The recent tax law has reduced the benefit many taxpayers receive for their charitable contributions, and as a result, has affected the level of donations for many not-for-profit organizations. Combine that with uncertainties about government funding, and it is easy to see that operating reserves are more important than ever for long-term sustainability. Yet studies show that organizations often fail to maintain adequate reserves, which could potentially lead to financial hardships during down years.
Why are reserves important?
Operating reserves are generally net assets without donor restrictions which you can tap into easily. But stable reserves are critical for far more pressing reasons than the metaphorical rainy day.
For starters, solid operating reserves demonstrate responsible financial stewardship to your stakeholders. They also increase the odds that you can achieve self-sufficiency, making you less vulnerable to unpredictable or cyclical revenue streams and government funding cutbacks.
Adequate reserves put you in the position to handle market-based swings in investment income and enable you to cover unbudgeted expenses. Reserves can protect against staff or program cost reductions that would cut into attaining your mission. And they can empower you to take advantage of sudden opportunities.
On the other hand, you generally should not rely on reserves to make up for income shortfalls, unless you have a realistic plan to quickly replenish the fund. Reserves are better applied to income-timing problems than they are to deficit issues.
What is the right amount?
Not-for-profits have different circumstances, so you should not base your reserves level on a rule of thumb, such as three to six months of operating expenses. Six months of expenses may be too much for one not-for-profit, but too little for another. At a minimum, though, your organization should have enough reserves set aside to cover one payroll cycle.
Also, look at organization-specific factors. If you are heavily dependent on government grants, public donations or fundraising events — each can experience dramatic shifts due to political or economic winds — your not-for-profit should have robust reserves. But, if you have multiple, diverse revenue streams, you probably can get away with less substantial reserves.
To determine the right amount of reserves for your organization:
Prepare a Long-Term Financial Forecast
Review your latest budget and how your strategic plans will affect budgets going forward. It is essential to develop a realistic financial forecast for all aspects of your not-for-profit, including every revenue stream and expense. Is any revenue stream in jeopardy or uncertain? Is a new program launch expected to hike certain expenses? For how long?
Do not limit the financial forecast to a single year. Taking a longer view will help you recognize trends and key influences that might not stand out in a one-year snapshot.
Quantify Your Risks
Setting your operating reserves is one good reason to undergo a comprehensive risk assessment that identifies your risks, including those related to:
- Your mission, sector and geographic location;
- The economy; and
- Pending or potential litigation.
Assess the likelihood and potential downside financial impact of each risk. These estimations of risk exposure can help you determine appropriate reserve amounts. Once the target level has been determined, develop a plan to fund your operating reserves.
Bear in mind that, while it might seem counterintuitive, your operating reserves can become too large. Your stakeholders want to see you using funds to achieve your mission, rather than accumulating stockpiles of money. Charity watchdogs often monitor not-for-profits’ reserves so potential donors can check on your financial stability. If your reserves are too high, donors may conclude that you do not truly need their money.
The reassurance of reserves
Successfully managing operational reserves takes time. However, the end result is worth it: A financial safety net and peace of mind for your stakeholders.
Sidebar: Building an effective operating reserves policy
To ensure your organization maintains adequate reserves as a regular practice, it is wise to develop a formal policy approved by your board of directors. The policy should address several issues, including:
- The minimum amount to be held in reserves at all times;
- A plan for funding reserves — for example, from net assets without donor restrictions, budget surpluses, investment income or contributions without donor restrictions;
- Where the funds will be held (options range from a low-interest savings account to equities, with a money market account somewhere in the middle);
- Circumstances that warrant using reserve funds, such as a natural disaster, as well as any limitations, such as requirements for a board vote;
- The evaluation process for determining if such circumstances exist;
- Requirements for reporting reserves’ use to the board; and
- The process and timeline for replenishing reserves after using them.
Like most financial policies, you should revisit your operating reserves policy on a regular basis. Make sure that it remains up to date and relevant to your organization’s current situation.
For more information, contact Caitlin Gibbs at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Not-For-Profit Group.