Liquidity – What’s all the fuss about?

By Lee Klumpp, CPA, CGMA and Adam Cole, CPA

Liquidity is crucial for not-for-profit (NFP) and for-profit entities alike to have the right amount of liquid and non-liquid resources available when needed to accomplish an organization’s mission. While there is a cost associated with not having enough liquidity, there is a foregone opportunity cost for having too much liquidity. Therefore, an NFP’s liquidity is an important story to convey to the users of its financial statements.

Defining Liquidity

Liquidity is a multifaceted concept that encompasses many different meanings, so in order to determine how liquidity should be communicated by an NFP in its financial statements, let’s first consider how it is defined. Often, when users of NFP financial statements use the term “liquidity” they are referring to liquidity risk or financial flexibility. For the purposes of our discussion, the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) defines liquidity and the related concepts of financial flexibility as follows:

Liquidity is defined in the ASC Master Glossary as an asset’s or liability’s nearness to cash. Donor-imposed restrictions may influence the liquidity or cash flow patterns of certain assets.

Financial Flexibility is defined in the ASC Master Glossary as an entity’s ability to take effective actions to alter amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

Liquidity Risk is not defined in the ASC Master Glossary, but it was discussed in a recent research project by the FASB on disclosures about liquidity risk and interest rate risk. This project utilized the term “liquidity risk” to mean the risks and uncertainties that an entity might encounter in meeting its financial obligations.

Liquidity is typically defined as how much cash and/or assets (such as short-term investments) that an NFP holds that can easily be converted to cash for use in the immediate or near future. An entity is thought to be liquid if it has ready access to cash to meet its needs. An entity may be described as liquid because it holds cash directly or because it holds other liquid assets such as money market accounts, certificates of deposit or other short-term investments that can readily be converted to cash. Some might describe an NFP as liquid if it has access to cash (borrowing power, lines of credit, etc.). Access to cash through borrowing may create liquidity, but it is more akin to financial flexibility and clearly is not a liquid asset that can be communicated in the statement of financial position at the measurement date.

Current Accounting Requirements

The guidance for NFPs (ASC Topic 958) requires that an NFP report assets and liabilities in reasonably homogeneous groups and sequence or classify them in ways that provide relevant information about their interrelationships, liquidity and financial flexibility. Some might interpret this requirement to mean that an entity might only need to sequence its assets according to their nearness to cash and its liabilities based on the timing of their maturities. This could be correct for some small, less-complex NFPs. However, for more complex NFPs with endowments and sinking funds, for example, it could be misleading to classify the endowment with the NFP’s unrestricted investments and to combine the sinking fund cash with the NFP’s unrestricted cash and cash equivalents. If items were grouped together solely by the nature of the asset (cash, investment, etc.) or liability, the users would get a different picture of the NFP’s liquidity than reality, even if further details are provided in the notes. In order for the users of an NFP’s financial statements to understand the NFP’s liquidity, they must be able to understand the restrictions, whether donor, contractual or legal, on the NFP’s use of particular assets.

The industry guidance for NFP business-like health care entities (ASC Topic 954) is more prescriptive, requiring the use of a classified balance sheet and the segregation of assets limited to use on the face of the balance sheet.

It has been our experience in speaking with creditors, credit rating agencies, grantors and donors of NFPs that they would like to know how much cash and/or liquid assets (such as short-term investments) an NFP holds that can be easily converted to cash for immediate or near-term use. That is because they would like to know what liquid assets are available to pay for current or future programmatic activity, debt service and other activities.

Some have argued that you can get to liquidity through analyzing an NFP’s net assets, but net assets is solely a residual of assets less liabilities and does not convey liquidity. For net assets themselves to be able to convey liquidity, they would have to be able to be converted to cash or used to settle an obligation based on the definition of liquidity. Therefore, it would be difficult to use the components of net assets to communicate what net assets are available, for what purpose the net assets can be used and whether the net assets are with or without donor-imposed restrictions.

NFPs currently have flexibility under generally accepted accounting principles (GAAP) in telling their story regarding liquidity to the users of their financial statements. The various ways NFPs currently can discuss their liquidity are:

  1. Sequencing assets according to their nearness of conversion to cash and sequencing liabilities according to the nearness of their maturity and resulting use of cash
  2. Classifying assets and liabilities as current and noncurrent
  3. Disclosing in notes to financial statements relevant information about the liquidity or maturity of assets and liabilities, including restrictions on the use of particular assets

Even with these options, it can still be difficult to understand an NFP’s liquidity. Additionally, there are even difficulties in comparing liquidity within particular industries of the NFP sector. Reasons for that include the following:

  1. Complexity of restricted contributions and designations by the board of directors
  2. Lack of information presented in the notes to the financial statements related to the board of director’s policy on investments specifically around pooled investments that include both restricted and unrestricted amounts
  3. Lack of disclosures about how the organization will meet its short-term liquidity needs

The most significant issue for an NFP around liquidity is the aggregation by type (nature) of assets in the statement of financial position versus the presentation of the components of assets based on their nearness to cash or how the assets are expected to be used. It is believed that a liquidity measure would benefit the users of NFP statements and address this issue.

What Does The Future Hold for NFP Liquidity?

In April 2015, FASB issued an exposure draft of the Proposed Accounting Standards Update (ASU), Not-for-Profit Entities (Topic 958) and Health Care Entities (Topic 954): Presentation of Financial Statements of Not-for-Profit Entities. This proposed ASU addresses the issue of how an NFP should disclose information regarding liquidity.

Specifically, the ASU proposes that an NFP disclose both quantitative and qualitative information about the liquidity of assets and near-term demands for cash as of the reporting date, including (1) the amount of financial assets at the end of the period; (2) the amount that, because of restrictions or other limitations on their use, is not available to meet cash needs in the near term; (3) the amount of financial liabilities that require cash in the near term; and (4) information regarding how an organization manages its liquidity, including the time horizon it uses in the management of liquidity as well as any other sources of cash (such as lines of credit) during that time horizon. It’s believed that this information will significantly improve users’ ability to assess NFPs’ liquidity risk. The comment period on the proposed ASU ended on Aug. 20, 2015, so stay tuned to see what the FASB Board‘s ultimate decision is regarding the liquidity component of the ASU as all comments are considered.

The FASB is not the only entity looking at this issue. Liquidity has also become a critical metric used by boards and stakeholders to measure the potential sustainability of an organization. Currently, the state of New York is working on a Medicaid transformation project that will result in enhanced reimbursements to those organizations that qualify. In order to qualify, one criterion will be that an entity has adequate liquidity.

These events highlight the need for entities to be able to measure, and more importantly, communicate liquidity.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Fall 2015). Copyright © 2015 BDO USA, LLP. All rights reserved.