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Why Ratios Aren't the Last Word

About Ratios in General 

We've all heard stories about financial abuses at specific charities—concern about nonprofit wrongdoing has even drawn Congressional attention. Some donors and charity watchdogs advocate using financial ratios to evaluate charities and ferret out the ones that are using their funds inappropriately. These groups and individuals argue that any organization whose ratios fall below certain levels should be regarded with suspicion.
There's no question that nonprofit organizations have an obligation to manage their finances responsibly. There's also no question that ratios can be valuable tools for evaluating charitable groups. By themselves, however, these figures can be more misleading than helpful.

Take program ratio—the percentage of an organization's total expenditures that is devoted to programs and services—as an example. A number of things, such as size, age, and location, affect a nonprofit's expenses. (For example, a nonprofit 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. For a discussion about nonprofit size and age, see How to Calculate Ratios, below, and Renata J. Rafferty, "Risk and Return: Defining Your 'Comfort Zone'.")

An organization's mission is even more important in determining its costs. Say you are thinking of contributing $100 to either a local art museum or a neighborhood food bank. From the organizations' financial pages on GuideStar, you calculate that the art museum spends 72 cents of every dollar on programs, whereas the food bank spends 95 cents of every dollar on programs. Obviously, the food bank is the more efficient organization and will put your donation to better use. Right?

Not necessarily. The median program ratio for art museums is 71 percent, and the median program ratio for food banks is 94 percent. Thus, both the art museum and local food bank are slightly above the middle of their respective peer groups.

Why is there such a difference between the two medians? Typically, art museums have higher overhead costs (such as insurance, building maintenance, security) and fundraising expenses than food banks.

At GuideStar, we believe that the ultimate test of an organization's efficiency is how well it performs its mission. Unfortunately, this criterion is not always reflected in ratios of any kind. Look, for example, at the following two hypothetical organizations that provide job training to people about to go off welfare.

For the purposes of this exercise, let's say that the two nonprofits teach the same skills, are the same size and age, and are located in similar areas. The only real differences are that Organization B provides more intensive training on how to be a valuable employee—office etiquette, problem solving, effective communication—than Organization A, and that Organization B sponsors support groups for clients who have made the transition from welfare to the working world.

  Organization A Organization B
Total Expenditures $100,000 $100,000
Expenditures on Programs and Services $90,000 $70,000
Program Ratio 90 70
Number of Clients Trained Each Year 85 65
Number of Clients Placed in Jobs at End of Training 76 55
Starting Salary $10.00/hour $10.00/hour
Number of Clients Still Employed after 2 Years 30 50
Average Salary of Clients Still Employed after 2 Years $12.50/hour $15.00/hour

Which organization is more effective? If the nonprofit's goal is to give as many people as possible the chance to succeed by providing job training and placement, Organization A is the "better" organization. If the organization's goal is to enable each client to get, retain, and advance in a job, then Organization B is the "more efficient" nonprofit.

When Ratios Are Useful 

So when is it appropriate to use ratios to evaluate nonprofit organizations? GuideStar advises 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 that have similar missions and programs.
  • When you are tracking an individual nonprofit's progress over time.
Without this contextual information, we believe that ratios can be misleading and even destructive.

Even in these situations, we urge caution in using ratios. Accounting practices among nonprofits vary widely, so that what appear to be discrepancies in the ratios for different organizations might merely reflect divergent accounting methods.

Special circumstances can also affect a nonprofit's ratios. Perhaps the organization is trying to establish an endowment. In the short term, its fundraising ratio will rise and its program ratio will fall. In the long run, however, a successful endowment drive could enable the nonprofit to spend more on programming and less on fundraising.

How to Calculate Ratios 

Subscribers to GuideStar Analyst Reports can use that service to find ratios for particular organizations. If you are not a subscriber and would like to use ratios as part of your overall assessment of different nonprofits, you can use the financial data from the organizations' GuideStar Report to calculate the following ratios.

Accounts Payable Aging Indicator

(Accounts Payable x 12) ÷ Total Expenses

The accounts payable aging indicator may shed light upon the credit-worthiness of the organization. The lower the indicator, the faster the organization pays its bills.

Contributions and Grants Ratio

(Contributions + Grants) ÷ Total Revenue

The contributions and grants ratio indicates the extent of the organization's dependence on voluntary support by calculating the percentage of total revenue made up by contributions and grants.

Debt Ratio

Total Liabilities ÷ Total Assets

The debt ratio indicates an organization's financial solvency by measuring the relationship of its total liabilities and debt to its total assets. Higher ratios could indicate financial problems in the future.

An organization's debt ratio may be distorted if it carries a high proportion of "grants payable" or "grants receivable" on its balance sheet. Grants payable—the unpaid portion of grants and awards that the organization has committed to pay other organizations or individuals—are carried as liabilities on the balance sheet. Grants receivable—funds pledged to the organization by government agencies, foundations, and other organizations—are carried as assets on the balance sheet.

Fundraising Ratio

Fundraising Expenses ÷ Total Expenses

The fundraising ratio measures the relationship between fundraising expenses and the organization's total expenses. Fundraising costs are noted on Form 990 in Part I, line 15. They are not noted on Form 990-EZ.

The fundraising ratio is perhaps the least useful of the ratios for several reasons. First, there is ample evidence that nonprofits do not report fundraising expenses reliably—about 60 percent of the public charities that file a Form 990 report no fundraising expenses at all. Second, unique circumstances facing a nonprofit might make its fundraising ratio higher or lower than that of another organization. For example, nonprofits that can rely largely on foundation funding will have much lower fundraising costs than organizations that must raise money through many smaller contributions.

Liquid Funds Indicator

([Fund Balances - Permanently Restricted - Land, Buildings, and Equipment] x 12) ÷ Total Expenses

The liquid funds indicator measures an organization's operating liquidity by dividing fund balances (other than an effectively frozen endowment and the land, building, and equipment fund) by an average month's expenses. These are the financial resources a nonprofit may legally and reasonably draw down. A high liquid funds indicator could point to low cash-funding urgency and excessive savings.

Program Ratio

Program Service Expenses ÷ Total Expenses

The program ratio measures the relationship between program expenses (funds a nonprofit devotes to its direct mission-related work) and the organization's total expenses.

Younger organizations might have lower program ratios than more mature organizations as they set about building the infrastructure to support their mission. Also, some types of services simply require more overhead than others. Over time, organizations should strive to achieve ever-higher program ratios, devoting as many of their resources to "program activity" as possible.

Savings Ratio

(Total Revenue - Total Expenses) ÷ Total Expenses

The savings ratio reveals the rate of the nonprofit's savings by measuring the relationship between total annual savings and total expenses. Although the savings ratio is an important component of longevity, high ratios may indicate excessive savings.

The savings ratio should be considered in combination with the liquid funds indicator. If the nonprofit has low liquid funds, a higher savings ratio may be desirable.

suzanne-coffman-150x150.jpgThe preceding post is by Suzanne Coffman, GuideStar’s editorial director. See more of Suzanne’s sector findings and musings on philanthropy here on our blog. 
Topics: Finance GuideStar