Loan payments, government contracts, United Way money – sometimes running the nonprofit Honolulu Children's Treatment Center was nothing but one big headache, thought Ron Williams, executive director of the Center. So many children needed help, and yet more and more time seemed to be spent on a growing number of financial problems. Ron saw that there wasn't enough cash to pay for the services provided by the parent agency, and payments were several years overdue. The temporary bank loan of $100,000 would need renewal soon and interest rates were moving up. The bank was unhappy that a so-called temporary loan had to be refinanced again, and was not inclined to renew the loan. The United Way would reduce its support dollar for dollar if the center had an operating surplus of more than $5,000, but without an operating surplus it might not be possible to take care of the overdue payables and the bank loan. Actually, an operating surplus was unlikely to occur. The forecast for 2005/06 was a deficit of $19,000. And if that wasn't enough, today's mail brought yet another letter from the Center's board of directors in California that said “if you just managed things properly, you should be able to pay off the bank loan, eliminate the operating deficit, and get current on payables.” The letter ended with the request: “Please explain.” The March annual meeting with the board of directors was coming up soon and they would be expecting some answers. “‘Managed things properly’ indeed,” thought Ron. “What did they think he was trying to do?” Life certainly had been simpler in the early days when he was merely a child psychiatrist.
The Center was a nonprofit organization founded in the 1920s to provide a home for dependent and neglected children. Over the years it evolved into a fully accredited residential psychiatric facility with a complete range of professional staff providing care to over 50 emotionally disturbed children. As the only fully accredited and licensed residential setting for the treatment of children with psychiatric disabilities in the Hawaiian Islands, children were received for care from anywhere throughout the entire state. Their length of stay, depending upon the severity of their problems, ranged from 5 to 24 months, with the average being l6 months. During this time, in addition to treatment for their emotional problems, they received a range of supportive services including special education, medical care, social services, recreation, room and board, and structured leisure time activities.
The Center is a subsidiary of a California-based nonprofit corporation and operated with its own board of directors that was responsible for reviewing the budget and setting general policy. The directors meet quarterly in California and then hold a meeting each March in Hawaii to review the budget for the fiscal year beginning on July 1.
As a nonprofit organization, the Center's basic objective was to render services. Success was measured by how much service was provided and by how well available resources were used. The Honolulu Children's Treatment Center thus differed markedly from a profit-oriented organization where decisions were intended to increase, or at least maintain, profits or to maximize the value of the firm. This was not to say that nonprofit organizations did not report profits – there were years when reported revenues exceeded expenses. If this happened over several years, however, it might be perceived not as a sign of good management but rather a warning signal that the organization was not accomplishing its objective of providing as much service as possible with available resources. Common thinking was that either it should cut the price charged for services or it should provide more services. The Board as well as management believed that a nonprofit organization's usual policy should be to break even in the long run. The equity interests involved would have little incentive to build up an operating surplus since they could not sell or trade their ownership to others and no part of the assets, income, or profit would be distributed to them.
In financial reports for this organization a clear distinction is made between capital charges and operating costs. Capital charges refer to the acquisition of fixed assets, equipment, and real property from which benefits will accrue over a long period of time. Operating costs include labor, materials consumed, and services purchased as part of operating an organization for a given period of time. The two types of expenditures are handled separately as are the revenues associated with them. Depreciation is not a part of operating expenses and so was not subtracted along with operating expenses when determining whether the organization operated with an operating surplus or deficit.
The Center's operating income would be close to $1.8 million in the next fiscal year, 2005/06. Income was expected to come from two primary sources, government agencies and charitable groups. Both of these sources set strict limitations, typically of a line-item nature, for the use of the funds they provided. One of the most stringently enforced rules was the prohibition against the accumulation of an operating surplus. The intent was to have as much as possible of the funds go to the ultimate beneficiary. The income received each fiscal year for funding operations should equal the allowable operating expenses incurred in providing services. Increases in working capital and funds to cover past operating deficits were not an allowable expense. If income was greater than operating expenses, the center would run into considerable difficulty with its funding agencies. If income was less, the Center would soon find its ability to continue operating impaired.
