When it comes to finances, one of the best tools to measure the accomplishment of your values and purpose is a budget. In simple terms, it is an exercise of forecasting money coming in and money going out. The problem is, most organizations either don’t take the time to prepare one or fail to use it as a guide for making financial decisions.
Why is that? Well, it takes time and effort to tie together your mission and vision with the resources used to fulfill it. It is often a painful revelation to see what you spend money on and discover how little of it goes to actually fuel the vision you have set out to accomplish. Too many people do not take their budget (or lack thereof) seriously, so they forge ahead with no road map to guide them.
It does not have to be that way. You can take steps now to produce a responsible and meaningful budget you can use to help meet the goals of your vision. We want to help you move in this direction.
In this article, we will:
- Explain the difference between a budget and a cash flow projection
- Show you how to prepare a “mission-based” budget
- Explore three different approaches to a budget
- Look at some metrics that measure the financial health of an organization
Budget vs. Cash Flow Projection – What’s the Difference?
Over time, budgets have taken on the meaning of a static and unhelpful document that is either avoided or just thrown together out of necessity. Some organizations look at budgets as a formal process because their bylaws require one. Some prepare one but not as a dynamic tool to be used in the day-to-day operations. Since they don’t use it, many will prepare:
- A “SALY” budget (“same as last year”) – This type of budget does not pay attention to actual expenses of the prior year, but uses the same budget from last year. In effect, they use last year’s estimate and avoid referring to what was actually spent (which is more accurate).
- An “expense control mechanism” – Only spending what the budget allows for, not accounting for unknowns or emergencies.
- A “good idea” budget – This version adds costs to your budget from ideas people have given without weighing in on the purpose of those expenses or determining what expenses should be reduced to make room for the new ideas.
- A “divide it by 12” budget – This takes an annual amount and divides it by 12 months but doesn’t factor in seasonal fluctuations for both revenue and expenses.
In contrast, cash flow projections break out of that stigma by closely examining cash coming in and cash going out. It’s dynamic. It looks at the cash balance through the year and how it fluctuates up and down. This influences not only how much to spend but when to spend it.
Budgets tend to just track revenue and expenses from the operations of the organization. Cash flow projections take a closer look at the sources and spending of cash. Here’s what it looks like for a nonprofit organization:
Where money comes from (sources):
- Regular donations
- Major gifts – one-time, unknown gifts
- Asset sales
- New debt
Where money goes out (spending):
- Operating expenses
- Major projects
- Purchase of assets
- Payment of debt
The cash flow projection considers both the activities from the profit and loss statement and the balance sheet. It accounts for all money coming in and out – not only from operations but also capital expenditures (i.e. buying an asset or paying off debt). It tells you what your cash balance should be at the end of each month if income and expenses are in line with your plan.
Since the cash flow projection is broader in scope compared to a standard budget, and therefore more useful, we recommend creating a cash flow projection for your organization.
While tracking all money coming in and out is critical, a more important function of the cash flow projection is measuring the effectiveness of spending resources on the right things. This requires a “mission-based” cash flow projection or budget, which we will talk about next.
What Is A “Mission-Based” Budget?
Most organizations have a mission statement to help them focus on what and why they exist. Distractions are inevitable, so keeping the main thing the main thing is critical to help prevent mission “drift” in people and organizations alike.
Too often, however, the mission of the organization is not evident in their budget. As we discussed earlier, budgets that are not well thought out tend to be static and not helpful to measure progress towards the goals put in place to fulfill their mission. This not only wastes resources but also undermines the organizational culture. The budget needs to be a tool to keep people on mission, not just a cost control mechanism.
We recommend a “mission-based budget”, which starts with the organization’s mission and vision. In simple terms:
- Mission answers the question “Why do we exist?”
- Vision answers the question “What are we to do about this?”
For your organization, ask yourself “what does success look like when we accomplish our vision?” This will help determine where and how much you should be spending.
Just as important, it should also help you decide where not to spend your resources. If you are like most organizations, you have limited resources – you will need to prioritize costs that best meet your vision.
For example, a nonprofit organization may decide that they want to increase their focus on improving the lives of teenagers in their geographical area.
- This requires more resources.
- So, they make the decision to increase funds for their youth programs.
- They do this by reducing funds in other programs that are not focused on youth.
- And they also hold a fundraiser specific to the youth program.
These are often difficult decisions, which is why the organization must be clear and supportive of the mission and vision.
Another dimension of mission-based budgets that is different from standard budgeting are the metrics used for determining success. A standard budget tends to interpret over-budget costs as irresponsibility because it is used as a cost control mechanism. However, over spending in a mission-based budget will prompt different inquiries. To use our earlier example, let’s say the youth budget was over budget by five hundred dollars for a high school event. Upon examining the cause, it was discovered that there were double the number of students that came than what was planned. This over budget item should be interpreted as a success rather than irresponsibility.
To clarify, costs should always be examined in light of the organization’s mission, regardless of whether actual costs are over- or under-budget. It’s possible, for example, that too much is spent in light of the outcome. Back to our earlier example, if the youth budget doubled compared to the prior year yet the outcome was that no more youth were reached, then the program and related costs need to be examined for its effectiveness. This should have a direct effect on the budget for the following year.
In summary, a mission-based budget is an active, living document that guides an organization’s financial decision to accomplish their vision throughout the year. To tie the mission of the organization to the budget requires time, but it is time well spent.
When you base your budget on your mission, it empowers you to know that you are investing in your vision, rather than just a means of controlling costs. The extra time you spend up front will always pay more dividends than it costs you.
