Are Your Operating Reserves Enough for Your Next ‘Rainy Day’?
Posted by Grant Lam
What would happen if a major fundraising event had to be delayed or a couple of long-expected grants fell through? Where would your organization find the dollars to continue operations until you could recover those lost funds?
Just like it’s important for individuals and families to set aside “rainy day” 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 operating reserve consists of unrestricted net assets that nonprofit boards and leadership designate for use during turbulent times caused by economic uncertainties, reduced funding or general unexpected events.
The idea is to establish the reserve from liquid assets, which can easily be used to cover operating expenses if needed. Equity in fixed assets is an example of what would not be included in operating reserves, since it is not easily converted into cash. Organizations that take a more conservative approach may also exclude the equity in other non-current net assets, such as long-term receivables, inventory and prepaid expenses.
Lack of reserves leads to crisis-based decisions
An organization with adequate operating reserves is better able to weather any financial crisis, because it can tap into its reserve to meet payroll and other operating costs until external funding is found. A reserve also buys the organization’s leaders more time to pursue other measures of funding.
Without a reserve, an organization facing financial hardship may be forced to make crisis-based decisions—such as cutting programs or laying off employees. Financial hardship also increases the temptation to borrow funds from temporarily and permanently restricted net assets. Use of restricted funds for purposes other than those imposed by donors violates the donors’ intent for the funds and creates legal and fiduciary issues.
Establish an operating reserve policy
All nonprofits should have a written operating reserve policy that considers the issues and circumstances specific to the organization and operating environment. It should:
- State the level of operating reserves adequate to the organization
- Define how the operating reserve is to be calculated
- Discuss a plan to replenish reserves if they drop below the stated minimum
- Review the logic behind how management and the board arrived at the policy
- Project how the reserves will be invested based on short-term, intermediate or long-term goals
The question of how much operating reserve is enough can be a thorny one. Some may argue that a nonprofit has an ethical obligation to devote as much of its available resources as possible to carrying out its mission. The optics of sitting on significant reserves when soliciting additional donations can also be a concern. Reserves, however, aren’t about accumulating wealth. They’re about securing the financial stability necessary to function effectively for the long run.
We suggest 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).
Operating reserve ratio (percentage) = operating reserves / annual expense budget
Operating reserve ratio (months) = Operating reserves / average monthly expense budget
As a general best practice, an organization’s operating reserve ratio should never fall below 25 percent or three months of the annual expense budget. We suggest you keep reserves above the minimum. For example, maintaining a six-month reserve gives you greater flexibility and could provide money for a new program initiative that’s not quite fully funded. The establishment and maintenance of an adequate reserve is something that can happen over the course of a few years.
Are you ready for the unexpected?
A reserve that will cover operating expenses for at least three months helps prepare your organization for the next crisis or unexpected opportunity—whether that means holding out for that next big grant or funding a program until government funds come through. Contact your Armanino nonprofit expert for guidance as you establish or review your operating reserve policy.
Key factors to consider when establishing an adequate operating reserve:
- Growth. Nonprofits that are not planning to expand their services will likely have capacity for a larger reserve, while those seeking to grow will probably maintain a smaller reserve, because they are likely more financially stable and will need to use surpluses for expansion.
- Structure. Generally, the more complex the organization, the higher the level of reserves required. For example, a multinational nonprofit will usually need a larger reserve than a single-location organization.
- Budgets. Nonprofits that historically have had significant fluctuations in budgeted-to-actual results will likely need a larger reserve, while organizations that have been more accurate in planning and forecasting may plan for lower reserves.
- Predictability of revenues and expenses. Organizations with significant fluctuations in daily operating costs, revenue sources and income/expenses will likely need to plan for a larger reserve to handle these fluctuations. For example, a nonprofit with a diverse mix of revenue streams and payers can support a lower reserve compared to a nonprofit that is reliant on only a few payers.
Grant Lam is a partner in Armanino’s San Francisco office, serving clients in the firm’s Audit practice. Grant has more than 11 years of experience auditing and consulting for companies and organizations in a broad range of industries. He works extensively with nonprofit organizations and specializes in Single Audits (OMB Circular A-133). Grant’s clients also include companies in the financial services, insurance, leasing, mortgage lending, life sciences, healthcare, private schools and government industries. Grant’s experience includes financial statement audits, reviews, compilations, general business consulting, mergers and acquisitions, and audits of federal funds (including Single Audits, HUD and Department of Energy audits).