Nonprofit Blog

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Thursday, June 2, 2011

Evaluate Nonprofit Organizations Before Donating

Posted by Armanino Nonprofit Team

The impact of the poor economy has taken a toll on charitable organizations, causing the relationship between grant makers and charities to become more “businesslike.” Savvy grant makers are much more strategic about giving than in the past. They’re also performing what amounts to financial due diligence with respect to their giving and with good reason: many charities are failing, endowments have shrunk and individuals have cut back on giving. Here’s a primer for grant makers to guide them in their effort to use funds wisely.

The last thing a giver wants is to see is a donation squandered by a mismanaged or fraudulent charity. That’s why grant making foundations and individual contributors are evaluating whether the non-profit organizations they are giving to are well managed and effective in the distribution of resources.

While a contributor is generally providing donations to support worthy needs, there are many who fail to create systems to properly evaluate the management of charities. Whatever you do, don’t base your giving decision on emotion.

Organizing for effective giving
To organize for effective giving, foundations should create a point person, preferably someone with a financial background, to set up and manage a process that allows them to identify and eliminate troubled organizations. If giving is done by a family or committee, having a thorough checklist or screening process is also important.

For a charity, it is important to demonstrate to potential donors that your organization is managing its finances securely and reliably and then finding ways to transparently showcase that capability to donors. For donors, it means choosing a charity that follows these principals and that can demonstrate it has good financial controls and management.

The process takes time and donors must be patient as they assess their efforts to distribute resources. Here are some of the tools that donors can use to perform due diligence on potential charities:

Tax returns – All exempt organizations are required to make their tax returns available upon request. Donors can even access most 501(c)3 organizations’ tax returns online at www.guidestar.org.

Financial statements – Donors can also request a copy of an organization’s financial statements. Any good organization will provide financial statements upon request. Obviously, if the organization refuses or cannot provide financial statements, it may be a big red flag.

With this information, donors can better understand the financial viability of an organization. In acquisitions, due diligence is crucial. An investor or potential buyer looks at the company’s financials, management style, history and many other factors to make a decision. Here is some additional detail that can help you get started with a checklist of documents that you will need to perform thorough due diligence on non-profit organizations:

Statement of Functional Expense – All non-profit organizations are required to annually file a Form 990 with the IRS. The form is informational, and is intended to help the IRS determine whether the organization should continue its non-profit tax exempt status. The functional expense statement can be found in Part IX of the Form 990 and it breaks out an organization’s expenses between program service, G&A and fundraising. A general standard is that the organization should be spending at least 75 percent of its funds on program services.

Schedules J and L of the Form 990 – These schedules are good indicators of organizational integrity. Schedule J reports compensation information for officers, directors, trustees, key employees and the highest compensated employees. On this form, you can also find out what types of benefits are paid to these persons and how compensation packages are established. Schedule L reports transactions with interested persons, such as loans to executives or board members. It also reveals potential conflicts of interest. For instance, whether the president’s husband’s engineering firm contracts with the organization. While there are often solid business reasons for these transactions, they still require public inspection and could be indicators of problems.

Auditors Opinion of the Financial Statements – If you obtain a copy of the organization’s financial statements, turn first to the auditor’s opinion page. Here you’ll find whether, in the independent auditor’s opinion, the financial statements are presented fairly in all material respects. If the opinion states otherwise, be sure to find out why. Deficiencies in financial reporting are good cause to reconsider an organization’s worthiness. Also be on the lookout for the auditor expressing doubt about an entity’s ability to continue as a “going concern.” This means the auditor doubts the organization’s ability to continue forward. For some, this may be cause to donate more, whereas for others, it may lead the search to other more financially viable organizations that do the same thing.

Financial Ratios – As a grantor, you can use ratios to evaluate the financial health and effectiveness of a charity. These include:

• Current ratio; helps to assess liquidity in a statement of current assets and liabilities. A rule of thumb in the for-profit world is that a minimum safety net requires current assets be at least twice that of current liabilities. Therefore you’d hope to see a current ratio around or above 2.

• Debt-to-equity ratio: helps assess long term solvency and stability by comparing total liabilities with total net assets. Find this in Part X of the 990. It compares resources provided by creditors with resources provided by donors, endowments and / or program services. The higher the ratio, the greater the creditor claims on assets (which would include your cash donation). It also can indicate the charity is paying higher rates of interest which means more funds are used to service debt than going toward services.

• Fundraising cost to raise one dollar of donation: this is a calculation of the cost of raising funds. This is found on line 1h of Part VIII of the 990. Generally, this amount should be lower than $0.35.

• Temporarily restricted cash ratio: this helps assess whether or not the charity will have enough cash to cover promised actions per the donor’s intended earmarks. This information is also found on Part X of the 990 and is an important tool for donors. Temporarily restricted net assets generally consist of revenues from foundations and other donors. The organization has an obligation to utilize those dollars in accordance with donors’ intent and not to “float itself” cash until unrestricted cash comes in. Any percentage below 100 percent means the organization is borrowing cash from its temporarily restricted net assets and is a sign or organizational distress.

These indices are the beginnings of a systematic approach to due diligence on a non-profit or charity. Donors who are just beginning to put these tools in place should seek the advice of a Certified Public Accountant who can assist in helping them build a systematic method for evaluating potential recipients.

Charities should also take heed: If you want to make your organization more attractive to potential donors, transparency is key. You don’t want to appear to be hiding anything when you’re in the market for donations.

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