Could it be time to take nonprofit and charity governance to a new level? Should financial strength and making a profit become core to board strategy? Phil Butler discusses
why these key themes emerged from the AICD governance study.
The nonprofit sector is a critical component of Australia’s society, often dealing with the most disadvantaged and disaffected people within the community. Without an effective nonprofit sector, our society does not operate properly. Despite this, many nonprofit organisations are left to operate in an environment that those in other sectors would not tolerate.
The Australian Institute of Company Directors (AICD) believes it is time to take the nonprofit sector to a new level, whereby nonprofits are encouraged and supported to achieve their long-term goals, where they are recognised for their efficiency and ability to collaborate to achieve outcomes, and where they are viewed as respected partners in the delivery of services rather than simply a vehicle of government to outsource risk.
The 2016 NFP Governance and Performance study has again shone the spotlight on some of the key issues that are affecting the sector. It was once commonly held that governance of nonprofits was generally poor compared with the for-profit sector, but side-by-side testing has repeatedly shown this is not the case. In fact, some see nonprofit governance as more complex due to the need to achieve both mission success and financial strength within the type of environments in which nonprofits often operate.
Many nonprofit organisations have actively invested in improving governance in response to growing awareness of the role of boards, external pressure from funding and regulatory bodies, and support from professional organisations including the AICD. However, there are some areas in which progress can still be made. Directors consistently raise concerns about financial sustainability, performance measurement and relationships with government. Many of these challenges are seen as insurmountable.
The AICD has been undertaking research into nonprofit governance and performance for over seven years. In this time it has tested long-held assumptions, examined claims about performance, and challenged directors to tell us about their concerns and opportunities – not just about what is happening but why, and what directors and boards can do to respond.
In 2016, financial strength and the need for nonprofits to make a profit emerged as a key theme.
Charity governance: nonprofits must aim to be financially strong
To achieve their long-term objectives, it is critical for organisations to build sufficient financial strength, and to do so they need to make a profit. In addition to this call for nonprofits to aim to make a profit is the need for government and the community more broadly to understand why nonprofits must build this financial strength. At the launch of the study, ACNC Commissioner Susan Pascoe AM stated, “Profit is not a dirty word.”
Challenging perceptions of profit, our research found that there is considerable misunderstanding about profit within a nonprofit context. At a number of the focus groups held as part of the study, there was often an intake of breath when profit was mentioned. Many participants stated they didn’t like the ‘profit’ word and that they looked to make a modest surplus or break even. However, in the same groups, others spoke confidently about their focus on achieving a profit margin of about 20% and the need to build this year on year.
Nonprofits can and do make profits, but the profit is retained by the organisation and applied to achieving its mission rather than distributed to individuals for their private benefit. Without access to capital, the nonprofit sector needs to make profits to build healthy balance sheets.
Many nonprofit directors perceive that their organisations and others in the sector operate in a constant state of financial stress. Achieving financial sustainability, diversifying income sources and managing expenses are consistently reported as challenges for the sector. Yet over the years our research has found that, despite this, some nonprofits are not only surviving – they are thriving. They are achieving their mission and creating organisations that are financially strong in doing so.
So what sets organisations that flourish apart from those that struggle?
The results from this year’s study reveal that nonprofit financial performance depends not only on size and operational environment, but also on directors’ and CEOs’ expectations of performance and their motivation and ability to deliver it.
This year we’ve compared financially successful organisations with those experiencing (or appearing to experience) difficulty to encourage all directors to reflect on their own nonprofit’s performance and what they can do to raise the bar.
The appropriate level of profit can be difficult for a board to determine, particularly in fields such as human services where making a profit to enable long-term survival may mean beneficiaries miss out on services in the short term.
The appropriate level of profit depends on a number of factors such as stage of development, operating environment and goals. Nonprofits working in complex and uncertain environments will require more profit to offset risk, as will those with ambition to grow. Others, such as those in high-margin sectors, will maximise profit while they can in order to build their assets and enhance long-term sustainability. Still, there are some nonprofits for which profit is not a priority, and this is unlikely to change.
In the life of a nonprofit, there will be times when things are good, times of stability, and for some, the time may come when it is best to wind up. Nonprofits can survive a loss in a single year, or even for a few years, but unless they have a reliable benefactor, over the long term they must make a profit to survive.
