Understanding the business model(s)
Many medium-sized and large charities are charitable businesses so they have a business model – although the complication might be that they have two or three business models. So you need to understand:
- Where does the demand for the charity’s services come from? Who are the beneficiaries or service users?
- How do you know how well the charity’s services meet the need – do you see feedback or evaluations?
- How are services paid for? Who has a stake or an interest in ensuring the charity does its work? How are services funded?
- How are costs linked to income and what are the key drivers for costs? In other words, what would cause costs to increase or decrease? It is useful to understand whether costs are fixed or flexible and therefore how much control you have over expenditure.
In terms of income, life is easier for charities with more predictable income, but many will have unreliable income. Ideally, a good mix of income from diverse sources will help to hedge the risk of shortfalls in predicted income. Charities with unreliable income and a flexible cost base can adjust their expenditure to match income, but their task in forecasting income is more difficult. They remain vulnerable if they suffer a significant loss of funding and may have to consider other options such as collaborative working or merger to gain more secure income. This is also the best option for charities with high committed costs and unreliable income as, in essence, they do not have a viable business model.
Ask questions to get early warning of potential problems
Charity trustees should look out for some warning signs that all is not well with the financial strategy of their charity:
- Reliance on one or few funders is dangerous. As a trustee, you need to understand how the relationships with funders are managed and how changes in the external environment could affect your charity’s funding.
- Do you have a number of funding streams ending at the same time? This is a predictable risk but needs to be managed well.
- Suggestions to go for ‘loss-leaders’ when you have insufficient evidence about the eventual return on the investment. This is also only a viable strategy when you have sufficient reserves.
- Beware big new contracts as these will have to generate enough income to cover the increase in capacity as well as the direct costs. Most charities are tempted by the income a contract represents but you really need to focus on the contribution it will make to overheads and the likely increase in overheads. If the contract is only for three years, then you could find the charity has scaled up in terms of overheads only to suffer a drastic reduction in funding.
- In charities, overtrading takes a slightly different form, typically using the funding for new projects to finish work on existing projects. So, in effect, robbing Peter to pay Paul. The problems become apparent when new projects dry up and there is insufficient funding to finish projects.
Financial problems are only symptoms
It’s easy to assume that finance is a specialist area and that only accountants can engage in the discussion. But this is completely the wrong way round. The accounts will show the reality of what has been happening, but if the numbers are not as expected, then this is the consequence of something else going awry. For example, the management accounts show income is lower than the plan. Trustees need to ask why that has happened. It might be because a member of staff left the team and it is a temporary problem, or it might be because the external funding environment has become more difficult. It’s important to know whether the income will recover without intervention or whether action is needed. This example illustrates that financial results are the merely the symptom – managers should explain the root cause, but useful questioning by trustees will help to arrive at a proper diagnosis.
There is no such thing as a dumb question. Trustees should not hold back from asking questions just because they cannot phrase them as technical finance questions. Underlying all finances are the day-to-day realities of people doing their jobs, so it’s good to ask questions that help you understand what might need to be different.
Kate Sayer is partner at Sayer Vincent.