THE EFFICIENCY SCORE
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As it has been applied to financial analysis, the concept of efficiency conveys a trade-off between risk and return. Risk and return apply differently to each of the decisions that the nonprofit organization makes. Use of the concepts of risk and return allows us to construct separate efficiency measures for each fundamental financial decision that can then be combined to determine an overall level of financial efficiency. By focusing on efficiency, we recognize that an organization is not always best served to manage with ultraconservatism because, by doing so, it may miss out on additional benefits that can be derived from a more liberal use of resources. Efficient organizations are those that derive the most "return" from the least amount of "risk." Another way of expressing this idea is to say that efficient organizations are those that strike a healthy balance between carrying out the mission now and setting up the means to carry out the mission later.
Constructing Ratios
Based on the manufacturing analogy described previously and the fundamental financial decisions faced by managers, we have constructed ratios that attempt to measure the efficiency achieved with respect to fund acquisition, resource allocation, asset leverage, and liquidity maintenance.
Fund Acquisition
Fund Acquisition refers to how the organization acquires the resources it needs to operate. The fund acquisition efficiency rating incorporates two important dimensions of this decision. The Fundraising Cost Ratio is used to measure the risk dimension of this decision. If an organization incurs high fundraising costs relative to total revenue, then there is a greater possibility that the organization's efforts are wasteful or inappropriate. However, this must be considered in conjunction with another element of the decision - the organization's reliance on public support. An organization that places a greater reliance on contributions is more likely to require greater fundraising efforts to support it. Therefore, the Contributions Reliance Ratio is used as the return measure for assessing fund acquisition efficiency. These ratios are defined as follows:
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Ratio Name |
Risk/Return |
Calculation |
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Fundraising Cost Ratio |
Risk |
Fundraising Costs/Total Revenue |
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Contributions Reliance Ratio |
Return |
Public Contributions/Total Revenue |
Criticisms of fundraising measures addressed |
| Traditionally, consideration of fundraising issues has focused on fundraising ratios that compare the amount of contributions received to the costs incurred to raise those funds. Despite popular appeal, many in the nonprofit community have criticized the use of fundraising ratios. One criticism is that it is difficult, if not impossible, to determine the true costs associated with raising specific contributions. Methods for assigning costs to fundraising efforts vary from organization to organization. Furthermore, the importance placed on fundraising ratios has given nonprofits an incentive to allocate as much as possible to program expense. A second criticism is that contributions represent only one possible source of revenue. Many organizations earn revenues in ways other than direct solicitation of public support. Focusing on fundraising efforts looks at only one component of the organization's overall resource acquisition activity. Third, some academics question whether a high fundraising ratio is necessarily a sign of inefficiency. They argue that an organization is better off spending money to raise money as long as it raises more than it spends. These concerns and others have caused many to question whether fundraising ratios should be used at all to evaluate the management of a nonprofit. |
| We have approached the fund acquisition decision in the following manner. First, we acknowledge that organizations allocate costs to fundraising differently. Although this reduces some of the comparability of fund acquisition measures, it does not entirely take away their usefulness. As improvements continue to be made in the accounting standards that set guidelines for cost allocations, some of the variability in allocation method will be eliminated. However, even with better standards, imperfect information will always be a weakness of purely quantitative analysis. That is why the analyst comments that are included in each nonprofit profile are an important tool for gaining a more complete understanding of the organization. Through these comments, analysts are able to shed light on the policies and procedures used by the organization to allocate fundraising costs. With regard to the second criticism, an organization's expenditures for fundraising should be considered in conjunction with its reliance on contributions as a revenue source. Organizations that rely primarily on contributions may be required to incur greater marginal fundraising costs than an organization that is able to generate revenue through other sources. We have incorporated this consideration into our fund acquisition efficiency measure through the Contributions Reliance Ratio. Finally, in response to the third criticism described above, we think that a measure of fund acquisition efficiency will continue to be desired by donors as long they are concerned about the efficient use of their donations. If a donor subscribes to the view that fund acquisition efficiency is not relevant, then our system allows the donor to focus on other efficiency measures when making a giving decision. The 5 Star Financial Efficiency Ratings are not intended to serve as an endorsement or recommendation of an organization. They are simply additional information that a donor may find useful and relevant. |
Resource Allocation |
