CFOs balancing credit rating vs. donor expectations.

Trying to balance the conflicting needs of donors and watchdog agencies with those of credit rating companies can be a daunting task. Donors and watchdog agencies want to see a nonprofit spend much of its income on current programs, while credit rating companies like to see a "fiscally prudent" management plan that allocates funds into a reserve account.

"It's really a double-edge sword," said Dulce Gomez-Zormelo, vice president of finance for the wildlife conservation, advocacy, and education organization, the National Wildlife Federation (NWF) in Reston, Va.

"We're very fortunate that we can put a high percentage of our donor dollars (84 percent) toward our programs while keeping our administration and fundraising costs low," she explained. While that keeps the donors and watchdog agencies happy, bond rating firms, such as New York City-based Moody's Investors Service "want to see us profitable," Gomez-Zormelo said.

To keep Moody's happy, the NWF kept 48 percent of its total assets in a reserve account during its last fiscal year, which ran from September 1,2003 to August 31,2004, Gomez-Zormelo said. The NWF keeps such a high reserve, because when times get financially tough, it will dip into that reserve to keep up levels of funding for its conservation/advocacy and education programs, she said. Because of its fiscal conservatism, the NWF received a Moody's rating of A3.

For a list of Moody ratings, see the accompanying chart on page 36.

The Arlington, Va.-based nonprofit watchdog agency BBB Wise Giving Alliance recommends that a charity's unrestricted net assets available for use not exceed three times the past year's expenses or three times the current year's budget, whichever is more, said Bennett Weiner, alliance chief operating officer. "However, we are not suggesting that they spend everything they bring in." The alliance believes that charities should not have more than three times their current year's budget in reserve, Bennett said few nonprofits actually approach that much in reserve.

Moody's likes to see about 2 percent to 3 percent of the yearly budget in a "rainy day fund" to handle any unforeseen events, said Beth Veasey, assistant vice president and analyst.

"We understand that not-for-profits are mission driven," and many do not have large reserves, Veasey added. "We are not so much concerned about reserves as we want to make sure they are running consistently, that they have a balanced budget and they are exercising financial prudence."

"It's a huge challenge for nonprofit CFOs," said John E. Courtney, president of Electra Enterprises LLC, a consulting and acquisition company in Gaithersburg, Md., and a former chief financial officer with the American Diabetes Association.

"One of the areas that organizations come into a lot of criticism for is if they are holding on to excessive reserves," at least with donors and the nonprofit watchdog groups, Courtney explained. "One approach that I think is helpful is that you look at your operating income (donations, pledges) versus your normal operating expenses. I'm a big believer that an organization has to have anywhere from a minimum of three or four months cash in terms of what normal operating expenses would be, up to a year in a reserve account.

The alliance established its Standards for Charity Accountability in 2001, which recommends a nonprofit keep up to three times its annual budget in reserve, after conducting a survey of the general public.

Weiner said 53 percent of the respondents said they believe that more than 50 percent of what they give should go to a charity's current programs, rather than put into a reserve for future needs. "We believe that nonprofits not accumulate funds that can be used for current program activities," Bennett said.

"Organizations that have more than a year in reserve are questionable in my opinion," Courtney said, differing with the alliance on how much should be kept in reserve.

"I believe that's a little on the high end. But at the same time, I think that organizations that have only 5 percent or 10 percent of their annual budget in reserve are really exposing themselves and their organizations to a high degree of risk. As a chief financial officer, one of our number one responsibilities is to be the chief fiduciary agent of an organization ... and help bring a consensus on the board as to what the reserve policy should be."

In a November 2004 report assessing the financial stability of the nonprofit sector during the course of the last three years and authored by Veasey of Moody's, she wrote, "many not-for-profits conservatively adjusted their annual budgets and multi-year financial projections in response to the significant financial challenges of the past several years."

Moody's believes that nonprofits are becoming more financially stable after three years of difficult economic times and one of the key factors is that nonprofit "mangers have generally made wise decisions during the stressful period ... leading to the maintenance of fundamentally healthy financial positions," and have "stable operating margins," Veasey wrote.

Nonprofits saw a downturn in donations, state and federal funding and return on investment income after September 11,2001.

For the NWE "it's a difficult juggling act," Gomez-Zormelo said. The NWF's annual budget runs between $115 million and $125 million, depending upon a number of factors such as donations, gifts, and the volatility of financial markets. Endowments are between $65 million and $95 million. The NWF tries to keep enough money in its "rainy day" fund to keep programs running in case of financial shortfalls, she added.

But sometimes keeping too much in reserve can lead to its own problems, Gomez-Zormelo said. If donations, gifts, and the market are up and the NWF has a big reserve, then organizations that issue grants to the NWF would wonder if the group really needs the money. "So, we would have a problem, if we are not spending enough."

This is where you come up with organizational goals. You come up with an investment policy and a reserve policy that go hand in hand," Courtney said." Look at what the rating agencies indicate as well."

In establishing its rating system, which runs from a high of Aaa, which signifies a "gilt edged" organization to a low of C, which delineates an organization at the very lowest point of the scale, Moody's looks at a number of factors. "Moody's ratings measure total credit loss--including both the probability an issuer will default and the expected severity of loss after a default occurs," according to a Moody's.

