Last week, in this column we finished discussing my finance cheat sheet with the set of mnemonics I used to teach myself accounting. This week being the week we celebrate Valentine, it seems apropos to talk about forever or, at least, as close as you can come to it in finance. This week we talk about endowment management.
The non-profit challenge
In the world of foundations and other non-profit organizations, including museums, schools and hospitals, while profit is not the goal, financial sustainability is certainly essential. For non-profits, financial sustainability is essentially about liquidity—that is, the availability of funds to cover cash expenses. Non-profit organizations generally have three types of income: operating revenue, donations, and investment income. A non-profit finance manager will normally divide expense into two: operating expenses and capital expenditures.
Capital expenditures tend to be large expense for purchasing equipment, buying land, or constructing buildings. Operating expenses, on the other hand, are the day-to-day expense of running the organization. This includes rental, salaries, and utilities. In addition, when a non-profit has a special project such as a research project or a special outreach project, there will be those special expenses.
Generally, non-profits are managed so that recurring expenses are set up only if it is clear that there will be recurring income to support them. Hence, if a donation to support a five-year research project is obtained, the expenses for that project need to similarly run only over five years—which means the staff engaged for those projects will be project staff with contracts lasting no longer than the funding for the project.
As for capital expenditures, because they are large, lumpy expenses, they are either covered through accumulating a surplus of collections over expenses over many years or through a special fund-raising campaign—i.e. through solicitation of donations. These donations tend to be earmarked specifically for the particular capital expense. In recent years, this has included as specific an earmarking as, for example, donations to outfit a laboratory for a school, inclusive of equipment. Once a new building or equipment has been financed and acquired, then the non-profit must contend with covering its operating expenses.
Operating revenue are the most obvious source of funds to cover operating expenses. These consist of user fees such as entrance fees for museums, tuition fees for schools, and medical charges for hospitals. Operating revenue can also include income from sales of merchandising such as any sales from a museum shop.
The challenge for non-profits is that, unlike for-profit enterprises whose primary purpose is to make money and who must therefore focus on ensuring operating revenue covers expenses, non-profits focus on a mission objective and financial sustainability is only part of the method. This means, for example, that a museum would prefer to not charge entrance fees in order to attract as wide an audience for its collection as possible. Now, of course, there are many creative ways to charge fees from those who can afford them in order to subsidize those who can’t. For example, many museums have discovered that asking for voluntary donations, especially with gentle benchmarks, actually raise more funds than a general affordable user fee. Hospitals likewise develop a tiered fee system charging more for convenience items such as larger rooms in order to support charity patients. In fact, some hospital systems actually operate high-end expensive facilities in order to support charity hospitals. Similarly, may schools have a system of partial and full scholarships designed to subsidize certain categories of students.
However, non-profits are also always looking out for other sources of financing. This is where donations come in.
Donations can be classified in two ways: intent and character. In terms of intent, donations can be specific or general. While generally all donations have an intention which is to support the institution the donation is being given to, some donations can have an even more specific intent – such as to construct a building or fund a research project. Essentially, these donations cannot be diverted to any other use without violating the terms of the donation. Even the investment income from a specific donation can only be used for the intention of the donation. As to character, donations can either be grants or endowments. Essentially, grants can be spent directly while endowments cannot be spent. Endowments are invested and only their investment income can be spent.
A comfortable endowment is the holy grail of every non-profit financial manager. With a hefty endowment and sound investment management, a non-profit organization can fund operations entirely from investment income. This means any additional income such as user fees or grants can then be used to further the organization’s mission.
This week, let’s do the easy, beginner part of forever. Let’s say you live in one of those countries where inflation is essentially zero. Let’s further imagine that in that country, net interest rates on long-term deposits are 3% per annum and can be relied upon to stay at that level for the foreseeable future.
Now, imagine a non-profit with 100 million dollars of endowment and 3 million in annual operating expenses. Theoretically, if the organization received its endowment and then invested it for a year, it would then have the original 100 million plus an extra 3 million representing one year of interest. This 3 million can then be spent on one year of operations while the intact endowment generates another 3 million for the next year of operations.
That is the magic of endowments. As I always say in finance class, there may not be a forever in love, but under certain circumstances, there is a forever in finance.
Next week, more on the mathematics and finance of forever.
Readers can email Maya at email@example.com. Or visit her site at http://integrations.tumblr.com. For academic publications, Maya uses her full name, Maria Elena Baltazar Herrera.