Measuring an organisation's financial health

1Why ratios?

An NGO's financial statements (balance sheet, income statement, cash flow statement) contain a lot of figures. Ratios make them comparable over time and between organisations, and allow the board, donors and auditors to ask the right questions quickly.

Three families of questions:

• Can we pay our short-term debts? Liquidity and cash.
• Can we absorb a shock? Unrestricted reserves, months of operation covered.
• Is our model sustainable? Dependency on donors, shared cost coverage, result on unrestricted funds.

An isolated ratio says nothing; a three-year trend and a comparison with similar organisations say a lot.

2Liquidity and cash

Current ratio = current assets / current liabilities. Below 1, the organisation cannot, in theory, cover its short-term debts with its short-term assets.

Quick (cash) ratio = (cash + short-term investments) / current liabilities. It excludes receivables, which may be slow to come in.

Beware an NGO-specific feature: a large part of cash often consists of donor advances not yet spent, recorded as liabilities as deferred income (funds received to be returned or used). This cash does not freely belong to the organisation.

Example. Current assets 2,400,000 USD (including cash 1,500,000, receivables from donors 800,000, other 100,000). Current liabilities 2,000,000 USD (including unspent donor advances 1,300,000, suppliers and salaries 700,000). Current ratio = 2.4 / 2.0 = 1.2. Quick ratio = 1.5 / 2.0 = 0.75. "Free" cash = 1,500,000 − 1,300,000 = 200,000 USD, to be compared with the 700,000 USD of current liabilities excluding advances: the organisation depends on prompt payment of its 800,000 USD of receivables from donors.

3Reserves and months of operation

Free reserves (or available unrestricted funds) are the share of funds that is neither restricted to a project, nor tied up in equipment, nor blocked by a board decision.

Months of reserves = free reserves / (total annual expenditure / 12). Some organisations use only overhead costs as the denominator, which gives a more flattering figure: the definition must always be stated.

Example. Funds 1,100,000 USD, of which 300,000 tied up in fixed assets (vehicles, buildings) and 200,000 designated by the board for an emergency fund. Free reserves = 600,000 USD. Annual expenditure 9,600,000 USD, i.e. 800,000 a month. Months of reserves = 600,000 / 800,000 = 0.75 months. On overhead costs alone (1,440,000 USD a year, i.e. 120,000 a month), the result is 5 months.

Common benchmarks aim for 3 to 6 months of overhead costs, but the right target depends on risk: frequent pre-financing, contracts in volatile currencies, end-of-contract indemnity obligations.

4Dependency and income structure

A fragile organisation depends on few sources. Useful indicators:

• Share of the largest donor in total income. Above 40 to 50%, the loss of this donor threatens the organisation's existence.
• Concentration index (Herfindahl-Hirschman): the sum of the squares of each source's share. Close to 1 = a single source; close to 0 = highly diversified sources.
• Share of unrestricted funds in total income: these are the only funds that give strategic freedom.

Example. Income: donor A 50%, donor B 30%, donor C 10%, private donations 10%. HHI = 0.25 + 0.09 + 0.01 + 0.01 = 0.36. Another organisation with five sources of 20% each has an HHI of 5 × 0.04 = 0.20. The first is clearly more exposed.

Diversifying does not mean multiplying small contracts: each contract has a management cost. The aim is to avoid a single external decision putting the organisation in jeopardy.

5The myth of low overheads

The overhead rate (overheads / total expenditure) is often used by the public as a measure of efficiency. It is misleading. The nonprofit starvation cycle is well documented: donors expect low overheads, NGOs under-report their true costs, underinvest in systems, staff and security, and then weaken.

What matters is that overhead costs are necessary, controlled and covered. An organisation with 6% overheads that has no internal auditor, no reliable accounting system and no security manager is not more efficient: it transfers the risk to its teams and its beneficiaries.

Shared cost coverage rate = shared costs recovered from projects (indirect costs and budgeted shared costs) / actual shared costs. Example: actual costs of headquarters and country offices 1,440,000 USD; recovered 1,152,000 USD. Coverage = 80%; the shortfall of 288,000 USD must be covered by unrestricted funds, or it will consume the reserves.

6The organisational financial dashboard

A dashboard presented to the board every quarter fits on one page. It combines:

Reading: reserves are melting because shared costs are not fully covered and the unrestricted result is negative; at the same time, old receivables are squeezing cash. It is not yet a crisis, but it is the typical configuration that leads to one within 12 to 18 months. Decisions: chase and escalate old receivables, review indirect cost rates in new proposals, freeze non-essential overhead spending, and present the board with a plan to rebuild reserves.