| Resource allocation refers to how the organization spends its resources to produce outputs. The first part of the spending decision answers the question of how much to spend now versus how much to spend later. Since nonprofits do not generate profits that can be distributed to owners, all resources will be spent eventually. An organization that does not spend all of its resources when they are received increases the likelihood that it will be able to fund future operations. However, it reduces the support provided to programs now. Therefore, the second part of the spending decision answers the question of how much spending will support the programs of the organization directly versus how much will be saved or used to cover administrative costs (including fundraising costs). We have constructed the resource allocation efficiency rating to measure both dimensions of the spending decision. The risk dimension is measured by the Spending Ratio. The return dimension is measured by the Program Output Ratio. These are defined as follows: |
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Ratio Name |
Risk/Return |
Calculation |
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Spending Ratio |
Risk |
Total Expenses/Total Revenue |
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Program Output Ratio |
Return |
Program Expense/Total Revenue |
Asset Management |
Asset management refers to how the organization leverages its assets to increase its operations, or throughput. In order to leverage its assets, an organization must often be willing to incur a certain level of risk through increased liabilities. Therefore, the risk dimension of asset leverage is measured by the Liabilities Ratio, which compares total liabilities to total assets. The benefit realized from leverage considers the amount of throughput (as we have defined it for nonprofits) generated from the organization's assets. Therefore, the return dimension of asset leverage is measured by the Operating Expense Ratio, which compares operating expense to total assets. Operating expense is defined as total expenses less interest, depreciation, and other non-operating costs. This measure is preferable to total expenses as a measure of throughput because it ignores expenses that capture the cost of leverage (interest) and the replacement cost of infrastructure (depreciation). Operating expense focuses only on those expenses that measure the real activity of the organization. The asset management measures are defined as follows: |
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Ratio Name |
Risk/Return |
Calculation |
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Liabilities Ratio |
Risk |
Total Liabilities/Total Assets |
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Operating Expense Ratio |
Return |
Operating Expense/Total Assets |
Liquidity Maintenance |
| Liquidity maintenance refers to how the organization maintains sufficient liquid resources to meet its operating needs. An organization's need for liquid resources is affected greatly by its current commitments. Therefore, the risk dimension of liquidity is measured by the Current Liabilities Ratio, which compares the level of current liabilities to the level of current assets. However, many organizations earn income on their current and long-term assets, and because the cash flows from other revenue are often more predictable than receipts of public support, other income can impact management's determination of an optimal level of current assets. Therefore, the return dimension of liquidity maintenance is measured by the Supplemental Revenue Ratio, which compares other income to current assets. These measures are defined as follows: |
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Ratio Name |
Risk/Return |
Calculation |
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Current Liabilities Ratio |
Risk |
Current Liabilities/Current Assets |
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Supplemental Revenue Ratio |
Return |
Other Income/Current Assets |
Potential Improvements in the Use of Financial Ratios and Ratings |
| The eight ratios used in the 5 Star Financial Efficiency Ratings system utilize information from an organization's IRS Form 990 or audited financial statements. This information includes variables from the statement of financial position (balance sheet) and the statement of activity (revenues and expenses statement). Although Wall Watchers believes that financial ratios are a valuable tool for nonprofit analysis, it also recognizes some of the problems and limitations associated with using financial ratios. For example, since the balance sheet reflects the financial situation at the end of the year and the revenues and expenses statement reflects a full year of activity, combining these two types of information can sometimes be misleading. One method that is commonly used to adjust for this (but not in the 5 Star Financial Efficiency Ratings system) is to use an average of beginning and ending balances for the balance sheet variables in ratios that use information from both statements. In addition, there are often one-time events that make an organization's financial information in one year significantly different from its "normal" years. To address both of these issues, Wall Watchers intends to eventually introduce ratings that utilize a three-year average for each of the financial ratios used. By using three-year averages, the comparability of organizations with different fiscal years and reporting dates will increase. Although constructing ratings that use three years of financial information is preferable, doing so requires that information from multiple years be available for all of the organizations being rated together. However, this amount of information is not always available for some organizations, so the 5 Star Financial Efficiency Ratings will initially be calculated based on only the most recent year of data. Another area where improvement could be made to the rating system would be to incorporate a dimension that measures how efficiently an organization utilizes personnel, whether employees or volunteers, to accomplish its mission. This also may require information that is not readily available. Wall Watchers will continue to seek ways to increase the availability of data and the relevance of the 5 Star Financial Efficiency Ratings system. Some of this improvement will occur with innovations such as the planned three-year rating or a dimension to consider the use of people. Some improvement, however, will not be possible until more information is available in the public realm. |
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