Key Capitalization Terms and Definitions

Capitalization is the accumulation and application of resources in support of the achievement of an organization's mission and goals over time. A well capitalized organization has the ability to access the cash necessary to cover its short- and long- term obligations, to weather downturns in the external operating environment, and to take advantage of opportunities to innovate. All capitalization is represented on the organization's balance sheet, primarily in the Net Assets section. An organization's appropriate scope and scale help determine its capital needs and capital structure.

Time Horizon is the projected length of time for an organization's operations and is a key determinant of capital needs.

• Short-term: organizations dedicated to address current-day needs or realizing a single person's innovative idea or artistic vision. May be low budget and require more flexible capitalization.
• Medium-term: organizations invested in a logic model, brand, or regular audience or membership.
• Long-term: organizations committed to the stewardship of buildings and collections and that are investing to meet the needs of future audiences. These organizations require permanence and stability, which impacts their capitalization needs.

Capital Funds - There are six distinct types of capital funds that are used to maintain organizational health. Each of these funds addresses a distinct need. A capitalization strategy will have identified the appropriate funds for an organization.

• Operating Funds: funds that are used by organizations use to pay for their reasonable, planned day to day expenses during the year to run their programs as stated in their current strategy.
• Working Capital: funds that are used to maintain ordinary business operations through cash flow bumps that arise from predictable business cycles. Each organization is unique in its need for working capital due to annual patterns of cash inflows and outflows. Having a working capital fund allows the organization to borrow internally when expenses are made before the income is received. When the income is received, the working capital fund can be refilled, much like a line of credit. In fact, for organizations with access to a line of credit, use of that line is an acceptable substitute for working capital, as long as the line is not used to finance debt. While there is no single standard benchmark level for working capital, organizations should maintain enough working capital to address the potential low points in cash flow.
• Operating Reserves: funds held in order to protect against unexpected downturns, i.e. the "rainy day." Frequently, such reserves are designed to cover operations for a specific period should ordinary income be disrupted, to survive the disruption or respond to changing circumstances. Unlike working capital, an operating reserves fund cannot be satisfied with a line of credit, as the source of the revenue to pay back the line is not often clear in the event of the fund's use.
• Capital Improvement Reserves: also called building reserves or capital replacement reserves, these funds are held by organizations with facilities to realize long-term facilities replacement plans.
• Endowment: a fund that ensures the longevity of organizations with long-term time horizons through investment earnings dedicated to ongoing costs, such as maintenance of a collection or historic building. In general the endowment corpus is composed of permanently restricted donations, although boards can create quasi-endowments not restricted by donor intent.
• The endowment ratio measures the level of endowment relative to an organization's operating expenses by dividing total endowment by total expense. An increase in the ratio over time indicates endowment growth at least in proportion to the growth in operations.
• Innovation Fund/Risk Capital: funds that give organizations the freedom to try out new ideas, such as product extensions, earned income ventures, major growth, or a new strategic direction. Risk capital is also used to address large environmental shifts that demand a change in strategic direction.

Net Assets are an organization's net worth. Net assets are most frequently explained mathematically, as the difference between an organization's assets and liabilities. Net assets are an important indicator when determining an organization's level of capitalization, for two reasons:

• Net assets represent net worth as a result of an organization's cumulative surpluses (and deficits) since its inception. This makes the net assets an indicator of past financial success, stability and resources for the future.
• Net assets can provide a more accurate picture of an organization's financial position than the budget. Determining the net assets available to support organizations takes into account organizational capital that is locked up in illiquid investments, and is therefore not readily available to support the organization's operations. This is calculated by subtracting the net equity position in fixed assets from unrestricted net assets. Net equity is the net fixed assets (capitalized assets less accumulated depreciation) less associated debt.

Net asset mix is an indicator of the degree to which an organization has flexibility over the use of its cumulative surpluses and the resources it has accumulated for specific purposes. Net assets are classified into three broad categories—unrestricted, temporarily restricted, and permanently restricted. These categories reflect intentions of the donor, rather than any decision internal to the organization. Except for endowment, which is often permanently restricted, sources of organizational capital usually reside within the unrestricted net assets. Specific uses may be identified through board-‐designated funds within unrestricted net assets, although not all organizations formally partition their unrestricted net assets. While these designations can be set aside by board action, they can function effectively to instill discipline, and remind board and staff of the importance of honoring the principle of maintaining capital reserves.

• Temporarily Restricted (TR) activity includes TR contributions that are restricted by the donor for a specific purpose or specific time. Some examples of temporarily restricted contributions are gifts for specific programs or productions, pledged gifts for operations for future years, and capital campaign gifts for facilities that are not yet built. When the restriction is fulfilled, the net assets are released to the unrestricted operating statement. "Net TR Activity" is the sum of all new TR contributions minus those released to unrestricted.
• Permanently Restricted (PR) activity includes PR contributions that are restricted by the donor in perpetuity. The most common example is a gift to an endowment fund.