Imagine this: Eyes race to the bottom of the page and a negative number between a pair of dreaded parenthesis stares back. Nonprofit staff and board members wonder what happened after they subtracted all expenses from total anticipated income. To many, this may be an immediate red flag. But how do we decide if this deficit is OK for our organization? The decision involves analyzing the balance sheet, assessing staff leaders’ and board’s appetite for a deficit, and forecasting more than one year into the future.
Can we absorb a deficit?
Deficits on our income statement erode our balance sheet’s net assets.
- Have we accumulated sufficient net assets over time to be able to absorb a deficit? If a deficit is planned, it’s important that decision-makers and budget-approvers recognize that the net assets from previous years’ surpluses will be drawn down. Looking further up the rows on our balance sheet, we must consider if our liquidity will allow us to absorb a deficit.
- Do we have sufficient cash and working capital? Or, do we have access to credit and a lender that is on-board with using the credit to fill this year’s deficit?
For more information on analyzing your balance sheet, see our Balance Sheet Cheat Sheet resource. If considering a deficit, pay special attention to Days Cash on Hand and the Working Capital Ratio.
Are we willing to incur a deficit?
Deficits are either strategic or accidental.
Strategic deficits are planned and intentional. Often times, organizations knowingly invest in programming or infrastructure for a future benefit, or perhaps intentionally spend down organizational reserves. In these situations, be careful to consider how a deficit might impact relationships with funders and lenders. Also, be mindful to protect the business model (see below).
Accidental deficits can result in disruptive cash flow crises, restructuring without strategy, or even program termination or dissolution. They are often caused by deferring difficult budget decisions or not having alternative budget scenarios prepared for quick implementation.
Are we protecting our business model?
Deficits are often structural, meaning there’s an inherent flaw to our business model that will repeat itself if left unaddressed. If approving a budget with a deficit, consider:
- Is there something unique that causes this deficit? Is it clear how the condition will change in future years?
- Are we able to achieve a recovery surplus? Net assets will only be replenished following a deficit if an organization is willing and able to incur a potentially significant surplus in a future year. Do your business model and dominant funding sources allow for a profit margin sufficient to recover from the deficit?
I like to think of budgets as “best-guess working drafts” for the future. They are our best guesses given all the information that we can gather and analyze, but they are still filled with risks and assumptions. Budgets are also working drafts, because they must be closely monitored and managed during a fiscal year to assure the desired financial outcome.
To learn more about activating your budget, be sure to attend the “Financial Drivers and Budget Benchmarks” session at the upcoming Nonprofit Finance and Sustainability Conference on April 19. And for further reading on this topic, check out “Nonprofit Budgets Have to Balance: False!” by our conference keynote speaker Jeanne Bell.
And if you find yourself sweaty-palmed and anxious staring at a budget deficit, drop us a line, and we can talk through it together.