Like many of you, we celebrated the letter co-authored by Guidestar, the BBB Wise Giving Alliance, and Charity Navigator titled “The Overhead Myth.” We’ve followed the nonprofit community’s response closely and we’re energized by the conversation among leaders, donors and funders, and supporting services organizations like FMA.
Yes, It’s Time to Debunk the Myth of Overhead: Just Don’t Abandon Financial Analysis
We agree with the message: administrative and fundraising expense ratios are not the best measures of effectiveness, especially when used as the sole means of evaluating an organization. Further, overhead metrics do not communicate much about an organization’s financial performance, or long-term financial viability.
But at FMA we use financial metrics every day to better understand the nonprofits with which we work. And we believe a thoughtful financial analysis is a critical component of assessing an organization.
So, Which Financial Metrics Should Donors Focus On?
Over many years of working with nonprofits we’ve developed a “go to” set of financial metrics. Here, we’ve boiled these down to two key ratios: Months of Liquid Unrestricted Net Assets (LUNA) and Operating Margin.
Full disclosure: these metrics take a bit of commitment. They are more complex than overhead ratios and require data from audited financial statements. And we recommend using at least three years of data to develop an understanding of performance over time. The good news is that just these two metrics provide a nuanced, revealing picture of an organization’s financial position.
1. Months of Liquid Unrestricted Net Assets (LUNA)
LUNA is the liquid portion of the Unrestricted Net Asset (UNA) balance, arrived at by removing any assets that can’t be easily liquidated like buildings. LUNA represents the funds available to cover ongoing operations, take advantage of opportunities, and weather downturns. After calculating LUNA we divide it by average monthly expenses and ask questions about LUNA and UNA trends:
- Is the UNA balance positive? Is it growing or declining?
- How many months of current operations could LUNA cover if all funding stopped tomorrow?
- Is a strategy in place for the accumulation of and potential uses for LUNA?
2. Operating Margin
The Operating Margin is a nonprofit’s operating surplus or deficit (including depreciation) as a percentage of total unrestricted operating revenue. Expressing surplus/deficit as a percentage allows better comparison across organizations of different sizes and consistent tracking of internal trends. We ask ourselves:
- Can deficits be explained by factors like growth stage, changes in the external environment, or planned infrastructure investments?
- Are negative results balanced by surpluses in adjacent years and/or operating reserves?
- Are positive margins staying steady, growing, or declining?
Beyond the Numbers
You may be wondering how many months of LUNA an organization should have. Or what a “good” Operating Margin looks like. It depends! We’re always thinking about the context an organization is working in. And we encourage donors to do the same. Factors like growth stage, size, mission focus, geography, and business model have a big impact on the story an organization’s financials tell.
We’re excited to share these alternatives to overhead ratios. And we’re looking forward to our next contribution to this conversation. Look for FMA’s thoughts on often convoluted definitions of overhead, administrative, shared, allocated, and indirect costs in a future edition of Nonprofits Count! Until then, check out FMA’s upcoming trainings and strongnonprofits.org which features over 60 free financial management resources.
Kate Garroway, Fiscal Management Associates