Operating reserves aren’t a luxury — they’re a necessity for financially savvy nonprofits. Organizations without adequate operating reserves leave themselves vulnerable to the financial instability and damaged reputation that interruptions in incoming revenue might bring.
A recent report from the Nonprofit Finance Fund, a community development financial institution, indicates that operating without an adequate financial cushion is fairly widespread among not-for-profits. The Fund’s 2015 State of the Nonprofit Sector Survey results showed that 53% of nonprofits responding had less than three months of cash on hand and 12% had less than 30 days’ cash in reserve.
What reserves are — and aren’t
Operating reserves can be defined as the portion of unrestricted net assets that nonprofits designate for use in emergencies or to sustain financial operations in the unanticipated event of significant unbudgeted increases in operating expenses or losses in operating revenues. Reserves should be liquid, or easily converted to cash, so the organization isn’t forced to sell long-term investments, take out a loan or pursue other undesirable alternatives to quickly generate funds.
Also remember that cash on hand isn’t the same thing as operating reserves. Cash can be restricted for specific purposes while operating reserves must be available to be spent on current operations.
Operating reserves also shouldn’t be confused with donor-restricted endowments. Only the income on these endowments is available to be spent (based on the donor’s wishes), with the principal portion held to perpetuity and, thus, unavailable for daily operations.
Why you need reserves
Remember the last recession? The years following the financial crisis of 2008 were challenging for many nonprofits, with plummeting revenues that led to painful cuts in staffing and programs — despite, at times, an increased demand for services. Some nonprofits shut down altogether. When a turbulent economy reduces revenues to a trickle, operating reserves can help organizations survive.
Healthy reserves also will allow your organization to seize opportunities that require a cash outlay (for example, purchasing a building), set aside funds for long-term goals and plans, and cover unexpected expenses after a natural disaster or other emergency. Reserves also can prove valuable when you need to augment your staff and deliver services under federal contracts that won’t provide payment for 30 to 60 days.
What if you run into skeptics on the board when it comes to keeping sufficient reserves? Consider running a “table-top exercise” with the directors and upper management. Instruct the participants to formulate a strategy for a scenario in which the organization experiences a payment delay — how will it pay its bills and meet its contractual obligations?
How much to set aside as reserves
The Nonprofit Operating Reserves Initiative Workgroup, an all-volunteer group of nonprofit leaders, financial management consultants and others, suggests nonprofits consider several issues when setting a dollar goal for their reserves:
- Are your revenue sources subject to large unexpected negative fluctuations?
- Are your resources subject to sudden increases in demand?
- Are your income and expenses subject to significant day-to-day fluctuations?
- Have your planning and budgeting processes been historically accurate in forecasting financial results?
- Are adequate backup funding resources likely to be available?
- Is the governing body trying to expand the organization?
The Workgroup advises organizations to maintain a minimum reserve level of 25% of the annual expense budget, enough to cover three months’ expenditures.
Others suggest that a sensible target might be the average gap between revenues and expenses. Under this guideline, organizations with more volatile revenue or spending would require greater operating reserves. Financial advisors typically say the ideal amount for most nonprofits is six months of cash expenditures. Ultimately, the right amount for your organization will depend on its particular circumstances — no single standard applies to all.
A critical layer of protection
Operating reserves add another layer of essential insurance when you run into revenue shortfalls that could threaten your sustainability. Building reserves greatly improves your organization’s odds of continued existence.
Sidebar: How to develop a formal reserve policy
When a nonprofit decides to build operating reserves, it needs to decide more than just the goal amount. That’s where a formal reserve policy comes in.
If you’re in the process of instituting reserves, you should develop a clear written policy that addresses the following issues:
- The goal amount of reserve funds (realizing that it might take some time to accumulate),
- The source(s) of reserve funds — for example, unexpected and unrestricted donations, unbudgeted revenues or cash generated by operations,
- How the reserves will be invested,
- The definition of circumstances and process that will trigger the use of reserve funds,
- The process and timeframe for repayment of reserve funds used, and
- Whether to impose any additional directions, restrictions or limitations on the use of reserve funds.
Once you’ve established a policy, review it regularly to ensure that it continues to reflect your circumstances, and make changes as appropriate. If you need more information or have questions, please give us a call.