Budgeting and Financial Planning

Reporting
Effective financial management is an ongoing process that features a cycle of good management habits. The financial management cycle is completed when board and staff leaders use the results of their analysis of the accurate and contextual reports they have received during the year to inform their plans going forward. Financial planning, in essence, is budgeting.

Organizational Budget
Operating Budget Capital Budget

Associated with Statement of Financial Position Associated with Statement of Activities (Balance Sheet) (Income Statement, Profit & Loss)

Planning income and expenses for a single fiscal year to accomplish immediate mission agenda Can be projected over multiple years as part of a strategic plan to include implementation of strategic initiatives

Planning for optimal cash position (operating & emergency reserves, other strategic reserves) Planning for capital investments (equipment upgrade/replacement, facilities acquisition and/or maintenance, special projects, etc. over a longer time period) Planning for long term endowment (if appropriate)

See Budgeting Practices.

See Budgeting for Capital.

An organization's financial planning should include budgets for operating and for capital. Together these comprise an Organizational Budget. Creating an annual operating budget is a familiar task. However, creating a capital budget, or capitalization plan, is often overlooked or deemed unnecessary for small or midsize groups or construed as only necessary for a capital campaign. The annual budgeting Process should be documented, with tasks, responsibility assignments and deadlines clearly stated. A good budgeting process:

engages those who are responsible for adhering to the budget in the creation of the budget,

allows time for the Finance Committee to participate, provides adequate time for research, review, feedback, revisions, etc. before the budget is ready for presentation to the full board, incorporates strategic planning initiatives, is characterized by realistic projections for income and expense is income-based (expenses do not exceed the realistic income projections) identifies fixed costs and relates them to reliable revenue, is driven both by mission priorities and fiscal accountability.

A well constructed operating budget will demonstrate in numbers the organization's commitment to fulfilling its mission. It will be based on reliable income projections and expense projections will be well-researched, conservative, and thorough. Those building the budget will understand what components of it are fixed and which can be adjusted as the budget year progresses. [See Budgeting Practices,Budgeting Terms & Concepts and Basic Accrual Concepts] Although the concept of developing a capital plan, or capital structure, may seem odd for a small or midsize nonprofit organization to consider, the truth is that any size organization has a capital structure, whether conscious of it or not. Deliberate capital structure planning takes into account building resources for long-term, non-operating needs. These might include: asset purchases (such as inventory, equipment, or leasehold improvements), financial stability targets (such as building an operating cash reserve or equipment/facility maintenance/replacement reserves), and funding program or management initiatives per the organization's strategic plan (such as a pilot program or staff capacity building). Capital budgets often require a funding plan separate from and in addition to the operating budget. This plan can include a capital campaign as well as other funding strategies such as specific project requests and designations of accumulated surplus. For small and midsize organizations, priority should be given to building an operating reserve before considering establishment of an endowment. Endowment funds are permanently restricted and the principal cannot be used for operating, cash flow, or other purposes. Conversely, an operating reserve creates liquidity and financial flexibility for the organization and positions it to withstand emergencies, temporary cash flow fluctuations, or unplanned reductions in revenue or increased demand for its programs. Organizations with sufficient operating and other designated reserves can focus beyond day-to-day cash flow needs and more effectively plan for the long-term health of the organization. Organizations with limited or negative liquidity tend to focus on the short term. A cash crisis unproductively consumes time and resources, causes stress, and can hinder engagement in long-term planning and consideration of new mission related ventures.

Good financial management requires the organization to be conscious and deliberate about planning for both its long term financial goals and immediate financial health.

Budgeting Practices
The budget process is the way an organization goes about building its budget. A good budgeting process engages those who are responsible for adhering to the budget and implementing the organization's objectives in creating the budget. Both finance committee and senior staff participation is built into the process and a timeline is established leaving adequate time for research, review, feedback, revisions, etc. before the budget is ready for presentation to the full board. The annual budgeting process should be documented, with tasks, responsibility assignments and deadlines clearly stated. A good budgeting process also incorporates strategic planning initiatives and stipulates that income is budgeted before expenses. Fixed costs are identified and related to reliable revenue. Budgeting decisions are driven both by mission priorities and fiscal accountability. Steps for developing a good budgeting process were covered in the previous section, The Budgeting Process.

