Balancing the Mission Checkbook

I have often said that my least favorite question is “What is the ideal target amount for a nonprofit to have in an operating reserve?” Because there is never a simple answer for the question, I wrote a post a while ago on The Cash Reserves Myth:

Every nonprofit should have a cash reserve equal to three months of expenses.” There’s some truth and some myth to this “best practice.” It is absolutely true that every nonprofit needs to have adequate cash balances available to support the timing of payroll and other expenses, as well as to pay for unanticipated costs or increases. It’s a myth, however, that a single standard applies for all nonprofits. I have two issues with the “three month reserve” standard. One is that different organizations need different amounts of cash on hand. The second is that building a reserve of three months of expenses is not a practical, or even desirable, goal for all nonprofits.

In an article I wrote a couple of years ago, The Yin and Yang of Nonprofit Reserves, I recommended different ranges depending on the stability of incoming cash flow, with reserves as low as one to two months of operating expenses. One reason for my caution about standard reserve ratios has been the business question of whether idle cash is an efficient use of capital.

I take it all back. Well, I take some of it back.

The Value of Cash Reserves

The past 18 months have been a lab test of the value of cash reserves. This isn’t a surprise, I suppose, but it has made me re-think my earlier questions about the focus on reserves. It is clear that nonprofits that have been able to build up a good cash cushion have had options and opportunities in the past year that enabled them to respond to reduced income and increased demand more strategically and carefully than those organizations with few extra dollars in the bank. You know what I mean whether you are affiliated with a nonprofit that has reserves or with one that does not.

In the survey that the Minnesota Council of Nonprofits conducted to prepare the most recent Current Conditions Report, several questions were included about operating reserves. MCN generously shared the survey data with me for an in-depth analysis of these questions. The responses illustrate the differences between nonprofits with and those without reserves.

• How much in reserves? For all respondents, 34% have one month or less, 18% have none, and 6% had a reserve fund but depleted it in 2009.
• Asked if they anticipated dipping into reserves in 2010, 24% of nonprofits replied that they do.
• Not surprisingly, 65% of nonprofits with minimal or no reserves experienced cash flow problems in 2009, and most of them anticipate prolonged cash flow problems in 2010. Nonprofits of all sizes fell into this group, most commonly in arts & culture and social services.

Why does it matter? I sliced the responses further and found that the nonprofits with minimal or no reserves were more likely to have cut budgets, eliminated staff positions, reduced wages and benefits. They were also less likely to have been able to increase services to respond to growing demand.

There’s a caveat that these results aren’t necessarily caused by the lack of reserves. It’s quite likely that other factors are at play, including the broader question of the governance and management practices and business model needed for nonprofits to build reserves over time through operating surpluses.

This survey and the practical cases that we talk with every day have taught me to truly appreciate – to love – operating reserves.

Build the Right Reserve for Your Organization

I still believe that the “right” target for reserves needs to be customized for each nonprofit based on their operating structure, cash flow, and ability to generate surpluses in the operating budget. Building reserves requires an intentional budget strategy and follow through to generate surplus funds. Whatever the target amount, reserves are most useful if there is clear agreement about their purpose and use codified in a written policy. Nonprofits Assistance Fund has developed Nonprofit operating reserves policy guidelines and examples. If you are interested in a deeper dive on the issues, considerations, and structure for reserves, you’ll love the Nonprofit Operating Reserves Initiative Workgroup White Paper. They answer the “how much” question with a useful chart that sorts through the “it depends” factors.

Worrying about cash shortfalls is, without a doubt, at the top of the list of stressors for nonprofit directors and finance managers. In this situation, everyone’s dream is to have a stash of cash – a cash reserve account set aside to tap at a moment’s notice to solve the problem. I’m reluctant to endorse a universal standard for reserves, but there are “rules of thumb” and accepted practices calling for nonprofits to hold reserves of three to six months of operating expenses. Well it turns out that this “best practice” is a practice in theory only for many nonprofits.

A study by the Urban Institute, reported in the Washington Post this week, Nonprofits Imperiled By Low Reserves found that 57% of the Washington area nonprofits studies had less than three months of reserves, and 28% had none. The June 2009 Nonprofit Current Conditions Report published by Minnesota Council of Nonprofits found new cash flow concerns caused by slower payments from county and state agencies. Surveys in Minnesota have found that at least 35% of nonprofits anticipate cash flow problems this year and 30% have one month or less of operating reserves. Low reserves and cash flow problems are not restricted to small or struggling nonprofits – it’s a widespread management challenge. The Urban Institute study contained an interesting finding, according to the Post article:

According to the study, larger groups were less likely to have sufficient operating reserves than smaller ones, a finding that surprised researchers. Seventy percent of charities with expenses over $5 million had low operating reserves, compared with 50 percent of groups with less than $100,000 in expenses.

This shouldn’t be that surprising when you do the arithmetic. Imagine that you run a nonprofit with an $8 million annual budget. Maintaining a three month reserve would require a $2 million cash account. That’s (a) a big number and (b) very difficult to build up in the low surplus, service delivery model of most nonprofits. Rather than dwelling on the best practice or target for designated cash reserve accounts, maybe nonprofits need to learn to be more sophisticated managers of cash and its relative, working capital. This financial concept was described well by Ben Cameron of the Doris Duke Charitable Foundation last week in a Chronicle of Philanthropy live online discussion, The Changing Role of Foundations.

