Financial Ratios for Nonprofits - The Overhead Myth

The Overhead Myth

In a huge, positive step for the nonprofit sector, the leaders of GuideStar, Charity Navigator, and the BBB Wise Giving Alliance published a letter this week calling for an end to donors' obsession with "overhead" as the dominant measure of nonprofits' worthiness and effectiveness.

I suspect most people who read this blog are aware of the overhead ratio and how it has become a yardstick for donors.  Charity watchdogs, including Charity Navigator (which has signed onto the letter released this week) have popularized the notion that "good" nonprofits spend less than 30% of their budgets on overhead, and that "bad" nonprofits spend more than 30% of their budgets on overhead.

Rather than ranting about just how wrong this is (and how unfortunate it has been that various media outlets picked up on the notion enough that it became a commonplace misconception about the sector), allow me to quote from the letter:

"[M]any charities should spend more on overhead. Overhead costs include important investments charities make to improve their work: investments in training, planning, evaluation, and internal systems— as well as their efforts to raise money so they can operate their programs. These expenses allow a charity to sustain itself (the way a family has to pay the electric bill) or to improve itself (the way a family might invest in college tuition)."

Dan Pallotta's great TED talk addressed elements of this problem (and is worth watching, even if you don't entirely agree with either the message or the messenger).  If we want nonprofits to be successful in tackling the social and environmental issues they're working on, we (as donors and supporters) need to help them succeed.  They need to be able to effectively raise money, to invest in good technology to help them better serve their constituents, to develop their professional staff to better meet their missions.  All of those things - and more - would be considered overhead costs, but without being able to make those investments, many nonprofits are stunted.  They are not able to accomplish all that we want them to accomplish, because we are implicitly telling them that we do not value -- and therefore do not allow them to make -- investments in many of the things that will help them succeed.

We at PhilanTech have felt strongly that overhead was a poor measure of nonprofit performance for a long time, so much so that we developed a financial analysis tool in PhilanTrack for Foundations (our grantmaking software) that helps grantmakers not only evaluate the impact of their grants, but also produces a series of nonprofit financial analyses that goes much deeper into understanding how organizations are performing financials.

It's going to take a while to change public perception about overhead ratios and re-train donors to think not only about administrative costs (which are a valid thing to evaluate, just not the only thing) but also about impact, transparency, governance.  And we in the nonprofit sector owe it to ourselves to help change that perception by educating our donors, our supporters, our families, our friends.

I applaud GuideStar and the Overhead Myth for taking a lead in moving this conversation in the right direction.  I signed the Pledge to End the Overhead Myth.  I encourage you to sign it, too.

Foundations - we'd be happy to show you how PhilanTrack's financial analysis tool can help you get beyond overhead ratios in understanding your grantees' financial health and performance.  Let us know if you'd like a demo.

Author: Dahna Goldstein
June 21, 2013, 11:02 AM

Nonprofit Financial Analysis – Financial Ratios, Babies and Bathwater

Note: this post originally appeared on PhilanTopic (http://pndblog.typepad.com/pndblog/) in February 2010.

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.

 financial analysis - ratios

Author: Dahna Goldstein
June 08, 2010, 05:27 PM

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