Good budgeting practices:

1. Practice income-based budgeting. Budgeting is a form of risk management, and the most reliable budgets yielding the best fiscal results for the organization are conservative and income based. This means:

Budget for income first. Base income targets on realistic expectations and only include reliable income in the budget. Never include an income projection that simply

fills the gap to cover expenses. This sets the organization up for a budget deficit if the organization fails to hit the "plugged" income targets. Take care to understand the impact and timing of restricted contributions and releases on the operating budget. Ensure expenses are lower than the dependable income total. This requires cooperation among all departments in setting organizational and programmatic priorities, timing new or adventuresome programs.

2. Analyze and understand your revenue concentrations. Is your organization overly dependent on single source of revenue? In many cases, lack of diversification of revenue sources can pose a serious risk to the financial stability of an organization should a single large revenue source become unavailable. There is no universally right mix of revenue sources - the right mix for your organization depends on your particular circumstances, your mission, your industry, your staff capacity, and even the age of your organization.

For an organization with little or no earned revenue associated with programs, having 80% of revenue from government sources may make total sense because of reliable, ongoing contracted programming. For another organization whose revenue sources appear to be well distributed among earned, government, foundations, corporations and individuals, the realization that 90% of foundation revenue comes from one large grant from a single foundation may still pose a concentration risk. Risk is also present if a big portion of an organization's annual revenue depends on the success of a single fundraising event or annual program event. The organization must understand the impact a cancellation of the event would have.

3.

Confirm your budget's relationship to your mission and long range/strategic goals. One of the very first tasks in the example budget process provided in the Tools & Tips section of this web site is "Review mission and strategic plan" with the note "Ensure that all strategic initiatives with budget impact are included in budget process." An organization's budget can and should demonstrate its commitment to its mission through numbers. Confirming the budget's relationship to mission requires answering questions such as:

Does the expense budget reflect the mission priorities of the organization by the way resources are allocated? Are we being pulled off course by going after grants just because they are available, even if they don't support identified mission priorities? If we are implementing programs that are not high mission priorities, are they at least contributing substantially to financially support the organization? As an exercise, plot your organization's programs on a Product Portfolio Map (example below). As long as there is some mission relevance, so called cash cows can support heart & soul programs, but for any that fall in the "problem" area, examine whether that program should be continued.

4. Don't forget infrastructure. Folks who work for small and midsize nonprofit organizations generally are very hard workers, intensely devoted to mission accomplishment, often working longer hours at lower pay than their for-profit counterparts. They deserve good tools and will perform even more efficiently and effectively with ongoing professional development opportunities and skills training. (Budget to send them to that Excel class!) Include information technology upgrades and maintenance, evaluation, and staff development costs in the budget. High quality programs can best sustain and grow with a welltrained and well-equipped staff, both program and administrative, to support them. Budgeting to provide good pay and benefits for staffers is also a way to keep those well-trained folks with you. 5. Budget for capital in addition to operations. An organizational budget should take into account the organization's annual operating income and expenses, as well as ensuring resources for long-lived and/or nonoperating needs - this is the capital budget. An organizational capital budget might cover several years and it should include target amounts and fundraising strategies to achieve strategic and financial sustainability goals. These could include:

creating or increasing an operating reserve deficit reduction furniture, equipment, or software purchases leasehold improvements a building & equipment maintenance and replacement fund a fund to support new program initiatives, experimental pilot programs, etc. a human resource capacity building fund

An organizational capital budget is different from a capital campaign budget, which is usually for bricks-and-mortar or other finite project(s), although they could be related. For more about budgeting for capital, see Budgeting for Capital. 6. Provide narrative notes to explain budget assumptions to the board. Board and finance committee members will appreciate explanations to help them understand the underlying thinking behind the numbers in the budget.

It goes without saying* that it is best to use a spreadsheet program to build budgets, but if notes are too many or too wordy to fit conveniently into spreadsheet cells, the notes could be written in a word processing document. Whether or not narrative notes are in a separate document, be sure to add letter or number keys to associate each note to the related spreadsheet line. *I'll say it anyway: it is best to use the right tool for the right job and let the software work for you. Please, never use word documents for budgeting - it's just plain dangerous - the spreadsheet will do a more efficient and accurate job of adding those numbers up and will automatically revise the totals when changes are made.

7. Pay attention to presentation. Your budget could be brilliant, well-researched, and well-documented, but if it is unreadable, your work will be undermined. Budgets that are easy to read and understand are well-formatted. Characteristics of good formatting:

columns and rows are well-labeled using font size, boldface, and underlines to create emphasis and for clarity, colors used for shading are chosen with black/white printing in mind, as not everyone will have a color printer (lighter color shading under dark fonts or lighter font colors for darker shading - dark fonts over intense colors are sometimes not readable when printed on non-color printers), column headers and row labels are carried to any second pages, enough detail is included, but not too much, narrative notes are given when appropriate and are keyed to the data they refer to, print parameters are double-checked before sending out electronic copies to avoid paper waste, footers include the file name and the work sheet name to assist with locating electronic version locations, consistent file naming protocols are followed to assist with version control (ORG FY10 Budget 2009-09-21 (Sept 21), then save new version as ORG FY10 Budget 2009-10-05 (Oct 5), and so on to have the latest version stack last in the Budget folder).

