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Financial Ratios, Babies, and Bathwater

February 05, 2010

(Dahna Goldstein is the founder of PhilanTech, LLC. This is her first post for PhilanTopic.)

Bathwater_main The nonprofit sector has been abuzz the last few weeks with talk of abandoning financial ratios in favor of program information to evaluate the impact of nonprofit organizations. The renewed focus on program measures was partially spurred by a joint press release issued by GuideStar, Charity Navigator, GreatNonprofits, and others.

There's no question that program information is essential in evaluating nonprofit performance and impact. But let's not get carried away.

There are good reasons to reject expense ratios as a tool for judging nonprofit performance, and they have been well documented (including here and here). I completely agree. It was, in part, the misplaced focus on expense ratios that led my company to team up with an expert in nonprofit finance several years ago to build a better financial analysis tool for the sector.

Many states require nonprofits to audit their financial statements. But while the quality of prepared and audited financial statements varies widely, much can be learned about an organization's financial health and stability by reading its audited statements and performing a few simple calculations. One can learn, for example, how many months operating reserves the organization has (a recent study showed that 53 percent of nonprofits in the Washington, D.C., area have less than three months, a significant vulnerability in these challenging economic times). Prospective donors also can see how quickly an organization pays its expenses, how well it is able to service any debt it has, and how much money raised in excess of expenses is available for investment in the organization's sustainability and growth. There's a wealth of information available -- if you know where to look.

Not everyone has the time or knowledge to analyze nonprofit financial statements. That's where our financial analysis tool -- and other tools like it -- can help. Based on nonprofits' financial statements, these tools typically produce a series of analyses that provide a detailed view of an organization's performance without presupposing specific financial analysis skills on the part of the person using them.

True, financial evaluation is only one tool in the nonprofit evaluation toolkit. But it's a critically important one as you make your donation decisions. A nonprofit that is doing great work but barely has enough cash on hand to sustain its operations is not likely to be an organization in which you'll want to invest. Or, maybe, if you believe in the organization's work, you'll decide to go all in and give it a larger donation with an eye to helping it survive. In either case, rigorous financial analysis can help you make an informed decision.

As the sector continues to explore ways in which program information can be used to evaluate nonprofits and help drive the more efficient allocation of scarce resources, let's be careful not to throw out the financial baby with the expense-ratio bathwater. And remember: Informed donors are effective donors.

(Original artwork: Patrick Gannon)

-- Dahna Goldstein

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