The Basic Financial Statements

The Statement of Financial Position

The Statement of Financial Position, the non-profit's balance sheet, is designed to answer a simple question: What is this organization's financial position? Financial position has both short-term and long-term components. If current assets exceed current liabilities, then the organization's short-term financial position is favorable. If long-term (i.e., non-current) assets exceed long-term liabilities, the organization is in a favorable long-term financial position. As you will see in the discussion that follows, an organization could be in a favorable long-term financial position but have a weak short-term financial position, and vice versa.

For that reason, a point of emphasis for the balance sheet is the relationship between the organization's assets and liabilities. An organization's net position improves if its assets grow faster than its liabilities. If an organization's assets decrease or liabilities increase, its net position will deteriorate. We are always mindful of why an organization's net position has declined over time. Is that because the organization drew down on its reserves during a recession, or do changes reflect a loss in value in the non-profit's investments?

The balance sheet offers a lot of this sort of detail. It also helps organizations formulate strategies to address the issues at hand. If the organization had to draw down on its reserves because of a deficit, it would need to budget for a surplus to replenish reserves. If the organization reported investment losses because of changes in the financial markets, it might opt to do nothing. Doing nothing is a strategy. We've seen the markets recover following a recession, including the Great Recession and the COVID-19 recession.

We provide a review of financial health measures, also known as financial statement ratios, that can help you answer some of these questions. Below are some questions you should ask when looking at an organization's balance sheet:

1. Do its total assets exceed its total liabilities? If they do, that is an indicator that the organization's long-term financial position is favorable.
   
   
2. Do its current assets exceed its current liabilities? If they do, that is an indicator that the organization's strong short-term financial position, sometimes referred to as working capital, is favorable.
   
   
3. What proportion of total assets are current assets? What proportion are fixed assets (i.e., buildings and equipment)? What proportion are restricted investments? Buildings and equipment add to operating costs (i.e., maintenance and operating costs). Investments, including restricted (or endowment) investments, are a real source of income, and unrestricted investments may be used to support the organization's operations.
   
   
4. What proportion of current assets are receivables? What proportion of receivables is due in 12 months or less? What proportion of receivables are due from a single donor or grantor? The concentration of receivables with an individual donor is a source of financial uncertainty.
   
   
5. What proportion of assets is in the form of cash and cash equivalents? What proportion of current assets is in the form of cash and cash equivalents? How much cash does the organization have relative to its current liabilities? We often hear the phrase cash is king. Cash is a liquid asset that allows the organization to meet its obligations as they come due and provides it with the opportunity to invest in new opportunities or immediately respond to a crisis. At the same time, an organization can have too much cash. If it has more cash than it needs to cover its day-to-day operations, it could invest some of that idle cash in marketable securities or other safe investments and earn a nominal return.
   
   
6. What proportion of net assets is without donor restrictions? What proportion of net assets is covered by donor restrictions? Net assets without donor restrictions can be used to cover short-term spending needs, while net assets with donor restrictions cannot, as doing so would violate donor intent.
   
   
7. Does the organization have non-current liabilities? How might these affect the organization's current assets in the future? Long-term liabilities like loans, bonds, legal settlements, and pension liabilities increase demand for cash.

It is essential to remember that the balance sheet is a snapshot in time. When an organization's accounting staff prepares the balance sheet, they present balances in every account on a particular day, usually the last day of the fiscal year. If an organization has a dynamic balance sheet, its financial position could look quite different from one week to the next or one month to the next based on activities in key balance sheet accounts (e.g., cash, accounts receivable, and investments).

Let's look at an example. The Statement of Financial Position for Treehouse for the year ending June 30, 2022, is below. The financial statements include consolidated accounts of Treehouse and 2100 LLC (i.e., Treehouse's interest in the 2100 Building) in FY 2022. Treehouse did not include FY 2021 information in its financial statements at the end of FY 2022. That information is presented here for comparison purposes only.

Every balance sheet will begin with a summary of assets first. Assets are listed in reducing order of liquidity. What that means is that the most liquid asset appears first, and the least liquid assets appear near the bottom. We can convert an asset to cash by selling it or, in the case of receivables, collecting it. Cash is, of course, the most liquid asset. That is why it is listed first.

Cash equivalents (including commercial paper and marketable securities like money market mutual funds and overnight repurchase agreements or "Repos") are safe short-term investments that can be converted to cash immediately at low or no cost. Receivables will convert into cash as clients and donors make payments. Current assets that we do not expect to convert to cash quickly are listed below cash and receivables. Restricted assets are not considered liquid and are reported below the least liquid current asset (e.g., inventory or pre-paid expenses) or are not reported as current assets (e.g., endowment investments).

