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Why Do Balance Sheets Matter? Rodney Christopher

Why Do Balance Sheets Matter? Rodney Christopher

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12/20/2014

 
Why Do Balance Sheets Matter?
Rodney Christopher 
Reprinted from the Grantmakers in the Arts
Reader,
Vol. 22, No. 1 Spring 2011©2011 Grantmakers in the ArtsOther articles from past GIA
Readers
, proceedings from past GIA conferences,and additional publications of interest are available at www.giarts.org
4055 West 21st Ave., Seattle, WA 98199·1247206·624·2312 phone 206·624·5568 faxwww.giarts.org
 
Vol. 22 No. 1, Spring 2011
G
rantmaker
 
s in the Arts
Ideas and Information on Arts and Culture
 
GIAreader
 
Grantmakers in the Arts Reader 19
Why Do Balance Sheets Matter?
Rodney Christopher 
I I have learned anything in my thirteen-plus years o help-ing nonprot leaders interpret their nances, it is that thenumbers alone can never tell you the ull story. Wheneverpossible, I encourage you to have a conversation with anorganization’s leadership i you nd that their nancials arenot passing your litmus test. I also urge you to keep in mindthat the knowledgebase and comort levelwith talking about bal-ance sheets vary widelyacross the leadership ocultural organizations.The eld will benet tothe extent it is possibleor you to gently guidethe groups you support toward clarity, ownership, and dia-logue about capitalization. Finally, improving capitalizationrequires time, patience, and celebration o progress. It alsorequires unders to play a leadership role in using carrotsand sticks to encourage and ensure that progress occurs.I we agree that the capitalization o arts organizations isimportant, and that evidence o capitalization can be oundon the balance sheet, what should you, as grantmakers, belooking or?
One way to think o the balance sheet is that it can inormus about the kinds and degrees o fnancial risk an orga-nization aces as it delivers on its artistic mission. In thiscontext, risk — and its converse, opportunity — has threedistinct levels:
Liquidity:
Does an organization have adequate accessto cash to meet its operating needs?
Adaptability:
Does an organization have fexible undsthat can allow it to make adjustments as its circum-stances change?
Durability:
Does an organization have access to undssucient to address the range o needs that it may acein uture years?Addressing liquidity is necessary, although or many orga-nizations it can be quite dicult. Healthy liquidity requiresan accumulation o annual operating surpluses (occasionaldecits may be planned or unavoidable) and, where appro-priate, a line o credit.
Funding adaptability and durability are more complex,since surpluses, when they exist and can be set aside asreserves, are rarely sufcient to do the job. Periodic inu-sions o contributed capital and strategic use o long-termdebt are typical strategies to und long-term needs, whichcan range rom investments in technology to making majorrepairs on a building to pursuing new or improved wayso generating revenue.
I will provide a case to introduce how to use the balancesheets o your applicants and grantees to make an initialassessment o their liquidity, adaptability, and durabil-ity needs. I will ocus on making observations about thenumbers you see and employing two key ratios. To reinorceyour learning, I encourage you to use a balance sheet romone o your grantees as you read. I will assume that youunderstand terms such as assets, liabilities, and net assets(see the nal section,“Additional Resources,”or ways to obtain deni-tions o nancial terms); Iwill provide denitions orless-common terms.
So, Let’s GetPractical
Grab the balance sheet o one o your applicants/grantees.In general, it is best or you to review audited fnancialstatements. Their numbers have been independently as-sessed and the notes to the audit, which you should al-ways review, can provide helpul details you will not see onthe balance sheet itsel. When examining balance sheets, itis also important or you to have the statement o activities(income statement) nearby. Because the balance sheet is asnapshot in time, it is possible that the audit might presentan artifcially pessimistic (or optimistic) picture at the fscalyear end (FYE). Thus, it is useul to learn about the cyclicalnature o a grantee’s business; or example, do they getmost o their cash during a specifc three-month window?
The sample balance sheet on page 21 is based on that o anactual theater company — let’s call them the Cider Hill Play-ers (CHP). Below the balance sheet (a.k.a. the Statement oFinancial Position), you will also see the operating expensesor each o the two years (ound on the income statement);this will help with our calculations.What can you see with a quick glance o the CHP balancesheet? Here are some important details you can identiy:1. They do not own a building (Property and Equipment,net o accumulated depreciation is $6,298 at FYE ’09),and the bulk o their property is equipment, sets, andcostumes that have all but ully depreciated rom an ac-counting standpoint. It is likely that CHP can use someo their items or a ew more years; it is also likely thatsome replacements are in order.2. They have a board-designated reserve ($50,000 at FYE’08 and ’09 — an audit note might tell us whetherthere are any parameters or use o the reserve).3. They have a line o credit (we don’t know how muchis available — an audit note should tell us that; but we
One way to think o the balance sheet is that it can inorm us about the kinds and degrees o fnancial risk an organizationaces as it delivers on its artistic mission.
 
