April 15, 2002
We base our evaluations on the financial information each charity provides in its informational tax returns, or IRS Forms 990. We use that information to analyze a charity's financial performance in seven key areas, described below, that assess its financial efficiency and financial capacity. After analyzing those performance metrics, we compare the charity's performance with the performances of similar charities. We then assign the charity a converted score ranging from zero to ten in all seven performance metrics, as well as a rating for its overall financial health.
A more detailed discussion of our financial rating system follows. For more information on the scales we use to assign financial health ratings, please visit our Financial Ratings Tables.
Analyzing a charity's financial efficiency reveals how well it manages its finances day to day. Charities that are financially efficient spend less money to raise more. Their fundraising efforts stay in line with the scope of the programs and services they provide. They keep administrative costs within reasonable limits. They devote the majority of their spending to the programs and services they exist to provide.
Four of the 7 financial performance metrics that we analyze are about a charity's financial efficiency: program expenses, administrative expenses, fundraising expenses, and fundraising efficiency.
Performance Metric 1: Program Expenses
Charities exist to provide programs and services. They fulfill the expectations of givers when they allocate most of their budgets to providing programs. Charities fail givers expectations when their spending on programs is insufficient. To evaluate a charity's program expenses, we divide its program expenses by its total functional expenses. Charity Z spends $2.5 million on program expenses, compared with its overall operating budget of $3.5 million. Thus, Charity Z spends 71.4% on program expenses. We score a charity's program expenses using the conversion scale listed in our Financial Ratings Tables.
Performance Metric 2: Administrative Expenses
As with successful organizations in any sector, effective charities must recruit, develop, and retain talented people. At the same time, they ensure that these administrative expenses remain reasonable and in line with the organization's total functional expenses. Here again, we calculate a charity's administrative expenses by comparing them to its total functional expenses. Charity Z spends $500,000 on administrative expenses, compared with $3.5 million in total functional expenses. Thus, Charity Z spends 14.3% on administrative expenses. Again, we use the scale listed in our Financial Ratings Tables to score a charity's administrative expenses.
Performance Metric 3: Fundraising Expenses
Charities spend money to raise money, but they do not exist to raise money. Givers support charities for their programs and services, not for their ability to raise money. Charities should ensure that fundraising expenses stay in line with the charity's total functional expenses. We evaluate a charity's spending on fundraising by comparing it with the charity's overall spending. That is, we divide a charity's fundraising expenses by its total functional expenses. Charity Z, which spends $500,000 on fundraising and $3.5 million in expenses overall, spends 14.3% on fundraising. We score a charity's fundraising expenses using the corresponding conversion scales listed in our Financial Ratings Tables.
Performance Metric 4: Fundraising Efficiency
Charities spend money to raise money. Financially effective charities must in part be efficient fundraisers, spending less to raise more. We calculate a charity's fundraising efficiency by determining how much it spends to generate $1 in charitable contributions. In other words, we divide a charity's fundraising expenses by the total contributions it receives. For example, Charity Z, with fundraising expenses of $500,000 and total contributions of $3.4 million, has a fundraising efficiency of $0.147, which means it spends 14.7¢ to raise $1. After calculating a charity's fundraising efficiency, we convert the results to a numerical score ranging from 0 to 10. Our conversion scales for fundraising efficiency are provided in our Financial Ratings Tables.
Indirect Cost Allocation Adjustment
The IRS requires charities to allocate their expenses into three categories: Program, Management/General, and Fundraising. The vast majority of organizations we evaluate allocate costs directly, the simplest and most transparent technique for fulfilling this requirement. A few use indirect cost allocation for some or all of their accounts, entering all their expenses for those accounts into one category, and then reversing out the expenses that belong to other categories in a single line item. In most cases, this technique can be a legitimate method for handling particularly complicated accounting systems; however, we have seen organizations push the envelope when reporting in this manner, using it as an opportunity to artificially inflate their program expense total. In an effort to treat all evaluated organizations consistently and fairly, we factor out indirect cost allocations where sufficient financial documentation and a reasonable description for the basis used to determine such allocated costs have not been provided to us.
