MinistryWatch 5 Star Rating System
Introduction to Ratings
Looking at Nonprofits and For Profits
The Ratings Framework
The Efficiency Score
The Model
An Illustration
LOOKING AT NONPROFITS AND FOR PROFITS
The primary goal of nonprofit organizations is to initiate and operate programs that meet a perceived need in the world. Nonprofits are not formed for the benefit of the organizations themselves or for the benefit of their donors. This is quite different from the primary goal of for-profit organizations. Their goal is to provide a return to their investors. The goals of an organization affect how its financial information is to be interpreted. For example, revenues minus expenses measures profit in a for-profit organization. This is a measure managers usually wish to maximize. However, revenues minus expenses measures surplus in a nonprofit organization. Surplus is not necessarily a measure that the managers of nonprofits wish to maximize. Many would even argue that managers should try to minimize surplus in order to avoid the perception that they are hoarding funds. This illustrates just one way in which the financial information of nonprofits is interpreted differently from that of for-profit organizations.
Despite different goals, nonprofit and for-profit organizations share a basic structure that can be likened to a manufacturing process in a factory. Like a manufacturing process, organizations start with some kind of input, or resource. They move these inputs through a process that has some kind of asset infrastructure. Because of the significant costs involved, organizations are sometimes forced to incur debt to finance the building of their asset infrastructure. This debt is analogous to a mortgage taken against a new manufacturing facility. The amount of processing that takes place through an infrastructure is often referred to as throughput. As throughput is channeled through the process, either the intended output or a bi-product is produced. Output is what an organization wants to generate from its process. Bi-products are typically not desirable, but they are usually unavoidable. We believe that the financial structure of organizations corresponds to the fundamental structure that we have laid out here. However, this correspondence between financial data and basic organizational structure is not the same for nonprofits and for-profits. The different goals of nonprofits and for-profits require us to define and evaluate these basic elements differently. Understanding how to interpret the financial information of organizations is critical to constructing useful financial ratios for use in evaluating financial management. In the view of Wall Watchers, the most useful way to interpret the financial information of for-profits and nonprofits with respect to their basic organizational elements is as follows:
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Manufacturing Elements
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Corresponding Financial Measure
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For-Profits
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Nonprofits
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Inputs
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Contributed
Capital, Retained Earnings
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Contributions,
Other Income
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Infrastructure
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Assets
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Assets
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Mortgage
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Liabilities
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Liabilities
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Throughput
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Revenue
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Operating
Expenses
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Bi-products
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Expenses
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Non-program
Expenses
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Output
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Profit
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Program
Expense
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The most noticeable differences between for-profits and nonprofits in this analogy are the concepts of inputs, throughput, and output. The other elements of the manufacturing process are very similar for nonprofits and for-profits.
Inputs - Inputs are the resources at the disposal of the organization. In for-profits, contributed capital (a balance sheet item) is the primary input. For nonprofits, contributions (a revenue item) are the primary inputs. Each measure represents the resources that the organization receives to carry out its mission. Since stockholders of for-profit organizations expect to eventually receive their capital back (along with their share of retained earnings), the inputs of for-profits affect the balance sheet. Since donors relinquish all rights to the resources they contribute to nonprofits, the inputs of nonprofits affect the income statement as revenue. Secondary forms of input are other income in nonprofits and retained earnings in for-profits.
Throughput - Throughput refers to the amount of activity that flows through the process. In for-profits, the amount of activity is the amount of product sold or the amount of service provided (their revenues). For nonprofits, the amount of activity is the amount spent to run their operations (their operating expenses). Throughput is a means to an end for both types of organizations. Sales in for-profits are meant to generate profit and expenditures in nonprofits are meant to operate good programs.
Output - Output is the measure of goal accomplishment. For-profits try to maximize the margin of revenues over expenses to produce the profit they desire. Nonprofits try to maximize the amount of program services they provide through their total spending. Program expense is the financial measure that most closely conveys the quantity of goal accomplishment for nonprofits. Admittedly, this measure does not tell us whether or not the actual program expenditures are producing the outcomes desired. However, from a strictly financial management perspective, the goal of the organization is to maximize expenditures for programs. Evaluating the methods and efficiencies of the programs themselves is beyond the scope of this quantitative ratings system.
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