Financial Management in Nonprofit Organizitions - Literature review Example

Financial Management in Nonprofit Organizations

Executive Summary

The issue of financial management in nonprofit organizations has in the recent past attracted attention more than ever. The study compared and contrasted the application of financial management techniques in nonprofit and for-profit organization. The comparison was done based on different components of financial management including ownership/governance, mechanism, purpose and funding; cost of capital estimation, capital structure decisions, capital budgeting decisions and financial analysis, planning, and forecasting. While both forms of business ownership develop weighted average cost of capital in the same way, nonprofit entities do not benefit from direct tax benefit but are compensated by the benefit from interest tax exempt. As regards to cost of capital, nonprofit entities have an opportunity cost that is to some extent equal to the cost of equity for the for profits. Nonprofits entities value social contributions as well as cash flows as opposed to the for-profit entities. Lastly, as regards to the format of financial statements, with minor exceptions, both forms of organizations have the same financial statement formats.

Financial Management in Nonprofit Organizations

Introduction

Both nonprofit organizations and for-profit organizations have similar financial management techniques. However, certain aspects of the two forms of businesses and financial statements are different. While for-profit organizations mainly aim at profitability and maximizing shareholder value, nonprofit organizations aim at providing socially desirable need on an ongoing basis (Desai, & Yetman, 2015). Compared to for-profit entities, nonprofit entities lack financial flexibility as they depend on resource providers. The recent past has, therefore, seen the increasing need for nonprofit organizations to demonstrate its stewardship and financial management of donated resources with insistence that money should be used for the particular purpose they are donated for. This study, therefore, seeks to compare and contrast the application of financial management techniques in nonprofit and for-profit organization with the comparison covering different aspects including the sources of funds, use of debts and performance evaluation amongst others.

Ownership/governance mechanisms, Purpose and Funding

For-profit organizations are mainly characterized with a well-defined stockholder or owners who exercise control over the organization through voting of the board of directors. The management is responsible to the stockholders to whom the firm’s residual earnings belong and the firm is subject to taxation at the federal, state, and local levels (Horngren, Foster, Datar, Rajan, Ittner, & Baldwin, 2010). The companies are able to raise more capital by bringing in more investors who may come in through purchasing the firm’s common stock through an initial public offering (IPO) or either through the primary market or the secondary market. Nonprofit organizations apart from being organized for a charitable purpose, they must be administered so that they operate exclusively for the public rather than private interest (Kaplan, 2001). In addition, none of the profits should be used for private inurement, no political activity is conducted and all assets continue to be used for charitable purposes in situations where liquidation occurs (Provost, 2014). The funding of nonprofits generally originates from bequests, individual donations and major gifts, corporate contributions, foundation grants, government grants and contracts, interests from investments, tax revenues, membership dues and fees and loans/program-related investments.

Cost of Capital Estimation

A firms cost of capital is mainly estimated though the firms weighted average or the overall cost of capital. The weighted average is a blend of the different costs of the numerous types of the capital the company uses. While the cost of capital estimation for nonprofit and for-profit organizations parallels each other, the difference is on taxation since the nonprofits pay no taxes hence the lack of tax effects associated with debt financing. The other difference is on the different ways of raising additional capital (Kaplan, 2001). While the for-profits raise equity capital through the sale of new common stock and retaining earnings instead of paying dividend, the nonprofits raise fund capital, which is the equivalent of equity funds, from earning profit, which according to law should be retained within the business, grants from government entities and contributions from individuals and companies (Provost, 2014). Therefore, nonprofits incur zero cost of capital. Therefore, on cost of capital estimation, both forms of business use the weighted average cost of capital in the same way despite the lack of direct tax benefit for nonprofits. The lack is covered for by the tax exempt on the interest received. As regards to the cost of capital, the opportunity cost in nonprofits is roughly equal to the cost of equity in for-profits entities.

