Executive Summary
The main aim of the non-profit organization is stated in its mission different from the for-profit firms that are motivated by owners’ wealth maximization. Non-profit organizations raise fund capital through earned profits, government grants and private contributions from firms and individuals. The WACC for the non-profit organization is developed just like for-profit firm. Non-profit organizations do not directly benefit from tax to issuer linked with debt funding but they benefit from interest earned through tax exemption therefore net cost from debt is the same for profit-making firms and non-profit organizations. The funds generated are geared towards offering services or goods to the community. Therefore, the non-profit should show stewardship of the donated resources to the supporters, volunteers and members that is cash contributed for particular function should be utilized for that function. That function is specified by contributor or implied in non-profit organization’s mission. The reporting activities and management of non-profit should highlight stewardship for these contributed resources and the employees should show how the money was used. The move to an emphasis in the external financial reporting on the contributors limit has made non-profit organization to adopt financial management just like the for-profit firms but there are still some vital distinctions between non-profit and for-profit organizations.
Introduction
Business managers and leaders must develop essential skills in the financial management. These essential skills start in crucial areas of bookkeeping and cash management that must be carried out based on specific financial controls in order to ensure reliability in bookkeeping process. Thus, managers and leaders should have knowledge of how to generate annual reports and assess these reports to actually comprehend the organization’s financial condition. Financial analysis indicates the “real” situation of the organization, thus financial management is a vital practice in any organization (McNamara, 2010). Financial Management is concerned with management of the financial resources, together with financial and accounting reporting, risk management, budgeting, business insurance and collecting debt (Smallbusinessnotes.com, 2011). Financial management can be applied in all types of organizations; non-profit and for-profit organizations.
Non-profit organizations are corporation that carry out business to benefit the society with no shareholders and profit motive. These organizations are also termed as not-for-profit organizations and are formed according to the state law. These organizations experience unprecedented inspection and growth, thus the organizations’ leaders are responsible for the establishment and monitoring of sound financial techniques, which will make sure that suitable utilization of resources in achieving the missions of their organizations (Langan, 2009).
Unfortunately, the mixture of exceptional governance structure, intense dependence on volunteers, as well as accounting rules together with industry-specific tax frequently makes it hard for the non-profit’s leaders to comprehend and adjust to their crucial function in the process of financial management. Numerous volunteer leaders from for-profit organizations might tend to use financial techniques of business in carrying out their supervision responsibility. Whilst numerous of these techniques are helpful and extensive overdue in non-profit world, but there are still some vital distinctions between non-profit and for-profit organizations that may make such extensive acceptance of the financial techniques intended for business unsuitable and possibly detrimental to the non-profit organizations’ health. Non-profit organizations include: schools, charities and hospitals (Langan, 2009). Therefore, this paper will help in understanding essential financial management techniques in non-profit organization with some distinction from for-profit organizations.
Mission and structure
Not-for-profit organizations are different from the for-profit organizations in that they are formed as non-stock corporations and they are owned by supporters or members of the organizations. Absence of the profit motive and stock ownership are the differences with for-profit organizations as well as the aspects that make numerous of the exceptional issues in financial management widespread in the not-profit organizations (Langan, 2009).
Just like for-profit firms, non-profit corporations adopt and prepare documents like bylaws and Articles of Incorporation, which put in place basic governance structure, mission as well as overall operating processes. Many non-profit organizations institute Board of Directors, appoint committees and elect officials from selected group of people who lead in other core businesses of the corporation like cancer research, manufacturing and franchising among others. The volunteers’ group is in charge of hiring chief executive responsible for directing the paid staff to accomplish the organization overall goals (Langan, 2009).
Unlike for-profit firms that are normally administered in a centralized way that is autocratic way by business insiders as well as compensated boards, leadership in non-profit turns over regularly as a result of voluntary nature together with the organization’s need to absorb and gain from varied supporters’ talents. Whilst this offers for a strong collaborative leadership style, it may result in expensive delays as well as uncertainty during the development and implementation of the key financial strategies (Langan, 2009).
Tax treatment
State and federal taxing authorities normally exempt not-for-profit corporations from income tax payments on any yearly surplus of income over expenditure because of advantageous nature of such organization’s deeds to the community. Organization’s leaders apply for exemption status under the suitable classification of their organization. Presuming the approval is granted, the non-profit organization may benefit itself from this important subsidy that is not accessible to for-profit firms (Langan, 2009).
The tax subsidy brings an ever-increasing price. Besides the common view of privilege by most in the media and public, a common complaint from the for-profit firms is that most non-profit corporations are given an unjust competitive advantage. In addition, non-profit corporations should conform to composite regulatory requirements (Langan, 2009).
Whilst it is acceptable to earn some income from the activities not related to organization’s exempt functions, such earning is obliged to be reported in the Form 990-T as well as the country comparable and is dependent on normal corporate rates of tax. Such deeds need cost allocation system between dissimilar and related deeds, which are rational and constantly applied (Langan, 2009).
