Financial Health Criteria

The impact of a nonprofit is dependent on good governance and financial management. If a nonprofit is spending excessively on administrative and fundraising costs or lacks certain basic financial procedures and governance controls, the nonprofit is likely a poor investment of philanthropic dollars. To account for this, nonprofits who fail criteria for financial health cannot receive more than 1 star.

A nonprofit earns one star if either of the following is true:

  1. At least two of the following warning signs are present: High administrative and fundraising costs (applies to all nonprofits); no audited financial statements (for nonprofits with revenue over $2 million); or any paid board members who work fewer than 5 hours a week (for nonprofits with revenue under $2 million).

  2. One of the following indications of improprieties: A medium or high Charity Navigator advisory or a report of excess benefit transactions or material diversion of assets.

Warning signs

Administrative and fundraising costs. Every nonprofit needs to spend money on administrative and fundraising expenses. Data show that overhead rates are a poor proxy for impact. In fact, overhead rates may be negatively correlated with impact. This could be the case if choosing and implementing cost-effective programs requires more investment in, say, senior management or facilities. Thus, our rating is not based on the rate of this overhead spending, but rather on the achievements the nonprofit makes towards its mission.

Having said that, administration and fundraising spending can be excessive, which could both waste money and call into question the nonprofit’s reporting on its programmatic effectiveness. Therefore, we consider overhead spending that is greater than 35% to be a warning sign. A nonprofit with two warning signs receives 1 star. Below 35%, we ignore these ratios entirely.

There is no universal number for the amount of money a nonprofit should spend on administrative and fundraising expenses. And of course, overhead is not impact, which is our real concern. We chose 35% because it is somewhat above where the bulk of nonprofits are, thereby catching negative outliers while not punishing nonprofits who are in the normal range. At this level, we believe donors can feel assured that they are not funding high overhead nonprofits, but at the same time nonprofits are not punished for running a good organization.1 Of the nonprofits we research, only about 7% are above this threshold. If a nonprofit has a good justification such as an odd timing of flows from one year to the next or is a startup − we may relax the threshold.

Audited financials. Nonprofits with revenue greater than $2 million must have an annual financial audit.

Paid directors. Nonprofits who have less than $200,000 in revenue may file a Form 990EZ, which does not provide as much information as a Form 990. For those nonprofits, we check whether the nonprofit has paid directors. We do not think that a nonprofit of that size should compensate directors unless they serve as staff.

Indications of improprieties

Charity Navigator advisory. Charity Navigator, a nonprofit rating agency, scans news articles and other sources and issues donor advisories when there is an indication of wrongdoing. We automatically assign 1 star to a nonprofit who receive a moderate or high advisory.

Excess benefit transactions. An excess benefit transaction is a transaction between a nonprofit and an insider, such as a member of the board of directors, where the economic benefit to the insider is higher than the value to the nonprofit. We automatically assign 1 star to a nonprofit that report an excess benefit transaction on its Form 990.

Material diversion of assets. A material diversion of assets is a use of a resources other than for its intended purposes. A nonprofit that reports a material diversion of assets receives 1 star.

Criteria by filing type and size

Criteria for financial health and governance vary based on the size of the nonprofit. This is because the data available changes based from the 990 to the 990EZ and because we only expect an audited financial statement from larger organizations.

Criteria

Check for

990, >$2 million rev.

990, <$2 million rev.

990EZ

Program service expenses >65%

Yes

Yes

Yes

Audited financials

Yes

No

No

Paid directors

No

No

Yes

Has Charity Navigator advisory

Yes

Yes

Yes

Excess benefit transactions

Yes

Yes

Yes

Material diversion of assets

Yes

Yes

No




Footnotes

1

The Better Business Bureau Wise Giving Alliance uses the same threshold.

2

This is somewhat more generous than the Federal Government requirement that nonprofits receiving more than $750,000 in government funding must conduct an audit.