Capital Structure Decisions

Capital structure decisions are important components of every organization’s management. In the case of nonprofits, making capital structure decisions require managers to take into consideration factors like whether tax-benefits-versus-financial-distress-cists trade-off theory are applicable to their operations. additionally, they have to consider whether there are any other characteristics that prevent them from following the capital structure theory (Ritchie, & Kolodinsky, 2003). Despite not paying taxes which could effectively reduce the cost of debt, nonprofit organizations still have the same effective cost of debt like the for-profit organizations due to the fact that they have access to the tax-exempt debt market.

The fact that nonprofits are subject to the same types of financial distress and urgency as the for-profits means that the costs are equally applicable. In this regard, it is expected that the trade-off theory would be applicable to the nonprofit entities. They should, therefore, have optimal capital structures that are defined by the trade-off between the costs and benefits of debt financing. Application of the theory however becomes a problem. Compared to managers in for-profit setting, the managers of nonprofit entities lack the same degree of flexibility in both capital investment and capital structure decisions (Kaplan, 2001). When faced with inadequate funds, it becomes necessary for the entities to either delay new projects when funds are inadequate or use more than the theoretically optimal amount of debt since it provides the only way to ensure financing of the needed services (Provost, 2014). On the other hand, in the case of for-profits, it is easy to access equity capital and to alter the capital structure with the open option of raising new capital through a new stock offering. Based on this, is clear is that a nonprofits firm’s ability to establish a competitive position heavily lies on its ability to raise funds since adequate funds mean the firm can operate at its optimal capital structure and thus minimize capital costs. Therefore, on capital structure decision front, we can conclude that while trade-off theory of capital structure applies to nonprofit entities, they lack the financial flexibility present in for-profit entities since they cannot issue new common stock.

Capital Budgeting Decisions

Nonprofit structure of business entities affects three elements of capital budgeting, namely, cash flow estimation/decision methods, risk analysis and appropriate goals for project analysis. As regards to cash flow estimation/decision methods, it is imperative to note that cash is a vital resource for nonprofit organizations and an organization must have enough cash flow in order to maintain financial viability (Horngren, Foster, Datar, Rajan, M., Ittner, & Baldwin, 2010). While the same cash flow estimation/decision methods are applicable in both nonprofit and for-profit entities, there are two differences. They include the need to take into consideration social value along with financial or cash flow value and the amount of capital available for investment under the two settings. On the need to take into consideration social value, since some projects are expected to provide a social value apart from a purely economic value, it calls for quantifying the social value of the services provided by the project in each year and determining the discount rate applicable to the services (Kaplan, 2001). This is well formalized by the net present social value model.

On the amount of capital available for investment, the standard capital budgeting makes an assumption that firms can raise virtually unlimited amounts of capital to meet investment requirements. In the case of nonprofits entities, they have limited access to capital due to their limited source of funding which is limited to the amount that can be supported by their fund capital. In this regards, the operations of most nonprofits are often subject to capital rationing with priority being placed to some low-profit or even negative NPV projects (Ritchie, & Kolodinsky, 2003).

Financial Analysis, Planning, and Forecasting

While the general procedure for financial analysis, planning and forecasting are the same for both for-profits and nonprofit entities, the differences is on the accounting procedures used. The different treatments for some accounting entries results in different look of the financial statements. Financial reporting of all companies follows the standards set by the generally accepted accounting principles (GAAP) with most of the standards set by the Financial Accounting Standards Board (FASB) and the Government Accounting Standards Board (GASB). In addition to these, nonprofits as subject to other regulations. Like for instances, for health care institutions which are nonprofit in nature, there is the Audits of Providers of Healthcare Services which provides provisions for preparation and reporting of their financial statements (Desai, & Yetman, 2015). The additional requirements introduce differences inform of disclosures and a detailed guidance on issues unique to the health care industry amongst others.

Conclusion

While financial management for the nonprofits entities may be similar to financial management for the for the for-profit entities in many respects, certain key differences exist. We therefore aimed at discussing financial management in nonprofit organizations and comparing and contrasting the application of financial management techniques in nonprofit and for-profit organizations. The comparison and contrast was based on ownership/governance mechanisms, purpose and funding; cost of capital estimation; capital structure decisions, capital budgeting decisions; and financial analysis, planning and forecasting.