"Credit ratings are very important for a charity particularly if they want to borrow money to expand. The first thing that banks and organizations will look at what is your ability to repay and your reserve fund," Courtney said. "Do you have a policy in place that you have to hold a certain amount in reserve? Banks won't lend you money if you do not have the ability to repay it. All nonprofits should have a line of credit to draw on in advance. They should get that in place in case there is a blip and be able to draw on the money as part of their normal business operations."

In establishing its rating system for nonprofits, Moody's divides organizations into five categories; cultural, service, research, philanthropy, and advocacy/memberships.

Veasey said cultural and research charities will probably have the most fluid reserves because, in the case of a cultural charity, such as a museum, an aquariums, a zoo, and the performing arts, reserves will be needed to improve or expand facilities for the general public. Research-based charities, especially those involved in hard science research, will be dipping into reserves and borrowing money to renovate existing facilities or expand them as technology and research needs and methods change.

Of the 80 nonprofits that Moody's rates, 26 are cultural organizations and they have a total outstanding debt of $2.7 billion. The average rating for these organizations is A1.

The biggest challenge for cultural nonprofits since September 11, 2001 has been putting fannies in the seats. Reduced attendance at events has resulted in "weakened balance sheets, lower operating margins and significant capital needs," Veasey wrote in her report.

Things are getting better. "The, median for expendable financial resources to debt stood at 1.8 times in 2003, compared to 2.5 times in 2002," she wrote.

"The median operating margin remains positive (for cultural nonprofits) at 1.8 percent, down only slightly from the 2.8 margin in 2003. This maintenance of performance is primarily due to the sound financial oversight exercised by many managers, who prudently trimmed expenses and built conservative revenue budgets in response to revenue pressures."

For the Field Museum in Chicago, Ill., its Moody's rating is more important than how it's looked at by nonprofit watchdog agencies because its credit rating will determine the cost of borrowing money, said Jim Croft, vice president of finance and administration. The Field Museum has a Moody's rating of A2.

"For us, the most important thing is that we concentrate on running a balanced budget, said Croft. "We have many challenges and our biggest challenge, like all museums, is finding enough funds to do our programs," Croft said.

He said that 100 percent of donor dollars go to "meet the needs of our programs." So, for the Field Museum it's, "reserve, what reserve?" The Moody's rating is important, Croft said, because if there is a downturn in attendance, gifts, federal and state funding, there is very little in reserve. The museum would first--trim programs and second, borrow money. As a back-up plan of last resort, Croft said, the organization could dip into its unrestricted endowments.

A breakdown of its revenue income shows that 20 percent of the Field Museum budget comes in the form of unrestricted contributions, about 20 percent from investment income, 17 percent from its museum store and cafeteria, 13 percent from a line item in the Chicago city budget, 11 percent in state and federal funding, 15 percent in attendance and the remainder in miscellaneous gifts, grants and donations. Should any of those areas decrease, the museum cuts programs and then borrows money, Croft said.

"We operate very much like a family budget," when there is a shortfall in funds, the family doesn't have much in a savings account, it will trim expenses or borrow, Croft said.

In its research section, Moody's rates 16 independent research organizations that have $1.5 billion in outstanding debt. The median rating for this group is Aa3. "The median annual operating surplus in 2003 was just 0.4 percent, with a three-year average performance of 0.7 percent, which highlights the need for sound financial management," Veasey wrote. These organization do not run a large surplus because "external grant funding only covers the cost of the research activity and does not allow for a surplus."

Service organizations, many which rely on government funding, are able to offset decreases in those funds by getting revenue from other areas. Organizations such as the YMCA might receive less in government funding during difficult economic times but can make that up in fees received from its child care operations, Veasey said. Moody's rates 17 service organizations with a total of $1 billion in outstanding debt. Ratings range from A1 to B2 with a median of A3. "We do not expect service organizations to generate large operating surpluses, but we view an organization's ability to cover depreciation and annum debt service with a modest operating surplus as a strong positive credit factor," Veasey wrote. Median total financial resources were a total of $33 million for the 17 organizations rated.

Advocacy/membership organizations such as the NWF are among the most financially stable groups that Moody's rates. There are nine organizations that receive ratings, which range from Aa3 to Baa1, with an average rating of A1. "Median operating margins were 5.3 percent in 2003. "They have a median financial resources of a total of $84 million in 2003, which is up from 2002's $77 million because of stronger investment returns.

Long-term Debt Ratings (maturities of one year or greater)

Investment Grade

Aaa--"gilt edged"

Aa1, Aa2, Aa3--high-grade

A1, A2, A3--upper-medium grade

Baa1, Baa2, Baa3--medium grade

Speculative Grade

Ba1, Ba2, Ba3--speculative elements

B1, B2, B3--lack characteristics of a desirable investment

Caa1, Caa2, Caa3--bonds of poor standing

Ca--highly speculative

C--lowest rating, extremely poor prospects of attaining any real investment standing

Short-Term Debt Ratings (maturities of less than one year)

Prime-1 (highest quality)

Prime-2

Prime-3

Not Prime (can be thought of as speculative grade)