A recent investigation by the Charity Commission into negative balance sheets found that 10 per cent of the charities they reviewed were experiencing real financial difficulties. Holding financial reserves has traditionally been seen as a way of managing this risk; but the evidence shows that this is not working for many charities.
In 2012 I helped the Charity Finance Group to produce a short publication called Beyond Reserves, which looked at the levels of reserves held by charities and the policies they had in place for managing them. We found that many charities agreed that there were better alternatives to holding as much as possible in reserves. Charities need a financial strategy that integrates risk management and addresses pricing, cash flow, return on investment and maximising returns from all assets.
Work out the purposes of your activities
The first step towards establishing a financial strategy is to work out the purpose of each activity carried out by the charity and whether its financial aim is to:
a) Make a profit (for example, a fundraising event, or a social business set up by the charity)
b) Break even (for example, projects funded by restricted grants)
c) Subsidise (important activities that deliver the charity’s aims, but that have to be funded by discretionary spending from donations or reserves)
This will help to determine attitudes towards risk, a pricing policy and the level of investment that is appropriate for the various activities.
Know your business model
It is also important for organisations to fully understand their current business model - in other words, the way demand for services and funding for them comes together.
A charity’s strategic plan probably relies on assumptions about the needs of beneficiaries and how services are funded. However, the priorities of the charity’s stakeholders may be changing in line with the economic environment.
If a service is seen as "icing on the cake," it may be dropped from the menu as funding is prioritised for essential services. Alternatively, the needs of beneficiaries may be increasing; so charities might need to come up with creative ways of meeting them.
Reassessing the business model will help organisations to develop an appropriate pricing policy and decide what the financial aim of each of their activities is.
Invest in new activities
There is lots of interest in setting up new social enterprises, but these can often take longer than expected to break even; and there may be strong competition, making it harder to get the desired prices.
New activities need investment. Staff must spend time developing a new service and building new relationships; and funding may be provided in arrears or be dependent on results. For each new activity, a clear business plan is needed to show the profitability in the first few years as well as the cash flow profile.
Plan a range of different income streams
Having a number of different activities with different financial aims and profiles helps to manage risk, but the balance needs to be right. New activities should be launched at different times. The majority of business failures are a result of cash flow problems due to over-trading; so pacing change and ensuring the change is funded is really important.
Take stock of your assets
Charities often have a traditional view of assets as just bricks and mortar, but they may be sitting on other potential sources of income. You may have developed a unique approach to handling a particular problem or client group, but you need to think about how to convert this into a stream of funding for your work.
This might include investing in an external evaluation to validate the proposed approach, or hiring help to develop a brand and promotional materials such as a website. You may also think about protecting your intellectual property, but to do that you may need to put your approach in writing.
It is still important to consider bricks and mortar, as buildings are often underused. With better technology, the need for property can be cut down, particularly with good connectivity and flexible working. For meetings, buildings can be shared so organisations only pay for what they need.
Test your new strategy
One way to test the robustness of plans and financial forecasts is to consider the level of uncertainty inherent in them. This also helps charities to identify potential trigger points and when action may be needed.
What is the relationship between income and expenditure? What are the key drivers? It is also worth considering the impact that changes in the external environment could have on both costs and income.
Different types of income will need slightly different techniques for forecasting, but it should be possible to group income into categories of confirmed, probable, possible and uncertain. Once the format for this established, the degree of certainty can be varied to test the impact on income. This can help organisations establish critical points to watch for as early warning signs.
Once a framework for preparing different versions of your financial plans is set up, it can be used to look at different scenarios and consider the consequences. For example, several versions of the budget can be prepared to show the impact of reduced levels of activity, reduced levels of income or ceasing certain activities.
Establish a strategy for reserves
Having managed risk in other ways, the charities we studied in Beyond Reserves found that they did not need high levels of reserves. Working capital is needed, along with funding for development and investment, but many unspecified risks are now being managed through the financial strategy.
Kate Sayer is a partner at the accountancy firm Sayer Vincent