How Your Not-for-Profit Should Manage Operating Reserves

In the not-so-distant past, board members at many not-for-profit organizations were panicking that the economic downturn would severely damage their organizations and perhaps even result in their ultimate downfall. But those concerns have generally faded as the economy gradually recovered and donations flourished.

Three Reasons for Reserves

Although operating reserve needs vary from one not-for-profit organization to another, there are usually three main reasons to build your rainy day fund:

1. So you can repair and replace fixed assets. Upgrades are usually needed in offices regularly. They could be for anything from outdated computer networks to inefficient heating and air conditioning systems. And sometimes, things may simply break and need to be repaired or replaced, such as a leaking roof or door locks that aren’t working properly. The operating reserves can provide the amounts needed for routine maintenance as well as extraordinary costs.

2. So you can expect the unexpected. As with a for-profit business, you must be ready for unforeseen expenses. At the very least, if you have operating reserves to fall back on, you can weather storms as they occur. Some typical examples are a sudden loss of a major contributor, an unexpected delay in the timing of grants and an unusually large decline in revenue from special events.

3. So you can reinvest in the organization. With operating reserves in place, your not-for-profit can implement a long-term plan for growth. This might include a pilot program for expansion, a redesign of an existing program, a new marketing test or plans to increase staffing. It’s critical to have funds on hand to invest for the future.

According to a report from the highly respected Indiana University Lilly Family School of Philanthropy, charitable giving is expected to increase by 4.8 percent on a year-over-year basis in 2015 and 4.9 percent in 2016.

Nevertheless, the sobering events of 2008 and 2009 — which are less than a decade in the rear view mirror — should serve as a powerful reminder of the need for properly managing operating reserves.

Your Rainy Day Fund

Simply put, the operating reserves of a not-for-profit organization serve as a rainy day fund that can be relied on if the economic climate changes for the worse or the specific organization experiences other financial difficulties. But the fund isn’t necessarily limited to amounts that have been exclusively earmarked for this purpose. The reserves often include all the excess amounts (excluding amounts tied up in fixed assets) that are available for use at the board’s discretion.

With the knowledge that operating reserves are at its disposal, an organization will be better able to take on risks associated with its mission, as well as react to temporary or even permanent changes in its circumstances. This could include a significant decline in revenue or dire situations where assets drastically erode or operating costs increase.

In this regard, a not-for-profit resembles a for-profit business entity. In fact, board members and not-for-profit managers are often advised to think like the executives of an established corporation, while organization founders may act like entrepreneurs. Just like a business needs working capital to prosper and sustain growth, a not-for-profit requires the equivalent in operating reserves. The main difference from the corporate world is that the benefits spill over to the organization instead of winding up in the pockets of shareholders.

Responsibilities of Board Members

Generally, decisions involving operating reserves are left to board members. Management of the funds is directly related to long-term plans in furtherance of the organization’s charitable mission.

By establishing operating reserves, the board can ensure that funds are available for handling cash flow on a day-to-day basis, while maintaining financial flexibility. This puts the organization in a position to seize opportunities when they become available, meet increased or unexpected demands for services, and make capital improvements when necessary.

The Right Reserve Level

This leads to the ultimate question: How much is enough?

The answer from the Nonprofit Operating Reserves Initiative (NORI) Workgroup is essentially, “It depends.” The group was formed in 2008, at the beginning of the economic downturn, by the National Center for Charitable Statistics at the Urban Institute. It was intended to address the needs for maintaining operating reserves at adequate levels for achieving and maintaining financial stability. Specifically, this group of prominent individuals from the not-for-profit sector was convened to define an “operating reserve ratio” that could be relied upon by organizations nationwide.

NORI Workgroup members acknowledged that there is no definitive benchmark for all situations. However, the group did conclude a minimum operating reserve ratio at the lowest point during the year is 25 percent or three months of the annual expense budget.

This goes along with traditional thinking that a rainy day fund should equal somewhere between three- and six-months-worth of regular operating expenses. On the high end, reserves shouldn’t exceed the budget for a two-year period. Conversely, on the low end, reserves are needed to cover at least one payroll period for the entire staff. Of course, these projections are less precise than the NORI Workgroup’s determination.

Policies and Reporting

The group also recommended that organizations develop a written policy defining their operating reserve level, describing how operating reserves are calculated and explaining the reasoning that led to these conclusions. It placed great emphasis on the benefits of the operating reserve ratio as a financial indicator. Relying on the ratio, a board should agree on:

      • How reserve funds can be used,
      • When they can be used, and
      • Who is authorized to use them.

Finally, any activities involving the reserves should be reported back to the board.

Have You Addressed Your Operating Reserves?

The need for establishing operating reserves can’t be ignored. If your board has not yet addressed this issue, or needs to revisit it, arrange for an analysis, regardless of your current donation levels. For more information, seek guidance from your not-for-profit adviser.

© Copyright 2015.

  • Comments Off

Comments are closed.