Top 5 Nonprofit Financial Red Flags According to a CPA
As a CPA working exclusively with nonprofits and a former nonprofit auditor, I’ve looked at thousands of nonprofit financial statements over the past 10 years.
Looking at that many balance sheets, you start to identify trends. And while some issues are evident to anyone, others only stand out once you know what to look for. Over the years, I’ve identified a set of 5 nonprofit financial red flags that are fairly common and almost always lead to trouble sooner or later.
Want to know if your nonprofit is headed for trouble? Or want to check out a nonprofit before you make a significant financial gift?
Keep reading to discover the 5 things to look out for!
Red Flag #1 – Insufficient Operating Reserves
Every nonprofit organization has swings in cash balances throughout the year. Sometimes they follow seasonal trends. Other times they may be a result of unexpected events or poor planning.
But maintaining an operating reserve of at least 25% of your annual expenses plays a major role in determining whether or not a cash flow problem turns into an existential crisis.
And it’s not just me– almost all large donors and grant makers will want to see 25% of expenses as a minimum operating reserve. And charity watchdogs like the Better Business Bureau and Charity Navigator use operating reserves as part of their calculations for what they consider a “Quality Nonprofit.”
So if you’re looking to build trust with government grant makers, foundations, or the general public, you’d better have some cash set aside for a rainy day.
What does a low operating reserve tell us?
In our experience, nonprofits with little in reserve and/or low cash balances tend to have financial management challenges, often including:
- Poor collection of accounts or pledges receivable
- Challenging vendor relationships (due to late payments)
- Risk of defaulting on loans
- Carrying high credit card balances
- Over-reliance on high-interest short–term financing
Just because an organization’s reserves have dipped below 25%, it doesn’t mean it’s destined for failure. It may be a temporary blip. But if you want to keep the trust level high, shoot for that minimum level at all times.
Red Flag #2: Hidden Compliance Issues
When most nonprofits think about ‘accounting issues,’ they’re concerned about poorly prepared financial reports, bookkeeping errors, gaps in communication with funders, bad audits and a million more things in this vein.
And those are all valid concerns. But they often overlook compliance or regulatory issues that could be much bigger problems.
For instance, you’d be amazed how many times I’ve gotten deep into an organization’s books yet they’ve failed to mention that they haven’t filed an IRS 990 for 2+ years! If you don’t file your 990 for 3 consecutive years, you’ll lose your tax-exempt status. And it doesn’t matter how pretty your Balance Sheet is or how accurately you’ve tracked donor-restricted funds.
After learning the hard way, here are a few compliance questions I always ask:
- Have you filed an accurate IRS 990 every year? If not, when was the last time you filed?
- Have you failed to withhold the proper state and federal payroll taxes required for your employees? And have you been notified of any issues with your payroll tax filings or associated penalties?
- Has the Department of Labor audited your organization for misclassifying contractors as employees?
If you answered “yes” to any of the questions above, you need to seek professional help immediately to help get them resolved.
DO NOT let compliance issues linger.
Tax penalties or compliance fines will not just go away. And the IRS will absolutely revoke your tax-exempt status (with no remorse). So don’t let fear or shame keep you from tackling these critical issues, or they could put your entire mission at risk.
Red Flag #3: Too Little (Unrestricted) Cash on Hand
Cash balances are not the same thing as your operating reserve. Your operating reserve includes other unrestricted assets you wouldn’t generally use to pay your bills.
For this reason, your “Days in Cash” metric is more helpful for managing the day-to-day business of a nonprofit. It will tell you how many days you would be able to operate with the cash you have in the bank today, assuming each day is an average day for your organization.
As a nonprofit, you need to concern yourself specifically with unrestricted cash and cash equivalents. One of the main differences between for-profit and nonprofit accounting is that much of your cash may have restrictions placed on it by your donors. This cash can’t be spent however you want, so it doesn’t come into play when calculating your Days in Cash metric.
At their lowest balance, all nonprofits should have no less than 30 days’ worth of cash on hand.
If a nonprofit falls below 30 days’ worth of cash on hand–even if they just ran payroll AND paid the rent yesterday–that’s a big red flag for me. Because learning to manage cash flows is the most important financial skill that a nonprofit leader must master to avoid an existential crisis for the organization.
Red Flag #4: Short Term Loans to Cover Operating Expenses
It’s an excellent idea for nonprofits to have access to a “Plan B” when liquidity problems pop up.
In fact, we recommend that our clients open a line of credit to fill the gaps, like when a funder is slow to pay, and you need some cash to keep things running. After all, it’s not like you can magically find a new donor to bridge that gap for you.
So the issue isn’t having a line of credit.
The issue arises when you constantly need to dip into your short-term funding, and you have no immediate ability or plan to pay it back.
In that case, these things tend to snowball. We’ve seen organizations max out their line of credit, take personal loans from founders or board members, hit up predatory payday loan services, and more.
But this road leads to trouble. And quickly.
When you’re running an organization on borrowed money, eventually you’ll have to pay it back. And if you’re waiting for a “big” donor to suddenly appear and bail you out, that’s a losing strategy. Instead, you need an actionable and disciplined plan to stop the bleeding and start digging your way toward financial freedom.
Strive to manage your nonprofit like you want to manage your personal finances–bring in more than you spend, pay off debt and build an emergency fund.
If you’re stuck in a starvation cycle, there is still hope. Check out this conversation about how to pull yourself out of the cash flow trap:
Red Flag #5: No Accountant or Bookkeeper
Yes, it may seem obvious, but you should have a dedicated financial professional to manage your books. Preferably someone with some accounting experience.
It’s a BIG red flag when a nonprofit tells us that they have a volunteer, a friend of a friend, or a board member managing their books. Or when a well-meaning but under-trained founder is doing the books themselves (along with half-a-dozen other roles).
It’s equally frightening when an organization doesn’t have accounting software, like QuickBooks, and runs its operation off of a bank statement.
Yet I bring these things up because they do happen. So if you feel “seen” right now, just know that you’re not alone. But you WILL need to make some changes.
Having a permanent and dedicated individual with accounting experience overseeing your books gives peace of mind to any banker, funder, or CPA looking at those books. But it’s not just the education and experience…
A consistent methodology for how specific types of transactions are recorded and reconciled brings stability to your finances. So having one person, doing it the same way every time adds tremendous value.
On the other hand, staff turnover leads to inconsistencies, mistakes, and a lot of wasted time. So, if you’ve had trouble maintaining consistency in your staff and procedures, you may want to consider an outsourced accounting firm. They can help your team build repeatable processes (and they won’t leave you stranded when a better job offer arrives).
If you have a reliable team member but they need to strengthen their bookkeeping and accounting skills, check out our free online nonprofit accounting course.
Have Nonprofit Financial Red Flags? Maybe We Can Help.
The Charity CFO helps 150+ nonprofits simplify their accounting, create timely and accurate reports, and keep their books squeaky-clean so that any auditor, CPA, or grant writer sees exactly what they want to see.
Beyond the day-to-day accounting, we’re an expert financial partner too. So we’ll tell you when we see red flags waving in your books, and help you create a plan to get things back on track. We can help you with creating annual budgets, preparing for an audit, and much more.
If you need a nonprofit accounting expert to help get your financial house in order, reach out to us for a free consultation today.
