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A discussion about financial ratios
The information on the charity’s summary page provides important clues about whether donations to the charity are being used as donors intended, but it does not tell the whole story. While most donors understand that running a charity requires some administrative and management costs, many do not have an objective standard for appropriate costs.
It may help to know that the BBB Wise Giving Alliance (www.give.org), affiliated with the Council of Better Business Bureaus, has established a set of non-binding Standards of Charitable Accountability as a guide to evaluating the efficiency of fundraising campaigns. According to its website, the Standards for Charity Accountability were developed with professional and technical assistance from representatives of small and large charitable organizations, the accounting profession, grant-making foundations, corporate contributions officers, regulatory agencies, research organizations and the Better Business Bureau system. The BBB Wise Giving Alliance also commissioned independent research on donor expectations to ensure that the views of the general public were reflected in the standards. Some of the key standards that may interest potential donors include:
Charities should spend at least 65% of total expenses on program activities (total program service expenses divided by total expenses should be at least 65%).
Charities should spend no more than 35% of related contributions on fund raising (total fundraising expenses divided by total related contributions should be no more than 35%). Related contributions include donations, legacies, and other gifts received as a result of fundraising efforts.
Charities should avoid accumulating funds that could be used for current program activities. To meet this standard, the charity's unrestricted net assets available for use should not be more than three times the size of the past year's expenses or three times the size of the current year's budget, whichever is higher.
Make available to all, on request, complete annual financial statements prepared in accordance with generally accepted accounting principles.
Include in the financial statements a breakdown of expenses (salaries, travel, postage, etc.) that shows what portion of these expenses was allocated to program, fundraising, and administrative activities.
Accurately report the charity's expenses, including any joint cost allocations, in its financial statements. For example, audited or unaudited statements that inaccurately claim zero fundraising expenses or otherwise understate the amount a charity spends on fundraising or overstate the amount it spends on programs will not meet this standard.
The American Institute of Philanthropy (AIP) (www.charitywatchdog.org) is another well-known charity watchdog that makes very similar recommendations, including:
A charity should spend 60% or more of its total expenses on its charitable programs, with the remaining percentage being spent on fundraising and general administration.
It should not cost more than $35 to raise $100 of funds (total fundraising expenses divided by total related contributions should be no more than 35%). AIP defines related contributions as money that is brought in as a result of fundraising activities. AIP is critical of charities that erroneously compare their cost to raise money with total income, which, according to AIP, can include patient revenue, investment income, sales proceeds and other items that are not affected by fundraising outlays. AIP says this faulty comparison often makes a charity’s fundraising efficiency appear better than it actually is.
AIP examines a charity’s reserves of available assets to determine how long it could continue to operate at current levels without any additional fundraising. It defines a charity’s “years of available assets” as funds currently available for the charity’s use, including investments that the charity has set aside as a reserve but could choose to spend if it wanted to. AIP recommends a reserve of less than three years and gives a failing grade to the “least needy” groups with reserves of more than five years, believing that the public’s donations are most urgently needed by charities that do not have large reserves of available assets.
The Secretary of State has provided links to additional charity watchdog groups, such as Charity Navigator, Wall Watchers’ Ministry Watch, and the Evangelical Council for Financial Responsibility on our Helpful Links page. These frequently-cited industry standards for evaluating charities are very useful tools, and they are an important part of the picture, but attempts to objectively measure the efficiency of charitable organizations should be placed in context.
As Chuck McLean and Suzanne E. Coffman of Philanthropic Research, Inc. (GuideStar) point out in a June, 2004, article posted on the GuideStar website (www.Guidestar.org), several factors can affect a charity’s expenses, such as its size, age, mission, and location. For example, a charity in an area with a high cost of living will need to pay more for office space, supplies, and salaries than a comparable organization in a less costly area. They advise that ratios are helpful when you are comparing organizations of similar size and age that are located in the same area or similar locales and have similar missions and programs, and when you are tracking an individual nonprofit's progress over time. As an example of the problem of comparing organizations with very different missions, they compared the program service ratio of a neighborhood food bank (95%) to that of a local art museum (72%). If a potential donor did not know that the median program service ratio for art museums is 71% and for food banks is 94%, comparing the two organizations on this criteria alone would not result in a wise giving decision.
Special circumstances can also affect a charity’s ratios. As McLean/Coffman point out, an organization that is trying to establish an endowment, in the short run, will see its fundraising ratio rise and its program ratio fall. In the long run, however, a successful endowment drive may enable the charity to spend more on programming and less on fundraising.
Here are some questions you might ask that could provide more perspective regarding financial ratios:
- Is this a newly-created organization? Younger organizations usually have lower program service ratios than more mature organizations.
- What is the organization’s mission, and are you comparing it to similar organizations? Some types of services require more overhead than others. Is there a stigma associated with the cause or environmental or political events beyond the organization’s control?
- What are the organization’s sources of revenue? For example, does it rely on foundation grants or on many small contributions?
- Is it involved in a capital campaign or building an endowment?
- Are there donor restrictions on the use of funds or exceptional bequests?
The financial ratios presented on the Secretary of State’s website, when considered alongside all of the information disclosed by the charity over time, can provide valuable insights, but they should not be used in isolation to approve or condemn a charity. They do not measure the impact of an organization’s programs or services. Since quantifiable outcome measures are lacking for the sector, if the financial ratios look off, donors should inquire further with the charity. Dig into the details of its Form 990s, which are also available on our website, and call the charity to ask how its programs are run. Remember that the best way to decide which organization deserves your financial support is to know its programs and know the people running the charity, know other people who are involved with it, or be involved with it yourself.