20 Grantmakers in the Arts Reader
do know the line is at least $25,000 as that was theamount outstanding at FYE ’09).Together, these items give us a good entry point. The rstinvolves durability, the second adaptability, while the thirdis linked to liquidity. It is possible to draw some conclusionsabout CHP rom these three data points, but I generallypreer to look deeper. Now take a look at your grantee’s bal-ance sheet. Jot down some initial observations or questions.Then put them aside. Ater you’ve worked through thebalance sheet with this article, go back and see i you havegreater insight into what you noted.Analysis o balance sheets can be aided by the use o someratios. There are limits to the useulness o ratios whenapplying sectorwide standards, which I mention at the endo this article. However, within an organization and lookingyear over year, ratios are meaningul. To gain perspective onthe signicance o the dollar amounts o the items on thebalance sheet, it is important to relate them to the state-ment o activities. At Nonprot Finance Fund (NFF), wedo so by creating ratios based on operating expenses.
Liquidity Measures
Two such ratios that assess liquidity and, to an extent,adaptability are Months o Cash and Months o Liquid NetAssets. Each gives you a distinct window. In both cases, wewant to know how long an organization can operate withthe unds it has in hand. Let’s look at Months o Cash rst.
Months of Cash
= the number o months o ex-penses that can be covered with available cash.The ormula is airly straightorward: determinethe amount o one month’s expenses by dividingtotal expenses by 12; then, divide total cash byone month’s expenses.
CashAnnual Expenses / 12
On the sample balance sheet on page 21 we seethat at FYE ’08, CHP had nearly seven months ocash, while at FYE ’09, the amount dipped to aboutfve months. In general, NFF encourages organiza-tions to aim or a minimum o three months o cashat all times (note that this is a guideline rather thana frm standard). For those producing and present-ing riskier/less commercial are, we suggest aimingor at least six months. Ideally, or all organizationsat least three months would be set aside explicitlyin a risk reserve, to be replenished as soon ateruse as possible.As a nonproft’s cash can oten be restricted, wealso want to measure liquidity against that portiono the organization’s net asset base that should betruly available to cover operations. Such net assetsdo not include property and equipment (which can-not easily be converted into cash or operations).We call this portion o unrestricted net assets “Liq-uid Net Assets.”
Months of Liquid Net Assets
(LNA) = the numbero months o expenses that can be covered with theliquid portion o unrestricted net assets.The ormula is more complex: take the total amounto unrestricted net assets and subtract rom it prop-erty and equipment (PE, net o depreciation) minusacility-related debt. Divide the result by one month’sexpenses. (Note: generally, board-designated undswould be subtracted rom unrestricted net assets,too. CHP’s balance sheet ormat takes care o thator us.)
Unrestricted Net Assets - (PE Net - PE Debt)Annual Expenses / 12
Cider Hill Players has little property and equipmentand no acility-related debt, so the calculation isairly basic. In the callout box, we see that at FYE’08, CHP had nearly seven months o LNA, while atFYE ’09, the amount dipped to about six months.It is sae to say, then, that CHP has strong liquid-ity. When we add their $50,000 board-designatedreserve, we could make a case that they have areasonable amount o adaptability as well. Howdoes your grantee’s balance sheet are on the liquid-ity measures?
Adaptability and Durability
Beyond liquidity are longer-term risks that cultural organiza-tions are challenged to address. Examples include:
• buffering against unexpected challenges (e.g.,
recessions)
• seeding support for pursuing new artistic opportunities• investing in organizational change that can lead to
improved net revenue
• funding new purchases, upgrades and replacements to
property and equipment
• providing long-term stability
As stated previously, organizations address these capitaliza-tion needs with inusions o capital rom strategic debt aswell as grants and contributions. An additional approachthat NFF urges organizations to take is establishing andbuilding reserves. Reserves help lower the risk o whetherunds will be available when they are needed. It is a veryrare organization that has sucient amounts set aside inreserves to meet all its uture needs. And we would notencourage organizations to move in that relatively impracti-cal direction. But, we have seen and do see the wisdom inputting a reasonable sum o unds into reserves that can bedrawn down and replenished as possible.
There is a range o reserves that can provide arts groupswith a frst line o deense or source o opportunity; a

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