For the first time we now have data on how much profit (or loss) nonprofits are making. As expected, there is considerable variance:
• about two-thirds of directors (64%) reported that on average their organisation made a profit in the last three years
• one in five (20%) reported breaking even
• 14% reported making a loss.
The outlook for the current financial year is less positive:
• more than half (59%) of surveyed directors reported their organisations will make a profit while a quarter will break even
• 17% expect to make a loss.
Of the 64% of directors who reported making a profit, a quarter reported profits of less than 3%, an amount that would barely cover inflation.
What this data indicates is that although some nonprofits are making a profit, the profit is often insufficient for their long-
If the trend continues, some organisations (at least a third) may soon be in financial distress. If profit does not exceed inflation, an organisation is effectively making a loss and will need to draw down on assets to continue to operate in the longer term. On the other hand, a quarter of the directors whose organisations made a profit said they had a 20% margin, indicating significant variability in profits and expectations across the nonprofit sector.
Strategy is critical for success
A second theme from the study was around the board’s role in strategy, and it noted the strategic conundrum faced by many boards of nonprofit organisations. The study reflected that, The most effective boards control their organisation’s future through appropriate strategic planning. When asked the questions as to which three things would have the most impact, 33% rated strategic planning, 32% noted implementation oversight and 24% noted performance monitoring. Clearly directors understand the need for a focus on strategy and yet, when asked what was their highest priority in the next 12 months, 40% stated: “Responding to changes in our operating environment” and 30% stated “Diversifying income sources.”
Similarly, in the focus groups held across Australia, there was commentary that too much time was currently being spent on operational issues and not enough on the strategic issues. In exploring this a little further it became obvious that the current tsunami of change is at the heart of this conundrum.
The introduction of NDIS and Client Directed Care is having a major impact on nonprofit organisations. While both should ultimately be of great benefit to beneficiaries of services, the impact on organisations going through this change is massive.
For many it will be the first time they will have needed to think about the marketing of their services. For others it will necessitate a complete rethink of their business model with the need to understand cash flow implications and have a much better knowledge of their unit costs. For others it will be a recognition that the services they once provided may no longer be in demand or that a competitor can provide these services better or more cheaply.
While recognising the need for this focus on strategy, it also became apparent that many boards were struggling in their succession planning for directors who could bring strategic thinking to the table. Many boards had the skills templates that identify directors’ professional skills or backgrounds, however the ability to think strategically was often more difficult to define.
The study noted that an impressive 90% of directors had undertaken some form of formal or self-directed training in the last year. However, it was noted that 70% of this was related to general governance training while only 40% was on strategic planning and only 20% in performance measurement.
Do nonprofits have the appropriate risk appetite?
In the study, some directors reported their boards take a ‘no risk’ approach to investment because they believe it is safer to do little or nothing than to actively manage the organisation’s resources.
It would appear that, in some cases, directors do not have the understanding or knowledge required to oversee investments or to define asset strategies. Others will simply have an extremely conservative approach. They therefore err on the side of caution or, in some cases, on the side of inaction.
In contrast, the more active boards saw themselves as stewards of their nonprofits’ assets. They felt a responsibility to ensure they not only leverage existing resources, but also build resources for the future of the organisation, recognising the need to realise a good return on assets.
This involves them taking a balanced approach to portfolio risk by investing in resources that support the organisation to achieve its mission in the longer term. These findings go to the heart of what the role of a board is and how it fulfils its duties.
Each organisation is different and hence the way that the board operates will be slightly different. However, it is critical that the board understands that its duties are to guide and control the organisation to achieve its purpose.
It is often assumed that those coming onto a board will automatically understand what their duties and responsibilities are. Formal training can assist in improving this understanding, but at the very least some sort of induction process should be undertaken. This does not have to be overly complex, but does need to cover what the expectations are of the newly appointed board director.
A board that understands its role, that can focus on the strategy while also monitoring its compliance obligations, and that can work appropriately with the management team can guide a nonprofit to achieve outstanding results
Phil is the Not For Profit Sector Leader for the Australian Institute of Company Directors. Since 2011, he has led the Not for Profit Project, which is designed to support organisations in the sector to achieve their respective missions through ongoing improvements in governance.