In the near past, numerous non-profit corporations have instituted the for-profit subsidiaries for the purpose of housing such activities so as to shield their status of tax-exempt and also benefit from other preferences from tax. Many non-profit corporations are obliged to file wide-ranging yearly information return that features financial operations, results and the relationships of the organization to show conformity to the ongoing tax exemption requirements. Distinct from for-profit firm’s tax returns from income, the annual report from the non-profit is accessible to anybody who makes a request (Langan, 2009).
Accountability
Based on their missions’ nature and support sources, non-profits are subjected to a superior accountability standard than for-profit firms. Leaders of the not-for-profit corporations ensure that there is internal controls system that safeguard assets and ensure timely and accurate reports are produced and show how the organization earns or raises income and how it spends its assets in order to conform to the functions that qualified it to have a tax-exempt status. Internal controls are the core business of accountability. Procedures and policies are the internal controls that if combined make sure that organization’s assets are protected and the transactions reported as well as summarized correctly and on time (Langan, 2009).
Organization’s treasurer is charged with the primary responsibility in overseeing internal controls. He/she is nominated to represent the board to make sure that there are suitable internal controls. This position was in the past ceremonial but in the present’s environment of the decreasing resources as well as increasing exposure, the role of the treasurer is particularly crucial and should be filled by a person with suitable skills who has time commitment that ensure the organization’s constituents are safeguarded from the financial mismanagement (Langan, 2009).
Toward decentralization
Besides, not-for-profit corporations are more and more decentralizing the task of the sound fiscal management from finance and accounting division to all other areas in the organization, to institute sense of possession by the not-for-profit’s employees in their financial plan (budget). Not-for-profit corporations are therefore increasing getting closer to the for-profit firms in such a context, developing widespread systems of cost allocation and examining the end result both in general and by every considerable activity (Langan, 2009).
Whilst performance monitoring and financial decentralization are suitable and very helpful to the not-for-profit corporations, distinct from for-profit firms, the outcomes of this practice do not essentially show that activities, for instance publications, annual conference, government relations and educational seminars, will or must be eliminated or cut (Langan, 2009).
The function of decentralized fiscal management in the not-for-profit corporations is to institute accountability and offer the organization’s supporters, volunteers and leadership with financial information essential to making sure that the organization balances its resources against present and future requirements of the organization’s constituents whilst offering long-range organization’s health (Langan, 2009).
Estimation of cost of capital
A company’s Weighted Average Cost of Capital (WACC) is a mixture of various costs of different forms of capital. Generally, WACC estimation for the non-profit corporations matches that of for-profit companies but there exist two main distinctions. First, because the non-profit corporations do not pay taxes this means that no effects of tax are linked with debt funding. Second, for-profit companies raise finances by selling additional or new shares and retaining earnings, which is equity financing while the non-profit corporations raise similar equity finance but it is called fund capital, raised through earning profits that by law should be retained in the organization. The fund capital can also be raised through grants received from the governmental bodies as well as through contributions received from firms and individuals. Therefore, fund capital is different from equity capital and thus the non-profit must use different methods to measure the WACC (Swlearning.com, 2009).
WACC is mainly used for decisions involving capital budgeting and it characterizes opportunity cost arising from utilization of capital to acquire non-current assets instead of optional uses. The for-profit companies’ opportunity cost linked with equity is evident and it can be returned to the owners if not required in investment as stock repurchase or dividends (Swlearning.com, 2009). In case of non-profit corporations that have no alternative, fund capital’s opportunity cost is more contentious. Historically, four positions are used relating to fund capital’s cost; zero cost in that donors do not anticipate monetary return on their donations; zero cost in that if there is inflation the fund capital should earn returns adequate to facilitate the organization replacement of the existing assets; cost for the fund capital but not very high; and that capital has similar cost just like for-profit’s retained earnings (Swlearning.com, 2009).
Capital structure
As discussed above non-profit corporations are exempted from tax payments and thus cannot decrease cost of using debt, and as a result most of the non-profits access the tax-exempt market for debt. This means that they have similar effective cost from debt financing like the for-profit companies. As described in previous section, non-profit corporation’s fund capital does have opportunity cost, which is generally equal to for-profit’s cost of equity of same risk (Blackbaud.com, 2011). Therefore, if the non-profit uses debt the fund capital’s opportunity cost increases just like it would for for-profit firm. Non-profit corporations are exposed to similar forms of agency costs and financial distress that are allowed by for-profit companies, thus these charges are similarly applicable.
Thus, we would anticipate trade-off theory to apply to non-profit organization meaning that it should have the best possible capital structure that may be defined as trade-off between benefits and costs of debt funding. But theory of asymmetric information cannot be applied in non-profit corporations because they do not have common stock (Swlearning.com, 2009).
Trade-off theory might be theoretically right for non-profit organizations but an issue arises when implementing the theory. Profit-making companies have comparatively uncomplicated access to the equity capital. Therefore, if for-profit company has extra investment opportunities which it cannot finance with its retained earnings as well as debt funding, it may raise the required funds through Initial Public Offering (IPO) or right issue. Additionally, it is comparatively simple for for-profit company to change its capital structure. For instance, if the company is under-geared it may easily issue additional debt and utilize proceeds in stock repurchase or if more geared it may issue extra shares (right issue) and utilize proceeds in debt retirement (Blackbaud.com, 2011).