Having an inclusive and thorough budget process, a conservative approach, documented policies, efficient budget tools, and well-formatted budget presentation that tells your mission story "by the numbers" positions your organization to have the best results.

Budgeting for Capital

An organization's financial plans should include budgets for operations and for capital. Together these comprise what I refer to as an Organizational Budget. The annual operating budget was discussed in previous sections of this web site. In this section we will discuss the terms and concepts involved in creating the capital budget. While an organization's operating budget reflects its planned financial activities for a year, showing how much revenue it expects from which sources and how much it will spend on operations, a capital budget, or capitalization plan, relates more to an organization's financial position: its assets, liabilities, and net assets, setting forth goals and targets for these areas. Although the concept of capital structure, may seem odd for a small or midsize nonprofit organization to consider, the truth is that all organizations have a capital structure, whether they are conscious of it or not. Good financial management requires an organization to understand its capital structure and to be conscious and deliberate about setting and reaching its long term financial goals. These goals as identified in a capital budget might include asset purchases (such as equipment, facility acquisition, or leasehold improvements), asset investments (such as production costs of a product the organization will sell), financial stability targets (such as building an operating reserve or eliminating a deficit), or strategic targets (such as building a fund to support program or management initiatives per its strategic plan). Capital budgets often require a funding plan separate from and in addition to the operating budget. This funding plan can include a capital campaign as well as other funding strategies.

Setting Capital Structure Targets Building and maintaining an Operating Reserve is a top priority.
Operating reserves are essentially the accumulation of unrestricted surpluses that are liquid (as opposed to invested in fixed assets) and thus available for use at the discretion of an organization's board. The presence of an operating reserve increases an organization's ability to take mission-related risks and to absorb or respond to temporary changes in its environment or circumstances, for example, significant unbudgeted increases in operating expenses or losses in operating revenues.

Numerous small and midsize nonprofits are founded by entrepreneurial visionaries who are in many ways comparable to their counterpart for-profit business owners. Nonprofits are in fact businesses whose profits (surpluses) remain with the (nonprofit) corporation rather than going to individuals or shareholders as in the for-profit business model. Note: "not-for-profit" does not mean "no surplus allowed". Just as for-profit businesses need working capital to function at peak capacity, so do nonprofits need the equivalent in operating reserves. Operating reserves or working capital funds create liquidity and financial flexibility for the organization. Organizations with a strong working capital position can focus beyond day-to-day cash flow needs and more effectively plan for the long-term health of the organization. Without an operating reserve, an organization can be thrown into cash flow stress and become distracted from good long-term decision-making or forced to make expensive shortterm crisis-based decisions, or worse; it may not have the resources to continue delivery of its programs. Organizations with limited or negative working capital by necessity focus on the short term and are less likely to engage in responsible long-term planning. You can see why building operating reserves is a top priority. In its December 2008 whitepaper "Maintaining Nonprofit Operating Reserves, An Organizational Imperative for Nonprofit Financial Stability" the Nonprofit Operating Reserves Initiative (NORI) Workgroup recommends that most small and midsized nonprofits should maintain a minimum liquid operating reserve representing 25% of its annual operating expenses. Your organization's capital budget should include figuring out how much your organization needs for its reserve (target amount), how many years it will take to reach the target amount, and what funding strategies will be employed for building the reserve. The NORI Workgroup has created a toolkit to assist organizations in creating a reserve policy to build an operating reserve. Endowment funds are permanently restricted and the principal cannot be used for operating, cash flow, or other purposes. For small and midsized organizations, building a board designated operating reserve in addition to other reserves listed below should be undertaken well before considering establishment of endowment. See FASB 116 for more about endowments.

Deficit Reduction is a top priority.

An organization with an accumulated deficit, where a year or more of operating shortfalls have built up to where unrestricted net assets are negative, will find it difficult or impossible to build an operating reserve before reducing or eliminating the deficit. In such a case, deficit reduction needs to be top priority. The organization should set a deficit reduction

schedule and funding strategies in its budget. Repeated operating deficits may be the result of poor budgeting and may indicate that the budget vetting process should be more vigorous.

