Nonprofit Operating Reserves – How Much is Enough? (Part II)

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In last month’s article, we discussed what a reserve is and the 8 main reasons why it is important for a nonprofit to have one:

  • R-Resilience – The ability to bounce back from an unforeseen financial event
  • E-Enhanced flexibility to develop new programs or redirect focus
  • S-Survive operating shortfalls or seasonality of cash flow
  • E-Expand credit opportunities & permit favorable financing for expansion
  • R-Replacement of capital assets
  • V-Vulnerability to high long term debt, payables, and deferred income
  • E-End game-Winding down of a program
  • S-Sustainability-Having the necessary resources to fulfill its mission


How and When to Create a Reserve

Reserves are created when an organization desires to become more financially healthy.

Best practices provide for the board of directors and executive director to work together to first craft a reserve policy. The policy will ensure consistency and serve as a documented reminder of the process the organization must go through when establishing, utilizing, and replenishing the reserve. The reserve policy should contain these 6 components:

  • P-Provide access: Without being too restrictive, the policy should address who is authorized to access the reserve with appropriate review from the board.
  • O-Original amount: Instructions for how the reserve will be returned to its original amount, when it is used.
  • L-Level or amount: The reserve level or amount should be stipulated in the policy. The amount can be described as a dollar amount or as a percentage of another amount, such as net assets.
  • I-Investment options: In some cases, reserves can get significant and the prudent stewardship of those funds may include investing some of the money in higher earning instruments. In this case, an investment policy statement for the organization that covers investing reserve amounts would be in order.
  • C-Calculation methodology: Step-by-step instructions for the calculation of the reserve that are easy to follow. Simplicity is the key here.
  • Y-Yearly measurement and reporting: At a minimum, the reserve amount should be measured annually and reported to the board, including usage – if any, during the year.

 

The reserve policy should also address potential windfalls the organization may experience. For example, the passing consistent major donor may result in an unexpected windfall in the form of a bequest from the donor’s estate to the organization. These windfalls provide an excellent opportunity to fund a reserve and can put an organization well on its way to a healthier financial condition.

Once an organization has a policy, it can begin funding the reserve on a regular basis by building such funding into the budget. Every nonprofit budget should include a line item for reserve funding. By regularly funding the reserve your organization will see quick results. By setting aside just 5% per year of your annual budget, your organization will have a 90-day reserve in just under 5 years, regardless of your budget size.

How much reserve is enough? The answer is……it depends. Each organization is unique in its mission, vision, and values, and so are its revenue and expense patterns. Understanding those patterns is critical to arriving at an organization’s ideal reserve level.  Experts agree there is no benchmark or simple one-size fits all approach to how much a nonprofit’s reserve should be. Sadly, most don’t have enough or any at all.

To determine how much is enough for your reserve, calculate the average daily cash usage. By dividing an organization’s total annual expenses, net of depreciation, by 365 you have an idea of the average daily cash usage of your organization.  Many nonprofits strive for 3-6 months of reserves. Again, the facts and circumstances of each organization require careful examination of revenue and expense patterns to determine a proper reserve level.

Whether just starting a nonprofit or needing a peek under the hood of an existing one, Pro Back Office has the expertise to help build capacity to continue your nonprofit’s mission into the future. For more information contact Rick Dahlseid – Rick@probackoffice.com.

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