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An operating reserve is an unrestricted fund balance set aside to stabilize a nonprofit’s finances by providing a cushion against future unexpected cash flow shortages, expense or losses.  In other words, an operating reserve is a rainy day savings account. Reserves are used to cover a short-term cash shortage caused by delayed payments, timing of grants, or seasonal cash swings. Reserves can also be used to pay unexpected, and unbudgeted, expenses like building repairs or technology upgrades, or for increases in costs like utilities or insurance. Reserves should not be used to make up for income shortfalls if the organization doesn’t also have a plan to replace the income or reduce expenses in the near-term future. Reserves should be used to solve timing problems, not deficit problems.

Reserves are different from restricted funds. Restricted funds are contributions that have been received for specific programs or projects. Restricted funds must be used according to the grant agreement or donor’s instructions, which means that sometimes restricted funds sit idle in the bank for awhile, but the nonprofit can’t use those funds for some other purpose. Reserves, on the other hand, are unrestricted funds that can be used in any way that the nonprofit decides. 

Where do reserves come from?
Occasionally a nonprofit will receive a grant or contribution to create or add to an operating reserve fund. Usually, though, reserves are built up over time by generating an unrestricted surplus at the end of the year – more income than expenses – and setting the cash aside into a segregated account.

How much?
There are some rules of thumb for setting operating reserve goals, usually based on the premise that nonprofits need to have enough unrestricted cash to cover operating expenses for a number of months. A commonly used reserve goal is three to six months’ expenses. At the high end, reserves should not exceed the amount of two years’ budget. At the low end, reserves should be enough to cover at least one full payroll. Standard calculations don’t take some important variables into account, like the stability of your cash receipts. Organizations that have contracts or fees with regular and reliable payments don’t need as much in cash reserves as organizations that rely on periodic grants, fundraising events or campaigns, or seasonal activities.

Managing operating reserves
To be a viable operating reserve, there should be a board agreement and policy about how reserve funds can be used. The purpose of the policy is to describe when these cash funds can be used, who is authorized to use them, and how this is reported to the board. Some boards go so far as noting a “Board designated reserve” on their financial statements. This helps to communicate that reserves are in place. Without a policy and agreement, reserve funds tend to be spent down over time, and are not available the next time the funds are really needed.

Authored by Kate Barr, Executive Director of Nonprofits Assistance Fund which provides flexible loans and  practical financial management training and advice to nonprofits in Minnesota.  Other resources and articles on nonprofit financial management topics can be found on their web site at www.nonprofitsassistancefund.org.  You can contact Kate Barr at 612/278-7180.

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