Build a Better Budget for Your Nonprofit Through Capital Budgeting
Nonprofits aren’t known for having a ton of extra cash on hand. In fact, most are experts at working on a shoestring budget to get the job done. But a limited budget doesn’t mean your nonprofit has to pick and choose which programs you can and can’t afford. You can become the master of strategic budgeting with the help of a capital budgeting process.
What is Capital Budgeting?
Capital budgeting is the process of appraising and determining the long-term financial profitability of any investment made on behalf of the organization. Put in simpler terms, capital budgeting is how businesses decide what to invest in.
Most organizations use a basic checklist to determine what’s a good investment. Though the funding structure is different, nonprofits can use this same process when creating a capital budgeting plan.
Most nonprofit professionals are not accountants and these terms are very technical in nature. For the sake of clarity, let’s take a closer look at each of these terms in-depth.
The payback period of an item, good, or service is the length of time it takes for an investment to make back the money that was spent on it. For example, if new insulation for your building costs $200 and it saves your business $100 a year in energy savings, the payback period would be two years.
Net Present Value
The net present value of an item is the difference between what the item is currently worth vs. what the item will be worth in the future. A key feature of net present value is that money in the future is worth less than money in the bank today.
An easy way to think about this is the value of a car. Most cars depreciate in value the second you drive it off the lot. A car that is worth $50,000 today might be worth $42,000 in five years. A good investment will have minimal or no loss in the net present value.
Accounting Rate of Return
The accounting rate of return refers to calculating how much money you make from an investment. This is different than the payback period in that a payback period focuses on how much time it takes to break even from your investment, whereas the accounting rate of return focuses on generated revenue from the investment.
For example, if you buy a smoothie machine for your shop and it costs you $300, the accounting rate of return is measured from the point that you make back the initial $300 it cost to buy the machine. If you make $1,300 from the smoothie machine, your accounting rate of return would be $1,000.
The profitability index is measured by calculating all of these other factors to determine which project or investment will generate the most revenue for the least upfront cost.
Example, if you’re deciding between launching a new scholarship program or a new grants program for your nonprofit, you should determine the profitability index of each proposed program and go with the one that has the higher probability index.
Why do You Need Capital Budgeting for Your Nonprofit?
Due to their funding structure, nonprofits need to be more careful than most businesses with their investments. Most nonprofit organizations fall under the 501(c)(3) IRS designation, which means most of their funding comes from outside sources.
The majority of nonprofits rely on donors or grants for their funding. This means that annual budgets will change depending on cash flow. Just like any other business, there will be years where your cash flow is great and others when your money runs low. Planning ahead is crucial.
3 tips for improving your capital budgeting process
Now that we’ve gone over the importance of capital budgeting, we can focus on how to improve your capital budgeting process.
For this piece, we’re going to skip past the obvious tips of searching for the best deals and creating an annual budget. Instead, we’re going to focus on some lesser-known tricks of the trade that will help your nonprofit increase your funding streams, save money in smart ways, and create a plan for what to do when your funding dries up.
1. Diversify your income stream
As we mentioned earlier in this piece, most nonprofits rely on donors or grants to fund their operations through donor management software and frameworks. This can leave a lot of organizations in a precarious situation. If funding from donors or grant programs suddenly dries up, your cash flow can be put at risk.
Diversifying your cash flow plan through other means is a good first step to take. Two ways nonprofits can find new funding opportunities are through capital campaigns and corporate partnerships.
What is a capital campaign?
A capital campaign is a targeted fundraising campaign used to raise money for a specific initiative or program. Capital campaigns are perfect for funding big projects that your current budget doesn’t allow for. They are typically used for building new office space or creating an endowment fund, but can be used for anything your nonprofit might need it for.
If you know that your nonprofit is planning on investing in something that your current budget doesn’t allow for, you can activate your donors through a capital campaign to raise the funds without having to divert money from other programs or initiatives.
What is a corporate partnership?
A corporate partnership is a relationship between a nonprofit and a for-profit organization.
These are mutually beneficial partnerships where the for-profit business gets the benefit of working with a trusted nonprofit and the nonprofit receives funding they would not otherwise have access to. As many as two-thirds of businesses are currently using corporate partnerships to improve their reputation, build brand awareness, and increase customer loyalty.
Example, if a university is looking to raise funds to build a new library, an organization may donate the required funds in exchange for naming the building after their founder.
2. Focus on where you can cut costs
Many nonprofits struggle to find places to cut their budget because so much of their funds are spent on their cause. There are a few non-conventional ways nonprofits can strategically cut costs to save money on their operating budget, but the biggest one is in-kind gifts.
What are in-kind gifts?
Social corporate responsibility has become a trending topic in corporate America recently which is great news for your nonprofit. There are many organizations out there who will provide in-kind gifts to nonprofits. In-kind gifts are different from corporate partnerships in that they are usually one-off donations to an organization without the expectation of anything in return.
This includes everything from office space, technology, software, legal services, and more. Even if you can’t find in-kind opportunities, many businesses will offer heavily discounted prices for nonprofit organizations. The key is asking for what you need and finding businesses that are willing to work with your budget.
3. Have a plan in the case of a funding shortage
According to MarketWatch, two-thirds of financial experts now expect a U.S. recession by the end of 2020. Whether or not this will happen will only be seen when we experience it – but that doesn’t mean your company shouldn’t prepare just in case. One key strategy nonprofits can implement now to prepare for funding shortages is creating an operating reserve.
What is an operating reserve?
An operating reserve consists of liquid, unrestricted assets that an organization can use in the event of unexpected loss of revenue, shortage of funding, or increase in expenses. The funds within an operating reserve should be either cash or investments that can be quickly converted into cash assets.
Operating reserves can be used for more than just a shortage in budget or unexpected circumstances, they can also be used for unplanned opportunities, development of new programs, hiring new staff, the purchase of property, and more.
How to create an operating reserve for your nonprofit
An operating reserve should not be confused with cash on hand. Operating reserves are your nonprofits savings account or rainy day fund. Most organizations come by funds for their operating reserves through unrestricted endowments from donors. Endowment funds and grants are not eligible for operating reserves because those funds are usually designated for specific funding purposes.
It can be tricky to convince donors to designate their funds for operating reserves because there is no set purpose for the money. You can also make it clear that any purchases made through your operating reserves are still subject to board approval.
Tip: Learn more about how to create your own operating reserve fund
Plan smarter by planning ahead
The key to a successful capital budgeting process is planning ahead with the help of intelligent planning. It can seem daunting to create a new financial strategy from scratch, but your nonprofit will be in a much better position in the long run.
Lauren is a Senior Content Specialist at G2 with five years of content marketing experience. You can find her work featured on CNBC, Yahoo Finance, and on the G2 Learning Hub. In her free time, Lauren enjoys listening to podcasts, watching true crime shows, and spending time in the Chicago karaoke scene.