Step-by-Step Guidance to Evaluating a Charity

William P. Barrett, Contributor, Forbes

December 21, 2015

For a would-be donor, evaluating a charity–big or small–is not easy. The latest available data is often dated. Metrics for measuring results and accomplishments are subject to outrageous spinning by the charity itself. On top of that, it appears a surprising number of folks are willing to pledge funds to outfits whose paid telemarketers cold-call on the phone and somehow don’t mention that 90% of the gift will go not to the charity but to the fundraiser–and that’s assuming the charity is legitimate in the first place. (Please note this is a fundraising efficiency ratio of 10%, which is very bad.)

But there are ways. The trick is to look for information–hello, Google–ask a lot of questions, and think before giving money.  And the annual Forbes list of the 50 largest U.S. charities can help. The Forbes list is quantitative, based on hard numbers. It’s not judgmental, although over the years we’ve bounced a few nonprofits for sketchy accounting. But the evaluative techniques for the largest charities in the land are just as valid when looking at far-smaller ones, and a good place to start.

First, some basics. The metric for making the Forbes list is the amount of private donations  received in the latest available year. The gifts can come from individuals, corporations, other nonprofits and estates, but not governmental agencies. Moreover, the largess can be in cash, stock and goods (called gift-in-kind). But this is charity, and the donations to be counted by us have to be of the no-strings-attached variety with nothing in return except the satisfaction of supporting a good cause. So we exclude membership dues from, say, a museum, figuring that the membership is getting something back such as a reduced admission price. And that admission price isn’t a donation, but a fee for service, like a bill from a hospital for services rendered.

Besides government grants and fee for service, our definition of private donations excludes fee for goods (like Girl Scout cookies) and investment returns.

Since our roster is aimed at would-be donors among the public, certain kinds of nonprofits are ignored altogether. These include academic institutions, which generally solicit only from their alumni; donor-advised funds (which administer gifts for many different individual donors, each with their own account), and religious groups that don’t provide information. Also ignored are nonprofits with few direct donors (virtually all private foundations), and charities that get most of their gifts indirectly via community-chest-like fundraising drives run by others.

Our basic data is generally drawn from the charity’s own accounting, as expressed in official filings, tax returns, its own website or answers on a survey form we send out annually.

For each charity we calculate several measures of financial efficiency, and the direction of the change, if any, from the prior period. Here at Forbes we consider financial efficiency important, but far from the only factor to be considered. Overhead, which is a component of these calculations, is not all bad. Charities need to pay for office staff, rent and, yes, accountants. The problem arrives when these ratios get seriously out of whack, as will be explained below.

Here we repeat our annual warning: Do not compare efficiency ratios for different kinds of charities. The metrics for a foreign-aid charity cannot be meaningfully compared with that of, say, a hospital or a museum. Take our word on this.

Here’s where looking at ratios can be useful. Say you’re considering donating to one of two charities in the same sector. Charity A has far better efficiencies than Charity B. Ask Charity B why it thinks it is doing a better job than Charity A. And if Charity B doesn’t get back to you, give elsewhere.

Thinking about donating to one of the 1.5 million smaller charities not on our list of 50? Find one on the list in the same line of work and compare those ratios to the charity you are eyeing. Then ask questions.

Especially for smaller charities, useful financial information for evaluation can be found on the IRS Form 990 (in Parts VIII and IX), an audited financial statement or an annual report. Form 990s can be downloaded for free from GuidestarFoundation Center, and, increasingly, the charity’s own website, although there you may have to look around.

The three financial efficiency ratios that Forbes calculates are these:

CHARITABLE COMMITMENT. This figures out how much of a charity’s total expense went directly to the charitable purpose (also known as program support or program expense), as opposed to management, certain overhead expenses and fundraising. On the IRS Form 990, the calculation is Part IX line 25(B) divided by Part IX line 25(A). The weighted average this year is 87%. Charities that get most of their donations as gift-in-kind tend to do better here, because the individual gifts are larger, entail little or no fundraising expense and have looser valuation rules. Charity watchdogs like the Better Business Bureau Wise Giving Alliance look askance at a charitable commitment ratio of less than 65%.

FUNDRAISING EFFICIENCY.  This shows the percentage of private donations left after subtracting the costs of getting them. On the IRS Form 990, the calculation is Part VIII lines 1a + 1c + 1f+ 8c minus Part IX line 25(D), divided by Part VIII lines 1a + 1c + 1f+ 8c.  The weighted average for all 50 charities is 92%, meaning that it cost 8 cents to raise $1. But this is an average of wildly differing kinds of charities with wildly different fundraising tactics. Relying on fewer but larger donations and perhaps expansive valuations, some gift-in-kind charities look very efficient, with ratios of 100% (rounded) or very close. At the other end are charities that use expensive direct-mail and telephone solicitation. Fundraising efficiency here can be as low as 10% and is a scandal. While some charity watchdogs consider 65% to be the bottom of respectability, at Forbes we draw the line at 70%. Fortunately, no one on the list this year falls below that level.

DONOR DEPENDENCY.  This is a quirky ratio, measuring how badly a nonprofit needed contributions to break even. On the IRS Form 990, the calculation is Part VIII lines 1a + 1c + 1f + 8c plus Schedule D Part XI line 2a minus Part I line 19 (current year), all this divided by Part VIII lines 1a + 1c + 1f+ 8c plus Schedule D Part XI line 2a. (Hey, we didn’t say this was simple.) A ratio of 100% means revenues equaled expenses. A higher ratio than 100% means the charity had more expenses than revenue. It’s also possible to have a negative ratio, which means the charity (often a hospital or museum) had an annual surplus greater than all private donations! The average for the list is 81%, meaning that the typical charity was able to bank 19% of donations for the future. This ratio is highly sensitive to investment results and for many charities varies wildly from year to year. For the other two ratios, all other things being equal, the higher the ratio the better. But the importance of donor dependency really depends on the donor. If the goal is to give to poor and needy charities, a rating above 100 is good. On the other hand, if the search is for charities that better stand on their own, a rating below 100 is better. This ratio tends to smoke out charities pleading for money that actually have substantial financial reserves or other kinds of revenue.

This article was written by William P. Barrett from Forbes and was legally licensed through the NewsCred publisher network.

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