Good Debt, Bad Debt

It is an admirable goal for small and midsized nonprofits to be completely free of debt, but this is not always possible or in some cases advisable. Good cash flow management may, on occasion, require an organization to access a cash flow loan or a line of credit. You should pay attention to the balance between your organization's liabilities and net assets, striving to keep net assets positive, and using debt only when it makes good management sense. "Bad" debt, such as being very far behind on vendor payments or maxed-out on cash flow loans, is not fiscally healthy and should be targeted as a part of deficit reduction. When utilizing planned borrowing, be sure to factor related interest expense into your expense budget. Payments to reduce the liability principal are not true expenses, but income to provide the cash required to pay down the liability should be included as an item in the budgeting process as part of the full organizational budget.

Furniture, Equipment, and Technology

For an organization not in financial crisis, investing in equipment and software upgrades or replacements is one of the next priority items to consider for a capital budget. Don't forget ample filing cabinets and decent chairs! Keeping staff well-equipped can make them more efficient and happier, leading to staff retention and loyalty while improving program outcomes. It's win-win. Some foundation and corporate funders and government agencies explicitly support fixed asset acquisition and technology improvements in addition to project and operating funding. Visit the Foundation Center or TechSoup websites to research funding sources for equipment and technology.

Facilities Part 1 - Maintenance, Repair, & Replacement

Whether your organization owns or rents its space, you may find it necessary to make improvements to the property (leasehold improvements, if renting). For example you may be responsible for maintenance and repair as the owner, or as part of the conditions of the lease. Anticipating what repairs or improvements may be necessary, researching and estimating the related costs, determining the target amount needed and the approximate timing of the expenditures are all part of the capital budgeting process, along with developing funding strategies. These funding strategies could include assignment of funded non-cash depreciation or dedication of certain revenue streams. In addition, your organization may want to create, budget for, and maintain an emergency fund, for unanticipated repairs.

Facilities Part 2 - Building Acquisition and Construction Projects

A classic capital campaign supporting a bricks-and-mortar building project is a familiar scenario. But this is a huge commitment for a small or midsize organization and should be undertaken only after a great deal of preparation, including an organizational selfexamination to ensure that the staff and board infrastructure can sustain the additional work load and fundraising effort, and a thorough feasibility study to ensure that the community can, and is willing to, support the endeavor. In addition, a multi-year business plan reflecting the financial impact of operating in the new building will need to be developed. Many organizations find themselves operating in the red for the first one to three years after implementing a facility project, and may also find themselves in debt for construction costs that were in excess of capital campaign income, rendering the organization financially fragile just when it needs to be strongest. Years of very careful planning, research on financing options, and a great deal of caution are advised. The Nonprofit Finance Fund offers a Facility Project Planning Guide that describes what a facility project is, and what factors to consider in deciding to embark on one, as well as outlining the dangers and pitfalls of doing so. The

impact of a facility project on small and midsize organizations cannot be underestimated.

Special funds
Once adequate operating reserves are in place, your organization may want to consider establishing funds to support special program activities and strategic initiatives.

Emergency Program Services - For organizations that serve clients affected by natural disasters or other calamities such as fires or air crashes, special emergency reserves may be appropriate. United Way Worldwide, admittedly a very large organization, has published guidelines for its member organizations to follow when setting targets for building such reserves to enable them to serve their clients. Strategic Initiatives - Many well written strategic plans sit on the shelf for lack of resources to implement identified initiatives. Don't let this happen to you. Research the probable financial impact of strategic initiatives, including the need for additional human resources. Determine the timing, and availability of funding, for initiatives and a design a fundraising strategy to complement the existing fundraising plan for operations. Perhaps the plan calls for adding a fundraising staff person, the results of whose efforts will likely not be seen for 12-18 months; with a human resource reserve in place, the payroll costs could be covered without putting the organization in debt. Opportunity Funds - With or without a strategic plan in place, sometimes new program opportunities present themselves unexpectedly and may require start-up funding. Having a special reserve for an artistic director or program manager to access under such circumstances can allow for program growth and quality enhancements that would cost far more if delayed or could allow an entrepreneurial founder to seize opportunities or act on ideas without putting the organization in financial jeopardy.

Naturally, building the funds to create the reserves takes careful budgeting and disciplined financial management, and policies must be followed in deciding whether and how to access these funds and replenish them as appropriate. The Tool Kit [Link: TBA ] developed by the Nonprofit Operating Reserves Initiative Workgroup provides prototype policies and contains a section by Richard Larkin setting forth factors that should be taken into account when determining the right level of reserves for your organization.