Reserves – What Kind and How Much?

Each month, Nonprofits Assistance Fund hosts the Financial Management Network. These free, informal gatherings are opportunities for members of the nonprofit community to get together to discuss different financial topics and network with peers. Key takeaways from these discussions will be posted and form an archive to help promote healthy financial practices.

Reserves – What Kind and How Much? (10/28/2009)

This is a particularly important time to discuss reserves. Boards of Directors are likely nervous about cash in the bank. In this difficult funding environment, some organizations may choose to draw on reserves in order to operate programs. Other organizations may be considering a line of credit. All of these discussions are overshadowed by anxiety that 2010 and upcoming years are going to be worse.

As a general rule, reserves should be appropriate for your organization and business model. There really is not a one-size fits all standard.

What Kind?

There are different kinds of board designated reserves, depending on your organization's fixed assets - a building, specialized equipment - and the reliability of your funding sources, you may need different types of reserves:

Operating reserve to meet planned cash flow needs
Capital reserve to fund future capital purchases or support ongoing costs associated with fixed assets
Emergency loss of income reserve - if a large grant does not come through, you can use reserve funds to finish out contracts
Emergency expense reserve to handle unexpected legal expenses, building repairs, etc.
Reserve to fund new programs and opportunities - foundations and potential funders like to see that you are already working (saving) to get a new program off the ground
Look at your balance sheet:
- Net asset reserve
  - Has the organization accumulated positive net assets over time?
  - Are the organizational assets greater than the liabilities?
- Working capital reserve - use the working capital ratio to figure out how much working capital you currently have available
  - Days Working Capital Ratio = (Unrestricted Net Assets - Equity in Fixed Assets) / (Total Expenses / 365)

Policies

The board should create a reserve policy
A policy will guide staff in planning and action
Policy should consider:
- Purpose and size of reserve
- How to build the reserve
- How to use the reserve
  - When it's appropriate to access funds
  - Who has the authority to use reserve funds
- How to replenish the reserve
  - A policy might say that reserves can only be used if you know you can replenish them, based on your cash flow projections
  - You might set a goal to pay yourself back in x years, to make the money more meaningful
Many organizations wait until they need cash to discuss options and then take action. If you have a trigger, action can be taken before a cash emergency happens.

Building a Reserve

Achieving an operating surplus is the first to set establishing a reserve
- Have deliberate goals and policies for building a reserve
  - Example goal: Build a six month reserve in six years, by achieving a one month surplus every year for six years
  - Example policy: Put x percent of each annual surplus into the reserve

A reserve starts with an unrestricted operating surplus.

Organizations can achieve this in a number of ways

Income
- Budgeting for a surplus
- Generating additional earned income or a robust fundraising year
- Surprise income, such as a court settlement or an unanticipated significant contribution/landmark gift
Expenses
- Find an opportunity to reduce costs.
  - For example, choose to delay rehiring.
Budgeting and management
- Craft a realistic budget.
  - Too many organizations have overconfident revenue budgets, and planned surpluses disappear when revenue fails to come in during the year.
- Reserve planning must start during the annual budget planning process.
  - In your annual budget, plan to fund depreciation on your fixed assets. To "fund depreciation," achieve a budget surplus while accounting for depreciation as an expense line item in your budget.
- Make sure you can operate your programs with the cash you have.
- Work to fund your management and administrative costs by allocating these costs into grant budgets and program funding proposals, when possible.

The "current services trap"

Should you use surplus cash to provide more services now, or save the cash for future needs?
Most nonprofits naturally want to provide as many services as possible.
However, ask what it really means to be a "nonprofit." Think about long-term sustainability and what financial health is necessary for this sustainability.
Program people who always want more money might find themselves opposed to financial managers who are concerned about the organization's balance sheet - organizational leadership needs to find the right balance between current services and long-term health.
It can be dangerous to get surprise contributions! It is too easy to spend surprise cash during the year, without thoughtful budgeting and planning.
How to Get Out of the Current Services Trap

How Much and How Accessible?

A 3-6 month cash reserve is most common
- This standard might not apply to you, because different organizations have different cash needs, depending on business model, capital requirements, etc.
  - The Cash Reserves Myth
- A cash flow projection helps you to understand your cash needs and risks, which should inform your target reserve amount.
Think about how you will use the reserve when deciding how to invest. Do you need cash that is immediately accessible? How liquid should it be?