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SOCIAL ENTERPRISE
A New Financial Reporting Model for Social Enterprises
Treating philanthropic grants as revenue can hurt social enterprises’ performance.
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By Mark Lederhos Oct. 18, 2016
In my role as senior vice president of innovation, strategy, and execution at the Housing Partnership Network (HPN), I am tasked with helping to ensure that the social enterprises we sponsor are effectively launched, managed, and monitored, using sound business principles. But when I started on the job about sixteen months ago, I found a curious thing: These social enterprises were reporting philanthropic grant dollars raised by HPN to fund them as “revenue” on their profit and loss statements. I looked further into this practice and found that it was fairly common across the nonprofit sector.
Because of this approach, many of the newer HPN-affiliated businesses appeared, based on their financial statements, to be profitable. That was accurate, in so much as their recognized revenues outpaced their expenses. However, to my mind, that view distorted these businesses’ financial fundamentals. If I characterized grant dollars as invested capital rather than revenue on the balance sheet, it became clear quickly that instead of being slightly profitable, some of these social enterprises were actually very unprofitable.
This finding wasn’t surprising, since these social enterprises were technically still in startup mode. Nonetheless, the observation piqued my interest, so I started looking at the financial reports of other, more well-established nonprofits and social enterprises throughout the United States. I found that this same reporting convention was more the rule than the exception.
The practice makes a certain amount of sense, since social enterprises are typically focused more on serving a social need and less on making a profit. However, from my experience working in startup environments, I believe that this kind of reporting can prove damaging if it’s the only way an organization looks at its finances. It’s fine to keep financial statements in this format for basic reporting or auditing purposes, but it’s also very important to understand how an enterprise is truly performing.
This is why for each social enterprise we sponsor at HPN, we now generate an alternative set of financials that recognizes grants as equity rather than as revenue. These grants are not truly equity, as the funders usually don’t seek a return on their financial investment other than the success of the stated mission. Nevertheless, this second classification scheme provides a more realistic view of the enterprise’s performance.
To illustrate the difference that this treatment of cash inflow reporting can make, consider the charts below, which show two different takes on a financial snapshot of one of the social enterprises that HPN supports. The first shows how financial ratios are represented when grants are treated as revenue. The second shows how treating grants as equity affects these ratios.
As shown, the financial ratios around return on assets, return on equity, and net profit margin change significantly when cash in-flows are categorized as equity. This new approach offers several advantages:
An Impetus to Improve Performance: Recasting the way cash inflows are reported forces leaders to focus on their organization’s profit and loss performance instead of on how much cash they have left in the bank to execute their plan. Focusing on what looks like a healthy cash position can foster a sense that there is plenty of time to build and execute on a business plan. And that false sense of security can stifle the urgency that would otherwise drive the organization to meet key milestone objectives. Reporting grant money as equity provides the impetus (in the form of a concrete metric) to improve performance and can push business leaders to focus on sales generation.
A Business-Focused Way to Prioritize Goals: When grants are booked as revenue, a manager can look at a profit and loss sta