Financial Health
Benchmarks: Ratios

by Kate Scorza Ingram

To effectively assess and communicate your organization's financial condition, it is important to apply the right tools and benchmarks - to look at a standard set of gauges on your organization's dashboard, understand what they are telling you and communicate the results to your leadership, donors, and staff.

In the last few years, AMS has been working with retired KPMG partner and former Yale University professor Herb Folpe to apply and tailor the KPMG Ratio Analysis for arts and culture organizations. The KPMG Ratio Analysis was originally developed to help institutions of higher education more easily understand financial statements, which, under the fund accounting basis required by Generally Accepted Accounting Principles (GAAP), had become so complex and obtuse that few outside of an institution's accounting department could comprehend the reports. The need to develop a simple yet powerful method for quickly and easily ascertaining the financial health of an organization was clear. Over the years the tool was modified, refined, and expanded to include new measures. Today, institutions use the ratios to monitor their financial health and compare themselves with peer organizations.

AMS has adapted five ratios that we find to be among the most effective yardsticks of financial health for arts and culture organizations. Each of these ratios utilizes standard values that are found in an organization's financial statements to make the necessary calculation. Three of these ratios are related to operations, and two are related to capital replacement.

Operational Ratios
1. Primary Reserve Ratio
2. Viability Ratio
3. Return on Net Assets Ratio

Capital Replacement Ratios
4. Physical Asset Reinvestment Ratio
5. Age of Facility Ratio

Forgive the jargon, but here's our best explanation:

Primary Reserve Ratio =
Expendable Net Assets ÷ Total Expenses
This ratio looks at the number of years an organization could stay in business if it brought in no additional revenues but maintained its expenses; by using its expendable net assets (available cash, unrestricted reserves, current accounts receivable, etc.) to pay its bills. KPMG believes that a primary reserve ratio of 0.4 is advisable as a minimum (meaning that an organization is viable for at least 5 months). This is one of the most frequently used and readily recognized ratios. The primary reserve ratio is currently used by rating organizations, such as Charity Navigator, to measure organizational viability and is a particularly useful snapshot of an organization's health when monitored over time. But, more than one variable is necessary to understand organizational health and we feel that the Primary Reserve Ratio is most relevant to our clients when combined with the following four ratios.

Viability Ratio =
Expendable Net Assets ÷ Long Term Debt
The viability ratio measures a nonprofit's ability to pay off any long-term debt should it need to settle its obligations to lenders as of the balance sheet date. A ratio of 1:1 or greater indicates that, as of the balance sheet date, an institution has sufficient expendable net assets to satisfy debt obligations. There is no standard value, as the ratio is, for the most part, institution-specific. This fact makes monitoring change over time another important measure to watch. This ratio has become increasingly useful for organizations that have found their debt to be suddenly "called in" as a result of the current economic situation.

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Return on Net Assets Ratio =
Change in Net Assets ÷ Net Assets
Similar to the return on equity ratio used in for-profits to measure profitability, this ratio determines whether the organization is financially in a better situation than in previous years by measuring total economic return. This ratio could show a positive financial status and at the same time the primary reserve and viability ratios could have negative changes. The result of this ratio needs to be evaluated with regard to the mission and/or strategy of an organization. One might expect this ratio to equal zero in a nonprofit organization. Whether this ratio is positive or negative should be as the result of a policy decision (i.e., to spend down net assets while investing in new programs or developing new facilities) as opposed to operating results (i.e., the result of an unplanned deficit).

Physical Asset Reinvestment Ratio =
Capital Expenditures ÷ Depreciation Expense
The physical asset reinvestment ratio calculates the extent to which capital renewal is taking place compared to the use of the physical asset, as measured by depreciation expense. Especially important to organizations that have significant capital facilities, a ratio above 1:1 indicates an increasing investment in physical assets while a lower ratio could indicate an under-investment in the maintenance of facilities and in future, unplanned expense. Planning for capital replacement is a particularly weak area for arts organizations with facilities. While this ratio has limited performance measurement value, as historical cost of depreciation may not be a valid measure of physical usage or needed future investment, our clients have found this to be a helpful ratio when their facilities are owned or maintained by their local governments. It has allowed them to demonstrate when additional funding is needed to maintain their facilities at the same standards as their colleagues or at the very least consistent with depreciation.

Age of Facility Ratio =
Accumulated Depreciation ÷ Depreciation Expense
This ratio provides a rough sense of the "aging" of capital facilities, and the potential need for future resources to be invested in the facilities. A low ratio is generally better because it indicates that an organization has made a recent investment (equivalent to "depreciation expense") in plant. A high ratio indicates that an organization has deferred reinvestment in plant and is likely to require significant expenditures in the near future. This has been useful for clients, as it demonstrates that a low primary reserve ratio due to the completion of a recent capital project is a positive result.

These ratios are an especially meaningful tool for non-profit managers to communicate with board members and donors who often come from the for-profit sector and are accustomed to using a few key measures to evaluate performance. The ratios are also a great way to initiate a conversation with peer organizations about performance standards and metrics. We have found that many arts and cultural organizations don't use the ratios to make day-to-day or long-term management decisions as much as they might. We strongly encourage this practice in the future.

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