Explore BrainMass

Limitations of Financial Ratio Analysis for Non-Profit Organizations

United Way of Metropolitan Chicago is a nonprofit, tax exempt corporation. Because it receives significant revenue in its annual campaign from large corporations, a recent reform of the board of directors resulted in a majority of directors from the Civic Committee of the Commercial Club that were corporate Presidents. The Civic Committee consists of representatives of large corporations in the area of manufacturing, banking, utilities and business.

The organization attempts to maximize its benefit to the community by minimizing its overhead expenses so that $1 raised in the general campaign results in close to $1 allocated for health and human services. When the board of directors saw that the 13.9% overhead rate for 2005 did not reflect staff costs in the Community Building Division where planning, assessment, monitoring, and evaluation activities are performed, some directors were concerned. They felt that, in the zeal to report a favorable number, the truth was not being told to the community.

Other directors argued that these staff efforts benefit the community in a similar way to the health and human services supported by United Way funding. It was determined that the latter argument was technically correct because of the accounting rules on program related services that apply to nonprofit corporations. The compromise was to report the 13.9% overhead rate with a footnote that 16% was the total overhead rate but that the accounting rules for nonprofits allow the exclusion of program related expenses.

Some of the board members from the nonprofit sector began to discuss other organizational matters that reflect a difference in business and management culture and philosophy. For example, the business sector members rely heavily on financial ratio analysis to understand United Way's financial position in relation to industry standards.

1. What are some of the limitations of financial ratio analysis as a tool for understanding operations that might validate the concern of these board members?
2. List and discuss two factors that limit an organization's ability to replace a depreciated capital asset even if the organization has set aside funds equal to the depreciation schedule for the asset in question.
3. Look at "The Cost of Chronic Disease" slides by Jack Zwanziger, PhD. As Director of the Illinois Department of Public Health, discuss management actions you would initiate to address the implications of this presentation.


Solution Preview

Financial Ratio Analysis for Not- For-Profit Organization

Financial ratio analysis helps an organization present a picture of operational efficiency in an effective manner. Although analysis of financial ratio is quite important to provide insight of company's operational performance, in case of non-profit organization, it has certain limitations. A non-profit organization must make decisions on the basis of its value for overall society where financial ratios consider cost only (Taylor & Pinczuk, 2006). This nonprofit organization will be unable to evaluate the businesses operational efficiency, as it concerns management, using financial ratios alone.

At the same time, non-profit organizations operate to fulfill different purposes. Due to this, their operations are quite different from each other. When making operational and financial decisions, non-profit organizations will compare their own ratios with similar organizations. However, with significant variation in operations between organizations, this may not provide an accurate base for decision making (Wrenn, 2004). Due to such differences, financial ratio analysis is not effective for not-for-profit organizations to address concerns of their board members.

Similarly, for a non-profit organization, it is essential to demonstrate a true picture about its liabilities and assets to both the community and donors. By identifying the assets and liabilities of a non-profit organization, it enables financial statement users to understand the organizations capacity for paying debt and delivering value to the society as whole. In this case, the analysis of financial ratio is not an effective reflection of the actual picture of the organizational operations as it ignores off-balance sheet items (Shim & Siegel, 2006). The exclusion of off-balance sheet items limits the effective use of financial ratios that might otherwise verify management concerns.

Non-profit organizations do not work to earn profit, rather, they operate to serve ...

Solution Summary

The limitations of financial ratio analysis for non-profit organizations are examined.