Three Approaches to a Budget or Cash Flow Projection
Here are three dynamic approaches for your organization to consider when preparing your budget.
- Annual budget – This is prepared once before the start of the year and is not adjusted during the year. Make sure to look at actuals from the previous year, not last year’s budget. This is the most common approach since it’s the easiest of the three to do. However, it may not be the best approach, especially if there is a lot of uncertainty about the future or the current year is significantly different than the prior year.
- Semi-annual or quarterly budget –This is a good option when the future is uncertain enough that it becomes wise not to project out more than 3 to 6 months. It takes more work compared to the annual budget, but may be more realistic because it is based on the most recent quarter or half year instead of the prior year.
- Rolling budget – This is an annual budget, but it is evaluated and changed at interim times (quarterly or semi-annually) to reflect recent actual activity and new information not known when the annual budget was prepared. It does not require a complete rebuild, but changes only what is necessary. The COVID pandemic caused many organizations to adopt this approach.
No matter which approach you choose, it needs to bring the budget or cash flow projection back to a realistic estimate of the coming months or year ahead. Generally speaking, the more different the current year is from the prior year, or the more uncertain the future is, the more often your budget or cash flow projection should be revised. Yes, it is extra work, but the cost of not having a plan or road map going into fast-changing times is far greater.
Benchmarks of a Financially Healthy Organization
A budget typically projects up to one year. However, even if you reach your annual budgeting goals, it doesn’t always mean your organization is financially healthy.
There are benchmarks that should be used to measure your financial health, and they are often used by third parties and banks. Some are from the profit and loss statement, and others are from the balance sheet.
Below is a list of common metrics used to measure the financial health of an organization:
Net Profit from Operations/Revenue in Excess of Expenses – A net profit generally increases operational cash, making the organization sustainable at least for the short-term. If an organization experiences a net loss from operations, losses are not sustainable in the long run because cash will continue to decrease.
Cash Reserves – We recommend cash reserves enough to pay 3 to 6 months of expenses. This is determined by taking cash on hand available for operations divided by the average daily expenses including debt payments based on the annual budget. Generally, the more debt one has, the higher the cash reserves should be.
Current Ratio – This measures the organization’s ability to pay short-term debt (due within 12 months). It is calculated by taking Current Assets (i.e. Cash, Inventory, Accounts Receivable) divided by Current Liabilities (Account Payable, Credit Card debt, debt owed within 12 months). The higher the ratio, the healthier your organization will be.
Debt Service Coverage Ratio – This measures the ability for an organization to pay their long-term debt for the next 12 months from net income generated by operations. This is an important metric to keep an eye on since the lender generally uses it to measure the organization’s ability to pay their debt. It is calculated by taking adjusted net operating profit (adding back interest and depreciation expenses) and dividing it by the total debt service annually (principle and interest payments). A minimum target is 1.1x to 1.25x. However, banks may require a higher ratio.
Accounts Payable Aging Analysis– This helps answer the question “Are you current on your bills”? Companies often use an accounts payable aging schedule.
Accounts Receivable Aging Analysis – This helps answer the question “Are you collecting on what clients owe you?” Companies often use an accounts receivable aging schedule. Generally speaking, the older the receivable is, the less likely it will be collected.
Debt to Equity Ratio – This tells you how much of your assets you owe versus what you own. It is calculated by Total Liabilities divided by Total Net Assets (Equity). The lower the ratio, the better.
Program Expense Ratio – This reflects how much is spent on the purpose of the organization. Every organization has overhead, but a healthy company tends to have a large percentage of the sources spent on the programs that drives their mission. It is calculated as follows: Program Expenses divided by Total Expenses. The higher the ratio, the better. A good range is 50-80%, depending on the volunteer base used in a nonprofit organization.
Achieving benchmark targets may take longer than one year to reach. The net revenue in excess of expenses/profit from the organization should be used to build your organization to a financially healthy place as measured by these metrics. Using budgets and cash flow projections help you see that you are heading in the right direction even if you do not reach the target in any given year.
Taking Your First Steps
We know preparing a budget takes time and energy, and we hope that this article helped you see the value and importance of creating one that can be a tool and guide for your financial planning. We believe it’s worth the effort.
- Taking the first step is usually the hardest one. We suggest you start with reading your mission and vision. Discuss it among your leaders to create awareness and purpose as to why the organization exists. This will help you determine where to concentrate your resources. Then ask yourself “what does success look like if we meet our vision goals?” From there, start designing your budget around those vision goals. This is the path to a “mission-based” budget that insures you are keeping the “main thing the main thing”.
- As a second step, we recommend preparing a cash flow projection that looks deeper at all sources of money coming in and going out. This will help you to reach for financial goals beyond a year like a targeted cash reserve, paying off debt, or purchasing large assets.
- Finally, use the benchmarks we shared above as a target for financial health. These will help give you parameters on what and how much to spend in your annual budget.
If you would like help in getting started or have specific questions about anything we shared here, please contact our office at 253-839-1620. We would enjoy the opportunity to serve you.
1. Website – Cash Flow Management by Propel Nonprofits. Click here.
2. Website – 15 practical budgeting tips by Dave Ramsey. Click here.
3. Book – Church Finance by Michael Batts, CPA. Click here.
4. Book – Budgeting for Ministries by ECFA. Click here.
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The author is not engaged by this text in the rendering of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the opinions based thereon cannot be guaranteed. Before taking any action, all references and citations should be checked and updated accordingly.