Determinants of the recovery of financially distressed nonprofits

Published date01 March 2018
Date01 March 2018
DOIhttp://doi.org/10.1002/nml.21296
RESEARCH ARTICLE
Determinants of the recovery of financially
distressed nonprofits
Elizabeth A.M. Searing
University of Albany (SUNY)
Correspondence
Elizabeth Searing, Public Administration and
Policy, University at Albany (SUNY), 305 Milne
Hall, 135 Western Avenue, Albany, NY 12222.
Email: esearing@albany.edu
Financial ratios are traditionally used to predict and diag-
nose financial vulnerability; this is helpful, but leaves
unanswered how the vulnerable nonprofit should priori-
tize this information in order to survive. Using panel data,
this empirical study observes the financial behaviors of
distressed nonprofits for 4-year periods where the first
2 years are financially vulnerable. Two definitions of vul-
nerability are tested: when liabilities exceed assets (insol-
vency) and when net assets shrink by more than 25%
annually (financial disruption). In determining which
nonprofits recover during the final 2 years, we find that
the type of vulnerability impacts which financial indica-
tors a nonprofit should target, and that common tactics
such as improving profitability may be counterproductive.
Finally, we do not find evidence for liabilities of newness
or smallness in the statistical analysis.
KEYWORDS
accounting, finance, financial management, financial
vulnerability, ratio analysis
1|INTRODUCTION
Over the last 20 years, a significant and informative body of literature has grown around the use of
financial ratios in predicting whether nonprofits will become financially vulnerable (Chang & Tuck-
man, 1991; Cordery, Sim, & Baskerville, 2013; de Andrés-Alonso, Garcia-Rodriguez, & Romero-
Merino, 2015; Greenlee & Trussel, 2000; Hager, 2001; Hodge & Piccolo, 2005; Keating, Fischer,
Gordon, & Greenlee, 2005; Lecy & Searing, 2015; Tevel, Katz, & Brock, 2014; J. M. Trussel,
2002; J. M. Trussel & Greenlee, 2004). These studies use a broad variety of data sources and defini-
tions of vulnerability,piecing together an evolving and patchwork definition of what characteris-
tics define an unhealthy nonprofit. The prior literature, though comprehensive, is primarily focused
on improving the diagnostic accuracy of the models that predict financial vulnerability. However,
Received: 28 September 2015 Revised: 6 October 2017 Accepted: 12 October 2017
DOI: 10.1002/nml.21296
Nonprofit Management and Leadership. 2018;28:313328.wileyonlinelibrary.com/journal/nml © 2017 Wiley Periodicals, Inc. 313
there is an absence of advice in academic journals on what to do once an organization is determined
to be in financial distress or vulnerable. This is a marked difference between academic and practi-
tioner publications since the diagnosis of vulnerability normally proceeds to a request for recovery
advice from stakeholders.
Thousands of nonprofits close every year, with most closures preceded by a period of financial
distress. A set of best practices on how to recover from this distress would be valuable to several
audiences, and yet the current literature is silent on the matter. First, nonprofit practitioners would
have practical advice on how to bring their nonprofit back to financial health. Second, funders with
limited resources would have a way to evaluate which ailing nonprofits would have the best chance
at recovery if assistance were given; further, there would be insight on how this assistance would be
most effectively structured. Finally, researchers could build a robust literature that could further
develop both empirical advice and theoretical rigor in nonprofit financial management.
Therefore, rather than expanding the current literature on mortality, this study explores the pro-
cess of healing from financial vulnerability. The remainder of this paper is organized as follows. In
the next section we review the relevant studies related to financial ratios and their use in evaluating
nonprofit financial health. We then develop hypotheses to test whether the same factors that influ-
ence the onset of nonprofit vulnerability and demise, such as the liability of smallness and revenue
concentration, will also affect whether and how financial health improves.
Next, we identify nonprofits meeting one of two specific types of financial vulnerability over a
22-year period and use logistic regression to compare characteristics of those organizations that
recover from financial vulnerability to those that remain vulnerable. We find that the type of finan-
cial vulnerability impacts the ideal treatment plan, which suggests a larger role for vulnerability type
than currently exists in the literature. Further, common advice such as improving surplus margins
may be counterproductive. Following discussion and implications of the empirical findings, we
conclude.
2|LITERATURE REVIEW
Financial ratio analysis was pioneered by the for-profit sector decades before the practice entered
the nonprofit mainstream. First, Beaver (1966) discovered that certain characteristics could be used
to predict firm bankruptcy up to 5 years prior to actual failure; shortly thereafter, Altman (2000) and
Deakin (1972) expanded on this theme by broadening the number of indicators and controls
included in the study. Altman (2000) began with a weighted five-ratio model developed through
multiple discriminant analysis, then tailored the ratios and re-specified the model to reflect different
ownership and production options. Ohlson (1980) expanded the sample size thirtyfold by employing
logit estimation and turning to filed 10-K financial forms for information rather than relying on pub-
lished resources from ratings agencies. All of the literature from this period used bankruptcy (that is,
the actual filing of Chapter 11 protections) as their definition of financial distress since this is easily
measurable and verifiable in the corporate sector. This precision in measuring organizational closure
encouraged the development of sophisticated models to measure corporate financial health.
2.1 |Applying for-profit financial ratio analysis to nonprofits
There are several difficulties in applying predictive measures used in for-profit companies to the
nonprofit sector. First, Ohlson (1980) made use of market valuations in his study, but concepts like
market capitalizationand earnings per shareare meaningless for nonprofits. While estimates for
314 SEARING

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