Non-profit organizations cannot access equity markets and their only source of capital is by private contributions, profit and government grants. Therefore, managers of non-profit corporations do not possess similar extent of flexibility in capital structure and capital investment decisions as managers from non-profit companies. Hence it is frequently required for non-profit organizations to hold-up new projects as result of financing inadequacies and they are also required to utilize in excess of the hypothetically optimal debt amount since that is the only way required services may be funded (Swlearning.com, 2009). These deeds might be unavoidable but managers should identify that such approaches do raise costs. Delaying projects result to non-provision of the required services on time, and utilizing too much debt than optimal level pushes the organization beyond point of maximum debt financing’s net benefit, increasing its cost of capital. Thus, if non-profit organization is compelled into a state of utilizing too much debt than optimal level, its managers must plan to decrease the debt level immediately the state permits (Swlearning.com, 2009).
Non-profit organizations capability to acquire government grants, attract contributions from private sector and earn excess income plays a vital role in instituting the organization’s competitive position. Non-profit corporation with sufficient fund capital may operate or function at its finest capital structure thus minimizing capital costs. While if the organization has insufficient fund capital, non-profit might be compelled to depend greatly on debt funding, leading to superior capital costs. In addition, its destabilized financial condition might stop it from purchasing capital equipment, which may improve its efficiency as well as develop its services, therefore hindering its general operating performance (Swlearning.com, 2009).
Capital budgeting
The basic objective of non-profit organization is to offer a number of services to the community, and not to maximize owners’ wealth. Thus, in such a case decisions involving capital budgeting should include numerous aspects in addition to profitability of the project. For instance, non-economic factors like community’s well-being should be considered, and these aspects might overshadow financial considerations (Blackbaud.com, 2011). Nonetheless, good judgement intended to ensure future feasibility of the organization needs financial impact arising from capital investment be completely identified. In reality, if non-profit organizations carry on unprofitable projects, which are not counterbalanced by the profitable projects, the organization’s financial condition may deteriorate, and in case the situation continues after a while it could result to bankruptcy as well as closure. Evidently, bankrupt organizations cannot meet society’s needs (Blackbaud.com, 2011).
Generally, similar techniques used in project analysis of for-profit companies are as well used in non-profit organizations. But two variations exist; first, because a number of projects of the non-profit organizations are anticipated to offer social value as well as economic value, the project assessment must think about social value together with cash flow, or financial value. Second, discount rate used to estimate the project’s Net Present Social Value (NPSV) when applied to the annual stream of social cash flow. As required return rate on equity for non-profit organizations, there is a significant argument over the correct discount rate that should be used for future stream of social values. One should identify issues involving fund capital, in doing so one many identify that the fund capital may produce social value through utilizing it to offer services itself and it may invest the cash and utilize the incomes to acquire services on open market (Blackbaud.com, 2011).
There are three different forms of the project risk; corporate risk, stand-alone risk and market risk affects. For-profit companies, market risks are relevant but corporate must not be completely ignored (Blackbaud.com, 2011). For Non-profit organizations, stand-alone risk is applicable if the company has simply a single project. In this case the organization will not be affected by portfolio effects, at the individual investor or firm level, thus risk may be gauged by variability of the forecasted returns. But many non-profit organizations provide countless and different services or products, therefore, they may be deemed as having a huge amount of the individual projects (Blackbaud.com, 2011).
Conclusion and recommendations
The objective of the non-profit organization is normally declared by mission instead of owners’ wealth maximization. Non-profit organizations raise fund capital through earned profits that are referred as retained earnings in business world, government grants and private contributions from firms and individuals. The WACC for the non-profit organization is developed just like for-profit firm. Non-profit organizations do not directly benefit from tax to issuer linked with debt funding but they benefit from interest earned through tax exemption therefore net cost from debt is the same for profit-making firms and non-profit organizations.
Trade-off theory associated with capital structure normally applies to the non-profit organizations but such organizations do not possess financial flexibility like the for-profit companies because non-profit organizations are not able to issue new or additional common stock. Generally, the appropriate risk associated with capital budgeting for the non-profit organizations is the corporate risk instead of market risk.
Despite of one’s specific professional career concerns or background in the non-profit management and leadership, some common proficiency and background in fiscal management is a critical constituent of being efficient manager in this field. Through many complicated and interesting systematic projects as well as with beneficial encouragement from colleague one may fully develop approval of the function, in which financial management takes part, in the general effectiveness of the non-profit organization.
References
Blackbaud.com. (2011). Financial management of not-for-profit organizations. Web.
Langan, J. (2009). Understanding non-profit financial management: how practices differ from for-profit organizations. Web.
McNamara, C. (2010). All about financial management in business. Web.
Smallbusinessnotes.com. (2011). Financial management. Web.
Swlearning.com. (2009). Financial management in not-for-profit businesses. Web.