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Rating agencies can unintentionally misinform donors about nonprofit effectiveness because they aren't measuring the organization’s ability to carry out its mission.

Financial Analysis Doesn't Tell the Full Story of Your Nonprofit’s Success

  • 5/9/2014

Donors are frequently turning to rating agencies like Guidestar to help them understand how nonprofits use their dollars. These rating agencies typically draw on audited financial statements and IRS Form 990s to help rate an organization, and prospective donors then use the third-party ratings to determine the effectiveness of the nonprofit, and ultimately, whether it is worthy of their support.

Therein lies the problem.

Rating agencies can unintentionally misinform donors about what it means to operate an effective nonprofit because they aren't measuring the organization’s ability to carry out its mission.

How a nonprofit added context to help stakeholders make more informed decisions about their investments. Case study

The measurements used by the rating agencies mirror for-profit financial reporting models that have been tweaked to show the financial health of nonprofits. However, for-profit financial models were created to measure the purpose of for-profit entities: profit.

The disconnect is clear: For-profit financials reflect profits, which attract investors; nonprofit financials fail to reflect the successes and outcomes of its programs, which is the reason to invest in a nonprofit. An organization can appear to be only marginally successful in financial terms, but still have a tremendous impact on its constituents.

For instance, measuring net asset reserves and functional expenses does not indicate how successful a charity is at carrying out its programs, such as providing meaningful and beneficial mentoring programs to children. Blanket metrics also assume that all nonprofits spend funds on the same things in the same way. But a mental health facility that employs highly educated and highly paid therapists has drastically different expense breakouts than a food pantry or a homeless shelter.

Counterbalance the numbers with your successes

Nonprofits can steer the conversation so that donors understand the context behind the numbers. By telling contributors about your program successes, you give them an opportunity to become a strategic investor who is connected to the big picture: carrying out your organization’s mission.

Here are four ways your organization can incorporate program impact data into your financial reporting:

Attach a cover letter to your financial statements

A cover letter could include program data, successes, and outcomes achieved during the year, a discussion of operations through management’s lens, and future plans for the organization. Keep in mind, the cover letter is not audited, and it is not part of the financial statements.

Add a management discussion and analysis (MD&A) section

This content could be similar to the cover letter with a few important distinctions:

  • It is included in the financial statements.
  • It is considered supplementary information (unaudited), even though auditors will review it for reasonableness.

Add programmatic measures and ratios to footnotes

Supplement financial reporting measures with qualitative program successes and outcomes achieved during the year, and a discussion of operations through management’s lens.

Remember, this section is audited because it is included in the financial statements, so organizations will need to provide documentation that substantiates the information. In addition, financial ratios should report programmatic success, such as consumers served or homes built.

Include programmatic details on IRS Form 990

Include details from the MD&A or other sources in Schedule O so donors will see your context when they look up your Form 990 on their own. This could include notes on executive pay to help explain your investment in attracting talent to move your organization forward.

There may be change on the horizon

Awareness of the flawed measurement approach is growing among the public giving community. A Stanford Social Innovation Review article identifies major issues with overhead ratios. Guidestar, Charity Navigator, and the BBB Giving Wise Alliance co-authored a letter on the topic.

Organizations like the Charity Defense Council are addressing micro- and macro-sized issues affecting the nonprofit industry as a whole. And our own managing partner, John Langan, recently argued that starving a nonprofit from overhead hurts its ability to pursue program outcomes.

You can help stakeholders understand the story behind your numbers. Add an MD&A section to your financial report, and tie these outcomes to your fundraising campaigns. Let's help the industry and its stakeholders move from shortsighted nonprofit analysis to a more comprehensive model that gives programmatic context to financial analysis.