Liquidity – What’s all the Fuss About?

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.

Liquidity is typically defined as how much cash and/or assets (such as short-term investments) a NFP holds that can be easily 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 deposits or other short-term investments that can readily be converted to cash.

Current Accounting Requirements

The guidance for NFPs requires that entities 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. This guidance is the same for NFP and for-profit entities alike.

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 might work for some small, less-complex NFPs. However, for more complex NFPs with endowments and sinking funds, for example, it could be misleading to classify an 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 the 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 (FASB 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) a 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.

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 a NFP should disclose information regarding liquidity.

Specifically, the ASU proposes that a 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 August 20, 2015, so stay tuned to see what the FASB Board ultimately decides 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.