The term working capital has been used in the for-profit industry for a long time. It is usually defined as the difference between a company’s current assets and its current liabilities. It is traditionally used as a liquidity metric in the form of a dollar amount. In addition, many individual financial plans include having a savings account, often referred to as “rainy day funds”, to be used when the “storm” comes. Many have also likely heard the old adage of putting aside funds to cover at least 3-6 months of living expenses for emergencies (loss of job, unexpected expenses, etc.).
How working capital applies to nonprofit organizations
When Charity Navigator began evaluating nonprofits, we wanted to include a metric that captured a similar aspect of a nonprofit but, of course one, that made sense for this sector. The idea was to evaluate the ability of a nonprofit to have funds on hand that would allow them to sufficiently operate during difficult financial times. Charity Navigator wanted to highlight that a nonprofit with insufficient funds may, in those difficult times, need to make tough choices which include eliminating program offerings or staff members.
We analyze a nonprofit’s working capital ratio by determining how long it could sustain its current operation without generating new revenue. In economic downturns, nonprofits may face revenue declines due to donations lagging behind expectations. And thus this ratio would show donors how long (in months/years) the charity can operate if incoming revenue sources dried up.
Working capital and its impact on ratings
Over the years, Charity Navigator has received many questions and concerns regarding the metrics we use to evaluate a nonprofit’s financial health, especially this working capital metric. We have heard some share the idea that nonprofits do not need to keep funds on hand for the future as their goal is to spend all they can on their mission and ultimately put themselves out of business. But often, a short-term vision like this can do more harm than good.
As we currently find the world in a time of economic uncertainty due to a global pandemic, we are faced with the reality that nonprofits may realize lackluster results in their fundraising efforts. Many charities have had to cancel major fundraising events and activities. This means that, as the “storm” possibly worsens, they will need those “rainy day funds” to be able to continue to operate.
Nonprofits who ensured that they had a strong balance sheet and enough available funds to run their programs for close to a year or more without new revenue will be better served in these times. These organizations will most likely not have to cut programmatic offerings or staff, which is more important than ever in difficult times where the need for charitable services increases during these periods. It would be a shame if charities that provide such important services had to either close completely or cut their charitable programs if they were not prepared in advance. The nonprofits with strong working capital ratios are of course not guaranteed to remain afloat or not introduce program reductions, but they do start in a much better position than the ones who had little to no working capital.
Tips to build working capital
To nonprofit leaders reading this, if you’ve historically not seen a need for working capital and are now faced with financial strain, here are some ideas to consider once you have navigated these difficult times to help build working capital. First, you can slowly try to build a reserve by allocating small portions of future donations to this fund. Second, you can discuss with some of your larger donors this particular need and ask if they will support this fund directly. We know most donors want to fund current programmatic activities, but, having lived through something like this, you will be able to share firsthand experience and clearly articulate the importance of having working capital on hand for the future. Third, make the case for this need to the board of directors and designate all or some portion of board contributions directly to this fund. Finally, allocate any savings, even temporary ones like salary from short-term staff vacancies, to this fund.
Written by Matthew Viola, Vice President Program Analyst Operations at Charity Navigator.