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Tuesday, October 5, 2010

The Importance of Maintaining Adequate Nonprofit Operating Reserves


The protracted recession has resulted in many organizations experiencing cash flow shortages and unanticipated decreases in operating revenues and/or increases in operating expenses. Nonprofit leaders are having to focus more time, energy and resources on managing the financial stability of their organization, and in some cases the mere survival of their organization, rather than focusing on carrying out the organization’s mission and programs.

The Nonprofit Operating Reserves Initiative Workgroup (the Workgroup) recognized the importance of maintaining adequate operating reserves and convened to issue the whitepaper, “Maintaining Nonprofit Operating Reserves, An Organizational Imperative for Nonprofit Financial Stability.” A final version of the “Operating Reserve Policy Toolkit for Nonprofit Organizations” is also currently being worked on. This paper provides a brief overview of operating reserves and key issues in establishing a formal reserve policy.

What is an Operating Reserve?
Operating reserves are the portion of unrestricted net assets that nonprofit boards have designated for use during turbulent financial times caused by economic uncertainties, reduced funding or general unexpected events. In other words, it is an organization’s rainy day fund. The operating reserve is established from the portion of unrestricted net assets that are available for use. This means available unrestricted net assets would exclude the equity in fixed assets (fixed assets net of related long-term debt). Other organizations have taken a more conservative approach and have also excluded the equity in other non-current, non-liquid net assets such as long-term receivables, inventory, prepaid expenses and other assets. The idea is to establish the operating reserve from liquid assets that can easily be used to cover operating expenses if the time comes for the reserves to be used.

What is an Adequate Operating Reserve?
There is not a general reserve policy that nonprofits can apply. The environment in which each nonprofit operates is distinctly unique and all factors need to be considered when developing the operating reserve strategy. Management and the Board should discuss the overall financial stability of the organization and the factors important to the organization in determining the reserve. Organizations that are heavily dependent on revenue sources subject to large negative fluctuations should consider establishing a larger reserve, while organizations whose main revenue sources generally do not fluctuate may establish a lower reserve. Other factors that nonprofit leaders need to consider include, but are not limited to, the following:

  • Mission and long-term strategy. Nonprofits that are not planning to expand likely will have capacity for a larger reserve, while nonprofits seeking to grow likely will maintain a smaller reserve as they are likely more financially stable and will need to use surpluses for expansion.
  • Historic accuracy in budget forecasts. Organizations with budgets that historically have had significant fluctuations in budgeted to actual results will likely need a larger reserve, while organizations that have been accurate in planning and forecasting may plan for a lower reserve.
  • Types of day-to-day operating costs. Organizations with operating costs subject to large fluctuations will likely need to plan for a larger reserve to handle these fluctuations.
  • Type of nonprofit organization. Generally, the more complex the organization, the higher the level of reserve required. For example, a multinational nonprofit will likely need a larger reserve than a single location nonprofit.
  • Current and future commitments. Organizations with significant, long-term commitments to pay down debt or lease payments should plan for larger reserves.

The Workgroup suggests that nonprofits establish a minimum operating reserve ratio, which can be calculated as a percentage (operating reserves divided by the annual expense budget) or number of months (operating reserves divided by the average monthly expense budget). The Workgroup recommends that the minimum operating reserve ratio at the lowest point during the year to be at least 25 percent or 3 months of the annual expense budget. These minimum reserve recommendations serve as a good tool, but it is still critical that nonprofit leaders consider the issues and circumstances specific to their organization and operating environment.

The establishment and maintenance of an adequate reserve is something that can happen over the course of a few years. Many organizations may not have the surplus to establish a reserve at the desired level right away. The first step is to determine the operating reserve adequate to maintain financial stability. Then, management should budget towards the achievement of that reserve level over a reasonable number of years based on expected surpluses in operations.

What are the Consequences of Not Maintaining an Adequate Reserve?
Nonprofit organizations that do not maintain an adequate operating reserve may face costly consequences. Without a reserve, organizations facing a financial hardship may be forced to make expensive short-term, crisis-based decisions, cut programs, lay off employees, or lose talented individuals who chose to leave for more financially stable organizations. As an example, the State of California’s budget crisis has seriously crippled the State’s cash flows and has led to the State not being able to make timely payments and reducing funding to many nonprofit organizations. Many of these nonprofits that are heavily dependent on State funding have had to cut programs, lay off employees and take drastic measures in order to keep the organization alive. Nonprofit leaders are left in a conundrum as to how they will keep the organization afloat. It is during these times that the true importance of the operating reserve comes to light. An organization with an adequately established operating reserve would be better suited to weather the storm by tapping into its reserve to meet payroll and other operating costs until cash is received from the State and to also buy the organization’s leaders more time to pursue other measures of funding.

Organizations experiencing tough financial times may also find themselves tempted to borrow funds from temporarily and permanently restricted net assets in order to meet general operating demands. Nonprofit leaders have a responsibility to ensure that restricted funds are only used for their restricted purposes, thus the use of restricted funds for purposes other than those imposed by its donors violates the donor’s intent for the funds and creates legal and fiduciary issues for the organization.

Establishing an Operating Reserve Policy
All nonprofits should have a written operating reserve policy. The policy should state the level of operating reserves adequate to the organization, define how the operating reserve is to be calculated, and the thought process behind how management and the Board arrived at the policy. Consideration should also be given towards how the reserves will be invested based on short, intermediate or long-term goals. Reserves that may be needed in the short-term should be invested in conservative investment vehicles, while portions reserved for the long-term can be invested in higher risk, higher return investments. The policy should also discuss how to replenish reserves if they are used or if the operating reserve level drops below the reserve policy. Once the policy is established, it should be circulated internally amongst the finance and accounting and fundraising departments, as well as to Board members not involved in establishing the reserve. Individuals within the organization should fully understand the purpose of the reserve. Management should also consider distributing the reserve policy externally to the organization’s accountants, legal counsel or certain funding agencies. By making the operating reserve policy transparent, the organization will not only show the public that management is being fiscally responsible by developing a prudent policy, but also that the organization may not appear as “rich” as it seems as certain funds have been set aside for emergencies.

Conclusion
Just like it’s important for individuals while maintaining their personal finances to set aside funds for unexpected events, it is also critical for nonprofit leaders to establish an adequate operating reserve as part of a prudent financial management plan. The recent recession has shown us the impact of not maintaining sufficient operating reserves. Fortunately, many well-managed nonprofit organizations have been able to work successfully through the economic downturn. As history tends to repeat itself, another economic downturn may be on the horizon. When it hits, organizations with adequate operating reserves will be in a much better position to continue carrying out their mission and programs without significant financial disruption.

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