Understanding your organization’s financial statements is essential to controlling the purse strings. These ten tips are intended to help you better assess and interpret your Balance Sheet – a.k.a. Statement of Financial Position, or Statement of Fund Balances.
The balance sheet captures the value of your assets (things you own), liabilities (what you owe) and net assets (difference between assets and liabilities). This statement shows your organization’s financial position at a single moment in time. (The next moment, things may change – every deposit and withdrawal changes the balance sheet.) The balance sheet is often more challenging to interpret than its companion, the statement of operations. However, grasping it is essential to understanding your charity’s finances.
- Understand your financial documents. Formal financial statements (including those prepared by professional accountants and those generated by commercial software programs) are designed to be understandable by people who’ve made a reasonable effort to learn how to read them. It’s worth taking the time to become familiar with the layout and terminology. Read your balance sheet regularly. The more familiar you are with your organization’s reports, the better you’ll become at spotting good news and bad news, and knowing how to address potential problems.
- Balance sheet accounts are “permanent.” These account balances roll on from year to year. Last year’s closing balances become this year’s opening balances. In contrast, revenue and expense accounts (found on your operating statement) start at zero each fiscal year, accumulate a full year of results, and are “re-set” to zero for the new year. That is, your operating statement shows only current year activity. When you read the balance sheet, you need to be able to interpret what’s current and what’s historical. Transactions stay on the balance sheet until they are settled. Thus, last year’s unpaid bills will sit in Accounts Payable until you use this year’s income to pay them off.
- Understand how day to day operations affect the balance sheet. The Balance Sheet shows your organization’s “lifetime” result – the accumulated surplus or deficit – in the Net Assets section. This year’s revenues contribute to an accumulated surplus or deficit, and this year’s expenses reduce it. If this year is going well from a financial viewpoint, then quite likely your operating results are increasing your assets, decreasing your liabilities, and increasing your net assets. The opposite is also true. You need both statements to understand your situation fully. (NB: see also “Ten Tips for Analysing Your Organization’s Operating Statement.”)
- Go beyond the cash account. Yes, most of your transactions probably go through the bank as cheques and deposits. It’s tempting to read the operating statement and the bank balance, and feel that you’ve gone as far as you need to go. However, you need to look at all balance sheet accounts to understand your resources and obligations. Some accounts contain transactions in progress, e.g. Accounts Receivable (we’ve sold goods or services but the client has not yet paid) and Accounts Payable (we’ve purchased goods or services but we have not yet paid). Receivables appear in your revenue accounts – but you haven’t yet got your money. Payables appear in your expense accounts – but you haven’t yet paid for them. These items haven’t hit the bank yet – but they will – and you need to know what to expect. These are just a couple of typical examples. Make sure you understand all of your charity’s particular balance sheet categories.
- “Current” has an accounting meaning. Anything “current” pertains to items that are cash or will be converted to cash within this fiscal year. (See the next two bullet points for fuller explanations.) Anything not designated “current” has a longer timeline. Thus, long-term liabilities don’t need to be settled this fiscal year (e.g. if you have a mortgage, this year’s payments are a current liability, and the rest is a long-term liability). Capital assets are items of substantial value that are owned for longer than a year.
- Current assets = short-term resources. The #1 current asset is cash – in the bank, in short-term investments, in your petty cash box. Other current assets are considered “near-cash” in that they will be realized for cash within the year. You need to know what you’ve got here. If people owe you money (Accounts Receivable) – who, how much, and how quickly can you collect? If you’ve paid for something in advance of receiving it (Prepaid Expense – e.g. a rent deposit for a special event), when will you get the value of it? These are typical current assets. Your charity may have other categories – all of which represent financial resources to you.
- Current liabilities = short-term obligations. These are debts that must be paid within the year. If you owe money to others (Accounts Payable) – to whom, how much, when are the obligations due, and how will you meet them? If you have received money in advance (Deferred Revenue – e.g. a grant or sponsorship for next year, received early), will you have enough cash to carry out the obligation when it falls due? These are typical current liabilities. Your charity may have other categories – all of which represent obligations that must be met.
- Working capital = current assets minus current liabilities. This figure defines your ability to carry on in the short term. If current assets exceed current liabilities, you’re doing well! You have more than you need to meet short-term obligations – as long as your near-cash items become cash before your debts are due. If your current liabilities are greater, you may be facing financial challenges. Calculating working capital and understanding the details behind your balance sheet figures are key to assessing what kind of shape you’re in.
- Capital assets and depreciation (amortization) policy affect your financial position. A capital asset is an item of value that your charity will own for more than a year. Typical examples include buildings, land and equipment. Depreciation (amortization) is an accounting mechanism that allows you to spread the cost of an asset over the estimated years of ownership. (It’s tempting to think that depreciation equals the decline in an asset’s value over time. This might be true – but often it isn’t. For example, many companies depreciate computers over a three-year period. Do you think your $1000 computer would fetch $666 if you tried to sell it after owning it for a year?) Depreciation is an estimate, pure and simple. Choosing a longer depreciation period versus a shorter one affects your financial position – and your operating statement. For instance, if I depreciate my $1000 computer over three years, each year bears $333 of expense. If I depreciated it over two years, each year would bear $500 of expense. If I used a four-year depreciation period, each year would bear $250 of expense. How many years will I get out of the computer? Impossible to know ahead of time. This is a fairly complicated topic – beyond the scope of this tip sheet – and a good one to explore with your chartered accountant.
- Compare deferred revenue to current assets. It’s fairly common for charities to have deferred revenue: e.g. grants and sponsorships intended for next year but received early; the unspent portion of a multi-year grant; subscription sales for next season. If you’re in good financial shape, your deferred revenue will be sitting in the bank, or in short-term investments. If your cash balances are less than your deferred revenue, it means that you’ve already spent that money on immediate needs. Comparing deferred revenue to your cash accounts will tell you quickly about your ability to meet this category of obligation.
This tip sheet was created by Heather Young of Young Associates. Founded in 1993, Young Associates provides bookkeeping and financial management services in the charitable sector, focused on arts and culture. Young Associates also provides consulting services in the areas of data management, business planning and strategic planning. Heather Young published Finance for the Arts in Canada (2005), a textbook and self-study guide on accounting and financial management for not-for-profit arts organizations.