During fiscal year 2005/06, payments from the federal and state governments would constitute the largest sources of operating income, as shown in the following table:
| Expected Distribution of 2005/06 | Operating Revenues by Source |
| Federal government | 35.8% |
| State government | 34.2 |
| Aloha United Way | 14.4 |
| Parents | 6.8 |
| Contributions | 6.5 |
| Other | 2.3 |
| Total | 100.0% |
Payment was usually received one to three months after billing. At the end of the federal fiscal year, federal regulations required an end-of-contract accounting report to be submitted. Payment for the last month was usually delayed an additional one or two months. The State government was the other major source of income. It, as well as parents who paid a portion of their children's expenses, was billed at the end of the month in which the service was provided and payment was generally received within the next 30 to 60 days:
| Sources of Income (%) —Fiscal year ends June 30 | ||||||||
| 1997/98 | 1998/99 | 1999/00 | 2000/01 | 2001/02 | 2002/03 | 2003/04 | 2004/05 | |
| State of Hawaii | 58 | 41 | 38 | 38 | 35 | 34 | 31 | 34 |
| U.S. government | 0 | 25 | 27 | 33 | 36 | 38 | 40 | 37 |
| United Way | 32 | 25 | 21 | 18 | 18 | 15 | 15 | 14 |
| Other* | 10 | 9 | 14 | 11 | 11 | 13 | 14 | 15 |
| Total | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 |
* Local foundations, parents, and other sources.
Aloha United Way was the largest nongovernmental source of funds, providing over 14 percent of the Center's revenue in 2004/05. United Way funds were allocated annually and distributed at the start of each month in 12 equal payments. Although the Center had to apply for funds each year, experience had shown that these funds could be counted on in the future as long as the Center did not make an operating surplus. The United Way reduced its payments, dollar for dollar, for any nonprofit agency with an operating surplus of more than $5,000 at the end of each year. They reasoned that funds were provided to pay for services, and if any recipient did not need them for that purpose, there were many other recipients who would use them for worthwhile purposes.
Over the years the Center's sources of income had changed dramatically. Starting in the 1980s, payments from the State of Hawaii for children placed at the Center began a slow but steady rise. By 1997/98, the year after Ron Williams became executive director, State payments were 58 percent of total income with no income at all coming from the Federal government. Without federal dollars, the Center was locked into trying to maintain a semblance of quality care for a very small portion of the total number of children needing help. Thus it was with great excitement that Ron and his co-workers viewed the availability of federal funds beginning in 1998. This new source of funds allowed the center to expand rapidly and to more adequately service the pressing needs of the community. A further advantage of federal funds was that they came in the form of signed contracts negotiated each year, which provided a guaranteed source of funding for a specific number of children. A lot of forms and government red tape were involved but Ron and his staff had learned how to handle the administration of the contracts.
From zero in 1997 the federal funds soared to 25 percent of revenues in 1998/99 and 37 percent in 2004/05. The growth of federal money, however, was not matched by a similar rise in funds from other sources. Most of the growth in the center's budget, $682,000 in 1997/98 to $1.6 million in 2004/05, came from the buildup of federal contract dollars.
In simplest terms the Center collected funds from its various sources and used them to pay for the services it provided for the children in its care. In the projected 2005/06 operating budget approximately two-thirds of all outlays would go for payroll expenses (see Exhibit 8A.1). The remaining one-third would be allocated to other operating expenses such as supplies, travel, occupancy/utilities, and equipment. Like many service-oriented businesses, the Center was labor intensive. Payroll outlays were made in the month the services were provided and the other operating expenses typically were paid later – 60 percent in the month following purchase and 40 percent the month after that.
* Includes $10,000 for payment of interest on the $100,000 bank loan.
Exhibit 8A.1 Projected Statement of Expected Operating Expenses And Income
The parent agency provided many direct and indirect support services to the Honolulu Children's Treatment Center, and the Center in turn paid 10 percent of its total gross income to the parent agency. These payments, called the “centage” fee, were due the month following billing for the services provided. The centage fee was a major source of operating funds for the parent agency. Principal among the services it provided to the center were program consultation, employee retirement and health plan provision and administration, a full range of insurance coverage, auditing services, legal services, public relations, federal-level governmental contract negotiations, fundraising for major capital expenditures, long-range fiscal and program planning, and centralized purchasing.
The first signs of impending financial problems came in 2003, with the situation becoming critical a year and a half later. In July 2004, there wasn't enough cash available to meet the payroll. The Center took out a bank loan of $75,000 for three months at 8.25 percent interest secured by federal government receivables. The interest rate was based on the bank's rate for similar-risk organizations, which was calculated as the prime rate plus 4.00 percent. Everyone, including Ron, thought it was just a temporary problem. As soon as the delayed end-of-fiscal-year payments were received, the loan could be paid back. This was done but to everyone's dismay a similar cash shortage almost immediately reappeared, necessitating another loan. This time the loan was for $100,000 at 8.75 percent interest and a term of six months with similar collateral. This loan was still outstanding, and it was only with some difficulty that the monthly interest payments had been made.
