How to Evaluate a Nonprofit Before Donating

Deciding which organizations deserve your philanthropy dollars can be tricky. The last thing you want is to see your donation squandered by a mismanaged or fraudulent charity. Or, if the nonprofit is flush with cash, you might question whether your funds are reaching the intended recipients.

Savvy grant-making foundations and individual contributors are strategic about their giving, creating systems to identify and eliminate troubled organizations while pinpointing the most worthy recipients.

Performing Financial Due Diligence on Nonprofits

A nonprofit’s tax returns and financial statements provide a wealth of information for determining whether they are using their funds wisely.

Reviewing a nonprofit’s Form 990

All nonprofit organizations are required to annually file a Form 990, which is an informational form the IRS uses to determine whether the organization should continue its nonprofit tax-exempt status. Exempt organizations are required to make these tax returns available upon request. You can either go directly to the nonprofit, or search guidestar.org.

Two sections of the Form 990 are particularly useful for potential donors:

• Statement of Functional Expenses – Found in Part IX of the Form 990, this statement breaks down an organization’s expenses between program service, general and administrative (G&A) expenses, and fundraising. A general rule of thumb is that the organization should spend at least 75% of its funds on program services.
• Compensation and Conflicts of Interest – Schedules J and L of Form 990 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. While there are often solid business reasons for these transactions, they might be indicators of problems.

Reviewing a nonprofit’s financial statements

Look for charities that are transparent and can demonstrate that they manage their finances securely and reliably. Any nonprofit should provide financial statements upon request. Turn first to the independent auditor’s opinion page, which speaks to whether 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 is a good cause to reconsider an organization’s worthiness. If the auditor expresses doubt about an entity’s ability to continue as a “going concern,” beware. This means the auditor doubts the organization’s financial viability. While many consider this a red flag and reason to take their money elsewhere, others might see it as a reason to donate more.

Indicators of Financial Health in a Nonprofit

The tax return and financial statements provide all the data you need for financial due diligence — if you know how to interpret that data. Following are some examples of the ratios that indicate a nonprofit’s financial health.

• Current ratio – Calculated by dividing current assets by current liabilities, the current ratio helps stakeholders assess a nonprofit’s liquidity. Since a common benchmark is that the value of current assets should be at least twice that of current liabilities, look for a current ratio of at least 2.
• Debt-to-equity ratio – This financial leverage ratio helps assess long-term solvency and stability. Calculated by dividing total liabilities by total equity (found in Part X of the Form 990), the ratio compares resources provided by creditors with resources provided by donors, endowments and program services. The higher the ratio, the greater the creditor claims on assets. A high debt-to-equity ratio also can indicate that the charity is paying high rates of interest, which means more funds are being used to service debt than are going toward services.
• Fundraising cost to raise one dollar of donation – This ratio is a calculation of the cost to raise funds. Generally, this amount should be lower than $0.35.
• Unrestricted liquidity – This ratio helps foundations and other donors assess whether the charity will have enough cash to cover promised actions. Any percentage below 100% is a sign of organizational distress, since it means that the organization is borrowing cash from temporarily restricted net assets.

Many contributors who have honorable intentions of supporting worthy needs can fall short of that goal because they fail to properly evaluate the management of those charities. Whatever you do, don’t base your decision on emotion. Whether you represent a foundation or are giving your own money, you should establish a rational, fact-based system to evaluate nonprofits before donating.

Are You Being Strategic About Your Donations?

Too often, philanthropy goes wrong when generous contributors don't thoroughly evaluate charities. Contact Armanino’s Trust & Estate Tax Planning experts to develop a strategic plan that helps you smartly reach your charitable goals.