Ben Cameron:
Most businesses recognize the need for ongoing working capital–it’s the heart of funds that allow a business to make strategic decisions around launching a new program or line of business, investing in a new facility, etc. I have been in discussions with some business executives who have been adamantly opposed to general operating support for arts organizations–thinking it gives organizations free license to be unstrategic and undisciplined–but instantly supportive of flexible working capital. In essence, the purposes are the same–the difference is in how the two terms are heard.

I’ve been advocating for better understanding of Nonprofit Capital for years. In the “nonprofits should be like business” debate, this is the one area where we do have a lot to learn. There aren’t many businesses that strive to hold a three month cash reserve account. That would be viewed poorly, in fact, because it’s an inefficient use of capital.

For peek at how the very largest and most sophisticated nonprofits solve a cash flow problem, read about how Dartmouth Joins Harvard, Princeton in Tapping Credit Markets. Because of the drop in endowments, Bloomberg reported that Dartmouth College just issued $250 million of 10-year notes “for liquidity and general working capital,” according to Julie Dolan, associate vice-president for fiscal affairs at Dartmouth.

Learn to love these words: Working Capital.

Following up on questions raised during some training workshops I presented last week, I’ve decided to start an occasional series called Mythbusters – Nonprofit Finance Edition. There are a number of pieces of “common wisdom” that I hear over and over again, and some of them are just not helpful. So starting with this post I’ll be adding my own spin to the Discovery Channel show Mythbusters (is it true that a penny thrown from the top of the Empire State Building will kill a person on the ground?).

Nonprofit Finance Mythbuster #1 – “Every nonprofit should have a cash reserve equal to three months of expenses.” There’s some truth and some myth to this “best practice.” It is absolutely true that every nonprofit needs to have adequate cash balances available to support the timing of payroll and other expenses, as well as to pay for unanticipated costs or increases. It’s a myth, however, that a single standard applies for all nonprofits. I have two issues with the “three month reserve” standard. One is that different organizations need different amounts of cash on hand. The second is that building a reserve of three months of expenses is not a practical, or even desirable, goal for all nonprofits.

First, how much should nonprofits have in cash reserves? A single standard doesn’t factor in some important variables, starting with the stability of the nonprofit’s cash receipts. Organizations that have contracts or fees with regular and reliable payments don’t need as much in cash as organizations that rely on a few big grants, fundraising events or campaigns, or seasonal activities. I’ve reviewed financial reports from large nonprofits with pretty low cash balances. They wouldn’t meet a standard requiring three months of expenses, but they also have regular cash receipts from program fees, contracts, and year-round fundraising. They also have high quality receivables and other short-term assets (which create “working capital”).

The other myth is that nonprofits can go from step one, the board adopts a policy requiring a three month reserve, directly to step two, open the savings account. Somewhere in there, voila, the cash is generated to deposit the required amount. Where do cash reserves come from? Consider a hypothetical agency that provides mental health services with a $2 million annual budget. A three month reserve is $500,000. Starting from zero, they need to generate a 25% surplus of income over expenses to build these minimum reserves. This is unattainable in the near future, and it may be far more cash than this agency needs. If the mental health services are paid for by third party insurance payments and contracts with the county government, cash flow may be stable enough that about one month in operating cash, or $165,000 – $200,000, will be enough.

Bust this myth. Rather than falling back on an easy standard, each nonprofit needs to understand their revenue sources, project month by month cash flow, anticipate any shortfalls, build in some cushion for snags or surprises, and create a workable and customized policy.

My interest in financial mythbusting is inspired in part by a series I’ve enjoyed by Paul Shoemaker at his SVP Blog at Social Venture Partners Seattle. Over the past few months Paul posted a series called “10 Things We’d Like to Tell Every New Philanthropist.” For example, Lesson #3 – “I need to be careful to not let the non-profit get too dependent on my contributions.” Each of the questions that he poses seem to make sense, but he warns that these common misperceptions and mistakes need scrutiny and discussion to avoid the problems they can cause. He’s finished the list of ten lessons for philanthropists and said he would follow this series with “10 Things We’d Like to Tell Every Nonprofit.” I look forward to seeing his new top ten list.

Instead of New Year’s resolutions, my first entry for 2007 is a list of ten common mistakes (with comments) that nonprofits make in managing their financial life. This list is excerpted from a terrific paper submitted by one of my students, Nick Eoloff, in a Financial Management for Nonprofits class at Hamline University. I thank Nick for giving me permission to share his paper.

Ten Mistakes Nonprofits Make in Financial Management:

1. All your eggs in one basket – Pay attention to your reliance on any particular source of revenue, in particular government contracts.
2. Cash flow analysis done annually – You can’t know everything at the beginning of the year. Management cash flow never stops.
3. Financials that are opaque – Nonprofit financial reports can be complex and difficult but that’s not an excuse for board members that don’t understand them or poor communication about your financial situation.
4. Inflexible – Things always change – go with it.
5. Little to no overhead – Some organizations still believe that infrastructure and overhead are not a good use of resources. This decision never turns out well.
6. Low operating reserves – Everyone wants to have operating reserves but the only way to build them to by planning and managing surplus budgets.
7. Never leverage – Using loans and credit lines to build the organization and grab opportunities is smart management.
8. No long term plan – Strategic plans are great, but how much better if they include a basic financial plan for three or five years.
9. Preparing financial projections, but never reading them – See above.
10. The auditor’s notes don’t mean much – Make sure you read all the pages of your audit report. I know they don’t look interesting, but you’ll be surprised at how informative they are.

For a complete copy of Nick Eoloff’s paper with more description and references, click here. Use this list as the start of your New Year’s resolutions for better financial management.