The size and cause of the loan had been a major source of concern to Ron. The Center was not against borrowing for short-term needs but it was against having a loan that never seemed to get repaid. Although it had been renewed several times, the bank might decide not to renew it again since it had now become obvious this was not just a temporary need for funds. In any case, bank loan interest rates had risen in recent months with the prime reaching 5.50 percent, up 1.25 percent from when the original loan was made. The expectation was for even higher rates as the Federal Reserve Board was tightening credit after a long period of low interest.
To compound the problem, state and federal contract negotiators would not accept interest charges on the loan as a reimbursable expense. Nongovernmental sources expected that their contributions would go toward providing services, not to pay loan costs. The United Way was of no help, either. Since the Center was funded as a nonprofit organization, it would drop its support, dollar for dollar, for any nonprofit agency that showed more than a $5,000 operating surplus at the end of the fiscal year. Interest payments were not an allowable operating expense in the UWA's calculations. To date, about half the interest expense had been met by income received from nongovernmental sources and the remainder had shown up as an increase in the operational deficit, which was projected to reach close to $19,000 for 2005/06. Although this was not high in terms of the projected 2005/06 budget of $1.8 million, it was still unacceptable to Ron as well as to his board of directors.
Of even greater concern to Ron and the board was the rise in payables, particularly the amount of payables that was owed to the parent agency. The unpaid centage fee was almost $400,000 at the end of 2004. There was no penalty for late payment to the parent agency but most of the other creditors had a discount for early payment, a 1.50 percent per month charge on overdue bills, or both. In 2004 no discounts were taken and late payment penalties were over $1,000.
These overdue payments had become an increasing source of friction with the parent agency in California and were the cause of a series of letters of concern from the board of directors requesting more information and early repayment of the bank loan and the payables. In their latest letter the board pointed out that they knew the centage collections were now coming in from the Center at the rate of 15 percent during the month service was provided, 60 percent the month after, 20 percent the third month, and 5 percent the fourth month. “Agreeably, this should have some initial effect,” they wrote, “but surely if you manage things properly you should be able to catch up after four months, and then you can pay the loan and begin to reduce your payables.”
Before preparing a response to the board, Ron decided to once again go over the budget for 2005/06 (see Exhibit 8A.1) and the 2004 calendar year-end balance sheet (see Exhibit 8A.2), both previously submitted to the parent agency and the United Way. The formats were mostly consistent with the generally accepted standards of accounting as applied to nonprofit agencies. Since there were no substantive changes in services provided or purchases forecasted for 2005/06, aside from a somewhat larger volume and cost increases due to inflation, the projections were believed to be reasonably accurate.
| Balance Sheets and Total Revenues: 1997, 2001, and 2004 Calendar Year-End | |||
| 12/31/97 | 12/31/01 | 12/31/04 | |
| Assets: | |||
| Cash | $ 5,067 | $24,221 | $20,521 |
| Accounts receivable | 22,204 | 81,036 | 266,267 |
| Prepaid expenses | 6,840 | 11,850 | |
| Reserves held by headquarters* | 46,649 | 94,905 | 47,535 |
| Total assets | $73,920 | $207,002 | $346,173 |
| Liabilities: | |||
| Accounts payable – trade | $17,484 | $137,971 | $117,322 |
| Accounts payable – headquarters | 31,438 | 32,819 | 396,896 |
| Bank loan | — | — | 100,000 |
| Accrued expenses and payables | 8,314 | 21,526 | 22,033 |
| Loan from headquarters | — | 15,000 | 15,000 |
| Total liabilities | $57,236 | $207,316 | $651,251 |
| Net assets | $16,684 | $(314) | $(305,078) |
| Total liabilities and net assets | $73,920 | $207,002 | $346,173 |
| Total revenues (Calendar Year) | $682,090 | $1,439,651 | $1,566,602 |
* These reserves are restricted for capital improvements and are not available to the center for operations.
Exhibit 8A.2 Honolulu Children's Treatment Center Calendar Year-End Figures
As Ron Williams thought about the Center's financial problems and the request from the parent agency, he realized the irony of it all. Ten years ago, when a lower level of services was being provided, there were few financial problems. Now that he had successfully increased the Center's funding, the financial situation seemed to be falling apart. Perhaps in coming up with a response to the parent agency's “please explain” request, he would be able to find a way to resolve the potentially crippling financial situation. There was at least one consoling aspect to all this: With federal funding many more children were receiving much better care than was previously possible. The governmental third-party payments at about 70 percent of total operating revenues were, from all expectations, here to stay.