MinistryWatch 5 Star Rating System
Introduction to Ratings
Looking at Nonprofits and For Profits
The Ratings Framework
The Efficiency Score
The Model
An Illustration
INTRODUCTION TO RATINGS
What is the purpose of the 5 Star Financial Efficiency Ratings system?
The 5 Star Financial Efficiency Ratings system was created to help researchers, donors and managers assess a nonprofit organization's financial performance. Wall Watchers believes that accountability and efficiency are increased when better information is available to donors. The 5 Star Financial Efficiency Ratings system provides better information in several ways. First, it highlights the relevant financial decisions of nonprofit organizations. The ratings system links financial information to managerial decisions, thereby providing a practical context for viewing financial information. Second, it adds an element of interpretive value to financial information. Donors, like investors, are not always willing to acquire the skills and invest the time required to perform their own financial analysis. Consequently, they see value in receiving information that has already been processed by others. Third, it provides a robust system to compare nonprofit organizations. Although these systems are common in the for-profit marketplace, such systems are almost nonexistent in the nonprofit world. In these ways, the 5 Star Financial Efficiency Ratings system provides better information to donors and nonprofit managers, which will ultimately assist in bringing improvement to the nonprofit sector.
What does the 5 Star Financial Efficiency Ratings system measure?
The 5 Star Financial Efficiency Ratings system objectively measures the relative degree of financial efficiency achieved by the managers of nonprofit organizations.
First, the rating system is objective. The ratings are calculated automatically (mechanically) based on financial variables taken from the organization's published financial information.
Second, the measurement is relative. Each rating reflects an organization's rank along a particular dimension relative to its peer group. By comparing a nonprofit to others that have similar structures and missions, Wall Watchers believes that the ratings compare apples to apples, which makes them more relevant to donors and managers.
Third, the system measures financial efficiency. Wall Watchers believes that financial efficiency, as defined, is desirable in all organizations, regardless of individual mission or structure. Nowhere within the rating system is an attempt made to assess the effectiveness of programs.
Fourth, the system focuses on managers. By structuring the ratings system within the context of financial decision-making, the rating system underscores the belief that it is the managers of nonprofits who are the stewards of the organization's resources and it is their decisions that should be assessed.
Fifth, the ratings are applied specifically to nonprofit organizations. Organizations that are classified as nonprofits under section 501(c)(3) of the tax code are the primary candidates for analysis using this rating system.
What is Wall Watchers' definition of financial efficiency?
Financial efficiency, as calculated in the 5 Star Financial Efficiency Ratings system, is a measure of how well a nonprofit organization has managed certain trade-offs (defined later as risk and return) in the use of its financial resources. This measure leaves out any assessment of how effectively an organization's specific programs are accomplishing their desired purpose of providing spiritual or social goods. Despite this narrow focus, Wall Watchers believes that the 5 Star Financial Efficiency Ratings system will be a valuable tool to donors who wish to answer the question of which nonprofits have made the most of the financial resources they have been given.
What are the major limitations of the 5 Star Financial Efficiency Ratings system?
The usefulness of the 5 Star Financial Efficiency Ratings system is limited by the quality of the underlying financial data inputs and the relevance of the model used to determine financial efficiency.
Quality of financial data
The data used in the model is taken primarily from an organization's audited financial statements or from the IRS Form 990 filed each year by many nonprofits. Wall Watchers makes no assurances as to the accuracy of the information contained within the audited financial statements or within the IRS Form 990.
Relevance of the model
All models have limitations. The 5 Star Financial Efficiency Ratings system measures financial efficiency. It does not measure program outcomes or program effectiveness. Although many of the financial ratios used to derive the ratings are commonly used ratios that may be useful in isolation, the model weaves them together to provide an overall measure of financial efficiency. The relevance of the rating system to users is dependent upon their agreement with the way in which these ratios are combined to evaluate financial efficiency.
Using the 5 Star Financial Efficiency Ratings
The 5 Star Financial Efficiency Ratings do not assess an organization's integrity or the worthiness of its mission. They provide very specific information, namely an assessment of financial efficiency. Donors are encouraged to use the 5 Star Financial Efficiency Ratings in light of the two primary limitations described above and the following additional observations:
- A rating is not a recommendation for or against giving to a nonprofit.
- The ratings system is just one tool that a donor could use when evaluating a nonprofit.
- The ratings are based on financial ratios that depict relationships within the financial information of nonprofits.
- The ratings do not convey information about the value or accomplishments of the programs of nonprofits.
- The ratings provide one possible assessment of financial efficiency.
- The ratings provide information about how the nonprofit has performed in the past and do not necessarily reflect how it will perform in the future.
- A nonprofit is rated only against the other nonprofits in its sector, or peer group. Others may not agree with the sector groupings made by Wall Watchers.
- The ratings are based on an analysis of the trade-offs that are made between the various financial objectives of nonprofits.
- The ratings should be used whenever possible in conjunction with Wall Watchers Analyst Comments.
- Ratings will not normally be constructed for organizations that have not been operating for at least five years.
The Use of Financial Ratios in Financial Analysis
An examination of relationships within an organization's financial information can provide a snapshot of management's decisions at one point in time or over a certain reporting period. Commonly referred to as financial ratio analysis, this technique is often used to evaluate for-profit organizations. Although the goals of nonprofits are different from the goals of for-profits, financial ratios can provide insight into how financial decisions are answered by both for-profits and nonprofits.
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