Measuring an organization’s ability to meet short-term obligations, the current ratio is calculated by dividing current assets by current liabilities.
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Since 1988, IFF has closed $1.6 billion in loans for more than 1,200 nonprofits, putting flexible capital in the hands of changemakers to help bring their visions for stronger communities to life. We’re sharing some of what we’ve learned over the past 36 years to help nonprofit leaders better understand how to leverage financing to amplify impact, how to evaluate and manage facilities projects, and more.
As spring turns to summer, capital availability remains tight and interest rates continue to hover near 20-year highs. One result of these market conditions is that organizations of all types are being forced to carefully consider how to pay for capital expenditures such as facility renovations and repairs. Nonprofits are typically more debt-averse than for-profit companies, making them more likely to avoid borrowing money and instead cover immediate needs with cash on hand. With continued economic uncertainty, however, it may be prudent to preserve assets that can be quickly deployed to weather the unexpected. And despite the current high cost of borrowing, the benefits of using debt as a tool for organizational investment instead of cash may still outweigh the costs.
As we covered in a recent article, smaller projects can still make a big impact on an organization’s growth. By financing these low-cost investments, an organization can preserve cash on hand – or liquidity – by spreading out the costs of capital expenditures over time without significant additional costs that result from high interest rates. In this article, we’re diving deeper into the concept of liquidity to answer three questions:
- What is liquidity?
- Why does it matter, and how much does an organization need?
- Is it better to spend or save…or are both options feasible?
What is Liquidity?
At an organizational level, liquidity is an organization’s ability to acquire cash—through a loan or by withdrawing money in the bank— or to convert assets to cash to pay its short-term obligations or liabilities. For a nonprofit, it’s most helpful to think of how much liquid capital an organization has on hand to cover immediate expenses out of pocket. Availability under a line of credit can also be considered when assessing liquidity.
Some common ratios to evaluate and monitor liquidity include:
Current Ratio
Cash Ratio
Cash ratio is a more conservative way to measure a company’s ability to meet short-term obligations. It assumes that inventory and accounts receivable may take time to convert into cash and be considered liquid. Cash ratio is determined with the following formula: (cash + cash equivalents) ÷ current liabilities.
Days Cash on Hand
The number of days an organization can pay expenses with the current cash it has available, without revenue coming in. It is calculated with the following formula: Cash ÷ Cash operating expenses ÷ 365.
Why does liquidity matter, and how much does an organization need?
Having liquid capital on hand allows organizations to readily cover short-term expenses like salaries, programming needs, and operating costs, as well as unexpected costs like emergency repairs. Cash on hand can also backstop unexpected delays in the receipt of payments – which can be an unfortunate part of doing business for many nonprofits.
When thinking about how much liquidity to maintain on an organization’s balance sheet, there is no one-size-fits-all answer. The “right” amount of liquidity is based on a number of factors, including revenue size, payor mix, payment terms, and condition of real estate, to name a few. Understanding the required amount of cash to cover monthly expenses and keeping enough to cover a few months of operations is generally a good place to start. A line of credit might provide a sufficient backstop for unexpected expenses or delayed payments, but keeping additional cash on hand may still be a wise choice. With tight liquidity in the financial system expected to persist, lines of credit may be even more difficult for nonprofits to access in the future than usual.
Spend or save…or both?
Now may not be the time to embark on a large capital project due to cost. And it also might be prudent to maintain higher levels of liquidity as economic conditions remain uncertain. But it also might be critically important to replace your roof or purchase a new vehicle or repair your boiler. While potentially costly, what might the cost be of not moving forward with these investments – either to the organization’s financial statements or in relation to its mission? Again, there is no one answer that applies to all organizations when considering the best way to evaluate the costs, benefits, and options available to achieve the optimal mix of critical investment and prudent saving. But even in uncertain times, understanding the potential variables and levers that can be used to accomplish the organization’s goals is the first step to making informed decisions that support growth and stability.
To discuss whether financing a capital expenditure is feasible option for your organization, please contact our Capital Solutions team.