The role of financial planning and analysis (FP&A) in both commercial and non-profit organisations is increasingly similar: it needs to help management make smart decisions about how to make investments and cut costs.
In both types of organisations it has become a more visible and important component of the strategic planning process. FP&A professionals’ involvement in capital budgeting and planning is critical and, if performed effectively, helps to narrow the gap between strategic planning and execution. Traditional capital project appraisal techniques are based on discounted cash flow (DCF) analysis, where weighted average cost of capital (WACC) is a key factor. Small fluctuations in the cost of capital can create huge swings in discounted cash flow figures, strongly affecting strategic decisions about future capital investments and acquisitions.
WACC calculations are based on the cost of debt and equity. That’s relatively straightforward for publicly traded companies but much less so for nonprofits; which frequently don’t have debt and never have equity.
That was the conundrum faced by Brenda Hodo-Iddris, director of corporate finance and business strategy for US non-profit education organisation Step Up for Students, whose quest was to improve her team’s ability to make smarter decisions about investing the organisation’s funds.
According to Hodo-Iddris a couple of drivers prompted Jacksonville, Florida-based Step Up for Students, which assists with scholarship funding, to start looking at how to calculate WACC:
Firstly, with income of close to US$500m the organisation was reaching a certain level of maturity where it needed a robust measure to help make investment and capital expenditure decisions. “We have a sophisticated business model that requires high-level analytics,” says Hodo-Iddris. “We look at return on investment [ROI], capital models and net present value [NPV],” she said. “It’s customary to lay WACC on top of that.”
Secondly, as part of a new fundraising effort, Step Up for Students began to receive more multi-year grants that required the finance team to discount the cash flow to net present value and incorporate a WACC component. But the organisation faced a common hurdle for non-profit institutions: It didn’t have debt, nor did it have equity. So what could it do?
The key to calculating WACC for a non-profit is figuring out what to use to mimic the cost of debt and equity.
One way to consider the cost of debt is to look at similar non-profits that have outstanding debt and use their debt cost, according to the chief financial officer (CFO) of one non-profit. However, he adds that it’s important to remember that “non-profits don’t pay tax, so there is no tax effect (benefit) related to the debt component of the capital structure.”
As to the cost of equity, his organisation refers to “fund capital,” which is capital from retained earnings, contributions, and/or grants. “The cost of fund capital can be thought of as an opportunity cost; approximated by the return the nonprofit could realize if it were invested in securities of similar risk,” he explains. “A non-profit’s opportunity cost of fund capital should increase as more debt is used – more debt generally increases the risk of financial distress; generally similar to expectations for investor-owned firms.”
According to Tony Relvas, director, enterprise performance management (EPM) transformation at business management consultancy The Hackett Group, for non-profits the cost of debt is a little more straightforward. If an organisation has debt, “they can use their current cost of servicing the debt as the starting basis rate for WACC. If they don’t, they can use publicly-traded organisations as a proxy.”
The hard part is trying to figure out the equity component. Non-profits can start the process by examining the return on investment capital; that is what is the required rate of return? If a non-profit’s board of directors has a mandate that the organisation annually returns US$1m of its assets through scholarships or other various charitable avenues, and its asset base (i.e. invested capital) is US$10m, it requires a 10% annual return.
“That works most easily for foundations whose purpose is to generate income – and less easily for institutions whose goal is to invest their funds in developing health or education programmes,” Relvas says. “Those kinds of institutions should look at their operating budget and given X annual budget, figure out that they should be putting in play X percent of that capital and keeping X percent in revenue to continue to operate so that they can continue to pay what they’ve committed to pay based on their mission.”
“If you’re only looking at the lower rate of return, you run the risk of making the wrong kinds of investments,” he cautions. “Organisations need to think about reaching a higher rate of return to make the right investment decisions to maximise the return on any given grant.”
Unlike for-profit companies, they’re not responsible to shareholders and the public but they are responsible to the donors, who need to see that they are making the right choices to make their investments sustainable overtime. “While you don’t have the market to answer to, you still have the opportunity cost of not having invested in better projects,” Relvas concludes.
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