Joint Cost Allocation Adjustment
Consistent with Generally Accepted Accounting Principles (GAAP), some organizations that follow SOP 98-2 or ASC 958-720-45 report a portion of their specific joint costs from combined educational campaigns and fundraising solicitations as program costs. The IRS requires that these organizations disclose the allocation on the Form 990. In most cases, charities utilizing this technique allocate a small percentage of their solicitation costs to program expenses from fundraising expenses. However, we believe that donors are not generally aware of this accounting technique and that they would not embrace it if they knew a charity was employing it, nor does Charity Navigator. Therefore, as an advisor and advocate for donors, when we see charities using this technique we factor out the joint costs allocated to program expenses and add them to fundraising. The exceptions to this policy are determined based on a review of the 990 and the charity’s website (in some cases we review data provided to us from the charity directly). We analyze these items to see if the organization’s mission includes a significant education/advocacy program or other type of program that would directly be associated with joint costs. If that is the case, we inspect in further detail the charity’s expenses in regards to those specific programs. Finally, we review the charity’s website to confirm that there is clarity for a potential donor that the organization in question employs the types of programs that entail joint cost activity.
We analyze a charity's financial capacity to determine how well it has sustained its programs and services over time, and whether it can continue to do so, even if it loses support or faces broad economic downturns. By doing so, we show givers how well that charity is positioned to pursue long-term, systemic change. Charities that show consistent growth and maintain financial stability are more likely to continute to provide services for years to come. They have the financial flexibility to plan strategically and pursue long-term objectives, rather than facing flurries of fundraising to meet payrolls and other short-term financial obligations. These charities can more ambitiously address our nation's challenges, envisioning and working toward long-term solutions.
Three of the 7 financial performance metrics that we analyze are about a charity's financial capacity: primary revenue growth, program expenses growth, and working capital ratio.
Givers should know that other independent evaluators of charities tend not to measure a charity's capacity. Indeed, charities that maintain large reserves of assets or working capital are occasionally penalized by other evaluators. In our view, a charity's financial capacity is just as important as its financial efficiency. By showing growth and stability, charities demonstrate greater fiscal responsibility, not less, for those are the charities that will be more capable of pursuing short- and long-term results for every dollar they receive from givers.
Performance Metrics 5 and 6: Primary Revenue Growth and Program Expenses Growth
As do organizations in other sectors, charities must grow over time if they are to sustain their programs and services. For charities, growth means first, increasing their primary revenue, which includes contributions from corporations, foundations, individuals, and government grants; program service revenue, contracts and fees; and revenue from membership dues and fees. Second, growth means growing their programs and services. Organizations that demonstrate consistent annual growth in both primary revenue and program expenses are able to outpace inflation and thus sustain their programs year to year. These organizations also supply givers with greater confidence by maintaining broad public support for their programs.
Charity Navigator analyzes a charity's average annual growth of primary revenue and program expenses over its four most recent fiscal years. We recognize that just like organizations in other sectors, charities engage in certain non-recurring activities that generate unsustainable spikes in their revenues. Such activities can include capital campaigns or endowment drives. Similarly, the start-up period for relatively new organizations represents an unsustainable pattern of growth. When we determine that an organization has engaged in these non-recurring and unsustainable activities in the first of the four years over which we evaluate the organization, we will expand the data we evaluate to five years. If a fifth year is unavailable, we alternatively reduce the data we evaluate to three years.
Once we determine the interval over which we will evaluate an organization, we use the standard formula for computing annualized growth: [(Yn/Y0)^(1/n)]-1, where Y0 is the value measured in the first year of the interval analyzed, Yn is the value measured at the end of the interval analyzed, and n is the length of the interval in years. (The growth interval, represented by 'n' in the equation, is actually only 3 when we are using four years of data such as 12/31/2010 to 12/31/2013.) We then evaluate the charity using the corresponding scales listed in our Financial Ratings Tables.
