July 24, 2012

Nonprofit Due Diligence: Six Financial Red Flags Donors Should Not Ignore

This content is out of date. For our latest thinking on nonprofit due diligence, please see Philanthropic Sourcing, Diligence, and Decision-Making: An Equity-Oriented Approach.

By: The Bridgespan Group
In your research of nonprofits, you may come across a "red flag”—something that will make you think long and hard about investing in the organization. Before providing a few examples of red flags related to a nonprofit’s finances, it is important to consider how to respond to red flags when you do encounter them:
  • Not all red flags carry equal weight. For example, in many cases you’ll find that nonprofits lack vital systems and supports due to a lack of resources. That’s a red flag, but one you may be able to live with; you might be able to provide the resources needed to fix the problem. Other red flags might prove to be more troubling, for example, if they shed light on fundamental gaps or issues, such as an ineffective program or an executive director’s flawed approach. In those cases, more resources may only exacerbate the problem.
  • More important than these red flags, in other words, is the context from which they arise. Try to figure out whether the challenges you identify are surmountable with the support you plan to provide. Are the leadership team and board willing to tackle (or even acknowledge) these weaknesses? If the weakness lies in capacity, consider your own willingness to fund some or all of the non-program expenses that capacity building would require.
  • Stay open minded: Don’t leap to judgment when challenges come to light. Engaging in conversation in the spirit of inquiry will reveal the story behind the weaknesses, how they have emerged, and how you might help address them with your support.

With these tips in mind, here are some examples of issues that should trigger further inquiry as you research a nonprofit’s finances:

  • The organization doesn’t have audited financial statements.
  • The organization has a growing deficit from year to year.
  • Budgeted income and expenses are not based on solid assumptions.
  • Accounting and finance functions all lie with one person.
  • The board is not involved in financial review or audit.
  • Revenue sources change drastically from year to year.
Remember that the existence of red flags doesn’t necessarily mean that you should forego investing in a particular nonprofit; instead, it may mean that it is necessary to offer the organization non-financial support in addition to the financial support you were considering.

What red flags do you watch out for when researching a nonprofit’s finances? What have you found to be an effective response to red flags you encounter in your research.

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