What is financial leverage and why should nonprofits know this term?
I’ve said it before and I’ll say it again – you need to pay attention to your balance sheet (i.e. Statement of Financial Position)! Too many organizations only look at and talk about their P&L (i.e. Statement of Activities) when telling their financial story. It is a monumental disservice to your organization and to your history. Your Statement of Financial Position shows you not only where you are, but where you have been; it gives you the opportunity to talk about your organization’s journey.
There are many good ways to talk about your Statement of Financial Position — commonly organizations use metrics like cash balance, days of A/R outstanding, days of A/P outstanding, days of cash on hand, etc. One of the metrics that should be on the list, however, is an organization’s Financial Leverage. In this post, we’re going to talk about how leverage is calculated, why it’s important, how you can use it to bolster your fundraising efforts, and finish off with additional considerations.
What all goes into calculating leverage?
Before I dive into the term “financial leverage” with you, let’s quickly level-set. If you already know how to calculate or identify your Net Assets, skip ahead to the next section called Let’s demystify leverage.
Leverage is calculated by taking your organization’s Total Liabilities and dividing by your Total Net Assets. Total Net Assets is sometimes referred to as Equity in the for-profit space, but “Net Assets” is the more commonly used term in the nonprofit space. Total Net Assets is relatively self-explanatory; to calculate your organization’s Total Net Assets, subtract your Total Liabilities from your Total Assets.
Let’s look at an example. In the below Statement of Financial Position (referred to as a Balance Sheet in the for-profit space), we’re going to calculate this organization’s Total Net Assets. To calculate, you’d take Total Assets of $17,900,012 (yellow highlights) and subtract the Total Liabilities of $9,725,084 (green highlights) to arrive at the Total Net Assets of $8,174,928 (pink highlights).
You’ll notice that on the Statement of Financial Position above, the Total Net Assets figure is already calculated. This will be true for your organization’s Statement of Financial Position as well – take a look now if you can!
Don’t want to calculate leverage yourself? Sign up for your FREE Azul Analysis dashboard and it will calculate your leverage for you with the click of a button. It couldn’t be easier!
The problem is that many organizations don’t know what this ultimately means, whether or not that number is actually good or bad, and how they can use these numbers to talk about the strength or opportunity of their organization’s financial position. To further complicate things, it only shows one point in time, so it’s hard to tell if an organization’s health is improving or declining. That’s where this term “financial leverage” comes into play.
Let’s demystify leverage
According to Investopedia, leverage results from using borrowed capital as a funding source when investing to expand the organization’s asset base and increase impact. Leverage is an investment strategy of using borrowed money to increase the potential impact of an organization. Leverage can also refer to the amount of debt a nonprofit uses to finance assets which ultimately supports the revenue generating activity.
Put simply, leverage is a relative indicator of how much debt an organization has used to grow and it shows how much financial resilience or ‘staying power’ an organization has.
If an organization is highly leveraged, it will have to be able to respond extremely quickly when faced with adverse conditions because a highly leveraged organization does not have as much runway to respond to challenging financial conditions. Nonprofits that have little to no leverage, conversely, typically have the ability to wait out adverse conditions and respond slower.
Please don’t interpret this as an endorsement of or a statement against leverage. I personally like to see organizations with little to no leverage because it shows me they are managing their financial position responsibly. I also believe, however, that leverage can be a powerful tool, so long as the risks are evaluated and managed appropriately. In fact, some of the largest nonprofit organizations in the world use leverage to expand their reach and amplify their impact.
The other thing you should understand is that Total Liabilities is more broad than most organizations think. It’s not just about your credit card, line of credit, or building loan (if you have any of those). Total Liabilities takes into account all of the ways you fund your organization’s operations and growth, including credit your vendors have issued you through your Accounts Payable and the accruing payroll of your staff members. All organizations have liabilities, so it’s important to talk about how your organization manages them. If you think of it in terms of fiduciary responsibility, it’s even more clear how important this is. Part of your job as a nonprofit organization manager or board member is to mitigate risk — liabilities present significant risk, so this is a key area in which you should be focused.
Now that we’ve covered that, let’s quickly discuss how to calculate your organization’s financial Leverage Ratio. We’re going to look at the same Statement of Financial Position from earlier (below).
To calculate this nonprofit’s Leverage Ratio, we need to take the Total Liabilities and simply divide that number by the Total Net Assets. In this case, the Total Liabilities are $9,725,084 (green highlights) and the Total Net Assets are $8,174,928 (pink highlights). When you divide Total Liabilities by Total Net Assets, you get a Leverage Ratio of approximately 1.2x. Here’s the formula:
Now that you’ve seen how to calculate this Leverage Ratio, you should do it for your organization. Take a few minutes now or later today to see how your organization compares to this example.