Performance Metric 7: Working Capital Ratio
Charities depend upon their reserves of liquid assets to survive downward economic trends and sustain their existing programs and services. If a charity has insufficient working capital, then it faces the difficult choice of eliminating programs or staff, amassing debts and liabilities, or dissolving. On the other hand, when giving flows, those charities that build working capital develop a greater capability for expanding and improving their programs.
We analyze a charity's working capital ratio by determining how long it could sustain its current programs without generating new revenue. To obtain this ratio, we divide the charity's working capital by its total expenses, including payments to affiliates, for the most recent fiscal year. For example, Charity Z holds $5.4 million in working capital. Its total expenses for the most recent fiscal year are $3.6 million, including a $100,000 payment to an affiliate for its national dues. Thus, it has a working capital ratio of 1.5 years. We score a charity's working capital ratio using the corresponding conversion scales listed in our Financial Ratings Tables.
As with each of our other six performance metrics, we calculate a charity's working capital using the information supplied on the charity's most recently filed Form 990. We include in this calculation net available assets. This includes unrestricted and temporarily restricted net assets, and excludes permanently restricted net assets. For evaluations based on fiscal years ending prior to 12/31/08, working capital includes only the following assets and liabilities: cash, savings, accounts receivable, grants receivable, pledges receivable, investments in securities, accounts payable, accrued expenses, and grants payable.
Assigning Financial Scores and a Financial Health Rating
After evaluating a charity in each of the seven performance metrics described above, we convert the charity's raw score to a numerical score ranging between 0 and 10. We calculate an overall score for each charity's financial health by combining its scores in each of the 7 performance categories and adding 30 points (to convert the scores to a 100 point scale). We then assign the charity a Financial Health rating by using the table listed in our Financial Ratings Tables.
Scoring Uniquely Functioning Causes
Charity Navigator is committed to judging all charities fairly. We work diligently to adjust our ratings to take into account the unique circumstances facing certain types of charities. Those adjustments are embedded in the way we score each performance metric. Thus, the rating and score we assign each charity for overall financial health accounts for the way different kinds of charities function. Consequently, we believe our ratings and scores are fair to all charities.
How do we adjust or normalize our scores in individual performance categories for certain charity types or Causes? Before arbitrarily deciding what is acceptable in each of our performance categories, we continue to study the way non-profits function financially. We adjust our scales whenever our ongoing research gives us a compelling reason to do so. Over time, we have learned that although most kinds of charities function in financially similar ways, charities in certain Causes function in financially unique ways. Because we aim to compare apples to apples and not to oranges, we score those uniquely functioning Causes differently.
For example, due to the nature of their enterprise, food banks require very little working capital to remain sustainable; conversely, community foundations typically maintain several years worth of working capital. In the working capital ratio metric, we score charities in these two Causes very differently. Similar adjustments exist for other Causes and in other performance categories.. Those adjustments can be analyzed in the scales listed in our Financial Ratings Tables.
Ratings vs. Rankings
Our ratings are not rankings. We do not identify the best performing charity in each of our performance categories. Nor do we assign ratings to charities based on where they fall in a top-to-bottom ranking, so that a charity's score in a metric is equal to its rank. We believe that rating charities according to rankings would mislead givers and treat charities unfairly.
Instead of ranking charities, our ratings are qualitative designations. After analyzing how more than 7,500 charities function financially, we define qualitatively distinct ranges of financial performance. For example, with the exception of Public Broadcasting and Media charities (see our Financial Ratings Tables for an explanation), we believe that charities which spend less than 10% of their budgets on fundraising all perform in a financially exceptional way. Whether they spend 1% or 9%, we score all of those charities equally assigning a score of 10 in that metric.