Treehouse reports the most typical current assets:

• Investments include holdings of stocks, bonds, and other conventional financial instruments, including investments in mutual funds. Note that investments are reported separately from Endowment Investments (non-current), as the latter is subject to internal (board-designated) and external (donor-imposed) restrictions. Note that investments are reported separately from cash equivalents, as they are bought and sold less frequently. This, however, should not be confused with liquidity. A vast majority of financial investments are liquid. However, unlike cash equivalents, investments do not mature every 30 days or every three months; as a result, they need not be actively traded.
  
  
• Receivables refer to money owed to the organization. When customers pay money owed to the organization, that asset converts to cash. Treehouse reports net receivables. This means it has subtracted from that receivables figure the portion of those receivables it has determined it cannot collect. Those removals are known as an allowance for uncollectible or bad debt expenses. The nonprofit reports pledges, rent, and contracts receivable separately. Pledges receivable represent a donor's commitment to give at a future date. Rent receivable represents rent due from tenants in their building. Rent receivable is reported separately from contracts receivable to capture differences in the types of services provided.
  
  
• Inventory includes goods that the organization intends to sell or give away as part of delivering its services. Much of Treehouse's inventory is in "The Treehouse Store," a thrift store where children can pick up clothing and personal items for free. Many organizations (Treehouse not included) report a separate category for supplies. These are goods and materials, usually commodities, that the organization intends to use while delivering its services. Unlike marketable securities and investments, there may not be a robust market for supplies and inventory, so they are among the least liquid current assets.
  
  
• Pre-paid expenses are incurred when an organization opts to pay in advance for services (e.g., insurance, memberships, subscriptions) it will use later. If the organization cancels or renegotiates a pre-paid expense, a refund will be processed for the unused pre-paid amount. This is rare and is subject to contract restrictions.

Treehouse also reports the most common long-term assets. These are listed in decreasing order of liquidity:

• Long-term receivables are monies owed to the organization to be received over multiple financial periods. This is especially true for grants, contracts, and pledges that are not in the current period. These long-term receivables are also reported as net of allowance for uncollectable or bad debt expenses. Long-term receivables must also be discounted to present value using the prevailing market interest rate. Recall that present value is the amount of money a future investment is worth today. Reporting long-term receivables in present value terms recognizes the foregone interest.
  
  
• Fixed assets are the least liquid, as the organization's ability to convert these assets into cash will incur costs and take time. Property and equipment are reported book value – that is, historical cost or purchase price, net of depreciation. Depreciation is the loss in value of an asset due to wear and tear. Effective December 2021, Treehouse became co-owner of its building when a portion of the property was donated to the organization. The Statement of Financial Position reports the fair market value of Treehouse's share of the building at the time of the donation. Going forward, the value of the organization's interest will be reported net of depreciation.

• Endowment Investments represent donor-restricted funds. For that reason, endowment investments are frequently listed as non-current assets. Note that investments remain liquid – the classification as a non-current asset reflects restrictions on use. Investment earnings could be invested in the programs or services if donor restrictions do not apply. Treehouse reports endowment investments separately from its other investments and cash holdings. Not all non-profits will report investments this way. That said, they must disclose the different types of endowment funds (or donor-restricted net assets) in the notes to the financial statements.
  
  
• Other Investments. Many investments are not liquid because their owner is not allowed to sell them. For example, venture capital funds, hedge funds, and private equity funds mandate lock-in periods. Investors trade off liquidity in these funds but expect higher investment returns. Some investments are less liquid because there are fewer potential buyers. Commercial real estate, for instance, can take some time to sell because there are fewer potential investors interested in those types of properties than in residential real estate. All these investments are reported as "other" long-term assets.

In every balance sheet, liabilities are listed in increasing order of maturity. Maturity refers to the moment in time when payment is due. Said differently, liabilities are listed based on how quickly the organization will need to pay them. Treehouse's balance sheet includes the two most common current liabilities: accounts payable and accrued salaries and related costs (i.e., wages payable). These are liabilities that will come due within the fiscal year. Like many non-profits, Treehouse does not report any long-term liabilities like a mortgage or a loan. If it had, it would list the proportion due in the next twelve months under current liabilities and the proportion due after that under non-current liabilities.

At a glance, three key features of Treehouse's balance sheet stand out. First, its current assets far exceed the non-profit's current liabilities. Its near-term financial position is robust, and the non-profit has more than enough cash to cover its obligations as they come due.

Every balance sheet will present a summary of the organization's net position (equity, net assets, net position, or fund balance). In the case of Treehouse, a non-profit, its net position is reported in one of two categories: net assets "without donor restrictions" or net assets "with donor restrictions". Net assets with restrictions include donor-restricted endowment funds (previously listed as permanently restricted) and contributions receivable that are restricted over time and/or use (previously listed as temporarily restricted). Board-designated quasi-endowment funds and accumulated profits are reported under net assets "without donor restrictions."

The balance sheet shows Treehouse is in a strong financial position, has the right balance across its current and long-term assets, and does not have any long-term liabilities. It also has greater autonomy over its financial resources, as 76 percent of its net assets are not subject to donor restrictions.