiscal year ends. If they aren't ready, this delays the start of the audit. The longer the audit is delayed, the more stale the information will be when the audit is finally done. More important, it may mean that the financial department just isn't organized properly.
Now be aware that some auditors and their clients may mutually agree to postpone the audit. Auditors have busy seasons, and sometimes it's easier for them—and possibly less expensive for their clients—to wait a month or two just to get past the busy time. That may be okay, but various reporting dates make it difficult to postpone the audit for very long.
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.
If you find that the difference between the two dates is greater than 120 days, consider it a RED FLAG. Such a gap is almost certainly due to disarray in the financial department. It's hard to imagine a good reason for taking such a long time to produce the most important public piece of financial accountability a nonprofit must issue each year. STOP—and investigate.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

11. Streetsmart Financial Basics for Nonprofit Managers
Balance Sheet
Turn to the balance sheet, or the statement of financial position. This statement gives a snapshot in time of the organization and its cumulative financial well-being.
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.
Here's a quick test. Find the largest asset on the balance sheet. Figure out who or what department in the organization controls that asset. Whoever controls the largest asset in any organization has a lot to say about how that organization functions.
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.
Sometimes a nonprofit's largest asset is the money owed to it for services already delivered, or its accounts receivable. This is a YELLOW FLAG because if the person or group that owes that money has problems paying for the services it already received, that can have a major impact on the nonprofit. In this situation it's worth examining those accounts receivable closely.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

14. 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.
In the current liabilities section of the balance sheet, you may see a current liability labeled “payroll taxes due” or something like that. This is almost certainly a YELLOW FLAG. Employers are required to withhold taxes and other payments from employees' paychecks and then turn that money over to the IRS a few days later. An entry for payroll taxes due may mean that the nonprofit has missed a payroll tax payment, and that it still owes money to the IRS.
It's always a serious matter to have missed a payroll tax payment. But it's especially serious for a nonprofit to miss such a payment, because usually payroll is such a big part of nonprofits' spending. It can be hard to catch up.
This yellow flag can be even more troublesome. Often an organization that's chronically short of cash will be prone to missing a payroll tax payment. If you see this kind of liability, make sure that it's not a sign of cash flow problems—or worse.
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.
If you see a set of parentheses around the total net assets number in the liabilities and net assets side of the balance sheet, you should be concerned—this is a RED FLAG. Net assets are the nonprofit equivalent of owner's equity in a for-profit company. If the number here is negative, it means that the book value of the assets are not enough to cover all of the liabilities. This is not technically bankruptcy, but it's very close.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

16. Streetsmart Financial Basics for Nonprofit Managers
Revenue and Expenses
The next statement in the document shows revenues and expenses for the full year. This is sometimes known as the profit-and-loss statement.
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 loss of less than about –5% should prompt further investigation of the organization, its programs and services, its funders, and its stability.
Contrary to what some may believe, nonprofit organizations are not expected to lose money every year. In fact, a nonprofit that loses money every year will eventually go out of business, without some extraordinary assistance. If a loss in any given year is less than about 5%, it should be motivation to review programs and services to see why the loss occurred. Nonprofits do not exist to make a profit, but without a profit they can have problems ranging from cash shortages to an inability to borrow more money from lenders.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

18. Statement of revenue and expenses
A loss of more than about –5% should prompt serious investigation of the organization, and its future stability. Such significant losses cannot be sustained indefinitely.
A loss of 5% or more is a RED FLAG. STOP! Make sure you know why the organization lost money, and what it is doing about it for the future. More than a 5% loss in any given year can be cause for concern. Ask if the losses have been stopped, or if the same situation will hold true next year.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin

19. Streetsmart Financial Basics for Nonprofit Managers
Footnotes
Finally, turn to your financial statement’s footnotes. This is where you can get some excellent information—all without even calculating a single number.
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.
The first footnote is usually used to document key accounting practices the organization employs. One thing to look for here is the basis of accounting. It should say the nonprofit uses the accrual basis of accounting, which is more reliable and allows for greater accountability. If it modifies the word accrual at all—such as by calling it a “modified accrual” or even a “modified cash basis”—you should know that you are reading financial statements that may not be completely accurate and that do not follow generally accepted accounting 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 understand the reasons behind the relationship before becoming involved with the organization.
Related party transactions are the nonprofit world's equivalent of insider training. They occur when an “insider” causes the organization to enter into an agreement with an outsider in such a way as to benefit or appear to benefit the inside party. For example, if the executive director hired his wife to design the organization's new building, he would be setting into motion a related party transaction. This is often not illegal, but it does call into question the integrity of all parties concerned. It's best to avoid these YELLOW FLAGS.
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.
Check in the long-term-debt portion of the footnotes. You should find a statement of yearly long-term debt that's coming due in each of the next five years. The numbers in this list should decline each year. If they rise it means that there is an increased payment coming due in the next five years. This is a YELLOW FLAG which can easily be dismissed if management can prove that it is fully aware of the borrowing pattern and that future financial plans will include resources to meet the increase.
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.
Short-term borrowing practices are one of the best places to see how knowledgeable outsiders rate the organization. The higher the interest rate, the more likely it is that the bank sees this organization as in risk of default. Rates of more than about 1¼% over the prime rate are often a sign that the lender sees the borrower as 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.
If the organization's line of credit is at its maximum amount, it means the organization cannot borrow any more money for cash flow purposes. This is a YELLOW FLAG, because unexpected developments in the future could strain the organization's ability to cope.
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.
Unfortunately, lawsuits do occur. In fact, as a nonprofit grows, it is virtually certain to face a lawsuit at some time or another. Those with tens of millions of dollars in revenue or more are often likely to face one or more lawsuits at any time. These will be disclosed in the footnotes and have to be considered YELLOW FLAGS. Practically speaking, outsiders cannot get enough information to form judgments about the merits of a lawsuit, so readers options are limited here.
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.
Sometimes one-of-a-kind transactions occur. These include things like major debt refinancing or crises like floods or fires. These must be considered a YELLOW FLAG until there is enough information to consider it otherwise.
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.
Complex funding environments often create rate adjustments, which should be considered YELLOW FLAGS until proven otherwise.
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.
Many nonprofits rely extensively on government funding which can be inherently unpredictable. Discount this as a YELLOW FLAG if you know that the particular funding source is not as problematic as it might seem.
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.
An event happens after the audit is completed but before it is released. Assume these are YELLOW FLAGS unless the implication of the subsequent event is positive or neutral.
Streetsmart Financial Basics for Nonprofit Managers
Copyright 2002 Thomas A. McLaughlin