What is a good Leverage Ratio and how can I use it strategically with funders?
Unfortunately this is a pretty complicated answer, but I’m going to give you a few different ways to evaluate and use your Leverage Ratio to talk about your organization.
One of the best things you can do to determine if your Leverage Ratio is good is to benchmark your organization against peers. The beautiful thing about using Leverage Ratios is that you can compare organizations with similar operating strategies or missions, even if the organizations vary significantly in revenue size. It makes it easy to create a benchmark that tells you if your organization is operating in line or out of line with peer organizations.
The easiest way to do this is to head on over to Propublica Nonprofit Explorer (our preference to Guidestar), search for organization(s) you consider to be your peer(s), and calculate their leverage ratios at their most recent fiscal year end. Once you get an idea of where your peers are operating, you can use that as a guide to tell you whether or not your organization is doing well.
If your organization has a higher Leverage Ratio than the benchmark, you and your board should be talking about why that is the case. It could be something as simple as an expected delay in payments to your vendors caused your Accounts Payable to increase temporarily. It could also be more alarming in that your line of credit is maxed because your organization hasn’t been using it appropriately. This should lead to a discussion around how to prioritize decreasing your Liabilities to create sustainability. Realizing you are in this position can lead to some important discussions with key funders and allow you to increase your transparency, deepen key relationships, and build a better organization.
On the flip side of the coin, if your organization has a lower Leverage Ratio than the benchmark you created, you still should be talking about why that is happening. What opportunity costs are you encountering and how could you be using leverage strategically to increase your impact in your community? If your low leverage strategy is intentional, how are you talking about that with strategic funders? Not only does your low leverage position allow you to respond to uncertainty in the short run, it speaks to your proven track record of being able to grow organically. Imagine what more you could accomplish with more funding!
Another way to decide whether your Leverage Ratio is high or low is to use a generally accepted maximum as your benchmark. While it’s hard to generalize what a good Leverage Ratio is because organizations have different profiles across different industries, you can comfortably say that you are sitting in a good position if your organization’s Leverage Ratio is anywhere under 1.5x. Again, if you have used debt to grow strategically and intentionally, a higher Leverage Ratio might be completely acceptable. However, 1.5x is a good maximum Leverage Ratio for the overwhelming majority of nonprofits.
Want to easily overlay a benchmark on your data? Sign up for your FREE Azul Analysis dashboard and it will calculate your leverage ratio and add in a benchmark line with the click of a button. It couldn’t be easier!
What other considerations should my organization think about?
There are three other considerations you should think about because they can further the conversation around your organization’s financial health. Before we dive into these points, however, know that these are advanced considerations. If you aren’t measuring and benchmarking your Leverage Ratio now, start there. If you are already measuring this or feel confident in your ability to pull that information, continue forth!
- Restricted vs. Unrestricted Net Assets. Since nonprofit organizations have unique revenue recognition standards, you can take your Leverage Ratio analysis a step further by considering only Net Assets without Donor Restrictions. In most cases, this will reduce your Total Net Assets base, which will increase your Leverage Ratio (because your Total Liabilities will stay the same while your Net Assets value will decrease). This would be useful if you want a very conservative view of your financial leverage position.
- Trends Over Time. The most useful way to present your Leverage Ratio is to show how your leverage changes over time. This can be achieved by utilizing a simple bar chart. Below is a great example of what this looks like with an overlaid Leverage Ratio benchmark of 1.5x (green dotted line). In this example, you can clearly see when (September 2019) this organization used bank debt to purchase a building in order to expand their reach into a new geographic region.
- Financial Literacy. As you probably are aware, not all Board members have the same level of financial literacy. When you start to show your Leverage Ratio, you need to make sure you educate those who do not understand this concept. You may also have to educate strategic funders. The good news, though? It shows that you truly understand the drivers of financial sustainability and will absolutely impress anyone who hears you talking about this.
Here are our final thoughts…
I’ve always been a fan of the adage: “What gets measured, gets managed.” Managing leverage is extremely important for organizations and can lead to better conversations with funders and greater impact in communities, yet it rarely is discussed. This might be because leverage is misunderstood or might be because there’s a certain level of stigma attached to the concept in the nonprofit industry itself.
Whatever the case, hopefully you now know what it truly means, how it can impact an organization, how to talk about it, and how to strategically use an analysis of your financial leverage.