Financially Efficient Charities

Which Are Good Stewards of Donations, And Which Are Not?

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Financially Efficient Charities: As we noted in another article, following careers in nonprofit organizations does not necessarily mean consigning yourself to poor compensation. Indeed, many nonprofits pay executives and senior managers very handsomely.

Unfortunately, some nonprofits are poor stewards of the donations that they receive, particularly by devoting excessive amounts to executive compensation and other overheads.

This is not only an issue for the savvy potential donor to consider, but also for an aspiring CFOcontroller or treasurer of such an organization who takes his or her fiduciary responsibilities towards both donors and beneficiaries very seriously.

The Forbes Ratings: For many years, Forbes magazine has rated charities on financial efficiency. The three metrics that they use are:

  • Charitable Commitment
  • Fundraising Efficiency
  • Donor Dependency

An explanation of each metric follows below.

Note that Forbes only looks at charities that receive broad-based support from the general public (thus eliminating, for example, educational institutions that necessarily make their appeals strictly to alumni, as well as private foundations) and that make adequate public financial disclosures (eliminating many religious organizations). Also eliminated are charities that have most of their donations funneled in from third parties, such as community chests or the United Way.

Charitable Commitment: This is the percentage of total expenses that support the charity's stated purpose, otherwise known as program support or program purpose. To arrive at this figure, Forbes deducts fundraising expenses, executive compensation and various other overheads from total spending. Among the big charities that they analyze, the charitable commitment percentage averaged 87% recently.

Forbes notes that charities receiving a large percentage of gifts-in-kind (which include donations of both goods and securities) generally score the best on this metric. Since these gifts tend to be larger than the typical cash donation, the associated fundraising expenses normally are rather small.

Fundraising Efficiency: This is the percentage of private donations left over after fundraising costs are deducted. The top 100 charities that Forbes rates recently averaged 91% on this measure.

However, there can be a wide variation. Charities that rely on many relatively small donations often score lower on this metric, especially if they utilize a lot of direct mail or telephone solicitations. Charities that advertise for donations, especially on television, are likely to score low as well. On the other hand, charities that get significant sums from large gifts-in-kind usually score very high. Forbes considers any charity that scores less than 70% to be suspect on this measure alone.

Note that a charity can score higher, at times considerably higher, on charitable commitment than on fundraising efficiency. This can be true if the charity receives significant funding from sources other than private donations, such as government grants, fees for service (e.g., admission fees at museums or patient billings in the case of hospital finance) and investment income.

In such cases, total spending can be far in excess of total private donations. A simple numeric example will illustrate this point:

  1. Total spending = $1,000,000
  2. Total revenues = $1,000,000
  3. Private donations = $500,000
  4. Fundraising expenses = $100,000
  5. Management and other overheads = $50,000

In this example, fundraising efficiency is 80% ((line 3 - line 4) / line 3) and charitable commitment is 85% ((line 1 - line 4 - line 5) / line 1).

Note that, in the case of museums, for example, Forbes classifies membership fees along with admission fees. This makes sense since members receive reduced or free admission in return. Insofar as other donations trigger similar benefits in return, one could argue that a similar reclassification should be made, but this may be too complicated.

Donor Dependency: This metric is the percentage of donations needed to plug the gap (if any) between expenses and all other sources of revenue.

For organizations with large endowments, this ratio can swing dramatically from year to year, depending on investment returns. Likewise for nonprofits heavily dependent on government grants that fluctuate significantly over time.

A ratio of 100% (as in the example above) exists when the charity breaks even, with total expenses equal to total revenues (including donations). Donations filled the funding gap precisely.

A ratio over 100% indicates that the charity ran a deficit, and needed, even more, donations than it got. Thus, a ratio of 140% means that the charity needed 40% more donations to break even.

A ratio of 100% indicates that the charity was in surplus, with only part of the donations needed currently. The recent average donor dependency ratio was 84% for the charities listed by Forbes, meaning that 16% of donations, on average, were put aside for future use.

A negative ratio indicates that the charity (most likely a hospital or museum) was in surplus even with no private donations at all. Nonprofits in this situation frequently complain to Forbes about this metric, because it exposes them as begging for funds that they technically do not need, and which likely will only add to expense inflation (among the key issues in hospital finance, as well as regarding other nonprofits).

Apart from the situation with negative ratios, Forbes believes that using this metric to judge the worthiness of a given charity is open to wide interpretation. To some, a high ratio (>100%) represents a charity that deserves help. To others, it may indicate a nonprofit that needs some belt tightening (especially if it scores poorly on the other two measures). A low ratio (<100%) may indicate a financially prudent organization to some, or one that deserves less to others.

Note that the explanation of the donor dependency ratio given in Forbes is misleading, and has not been changed despite past communications from this author to them on the subject. They describe it as simply the ratio of total expenses to total revenues, but that would never produce a negative ratio, for one.