Operating reserves – generally, assets without donor restrictions that you can tap into easily – frequently are referred to as “rainy day funds.” But stable reserves are critical for far more pressing reasons than the metaphorical rainy day.
Solid operating reserves demonstrate responsible financial stewardship to your stakeholders. Reserves also increase the odds that your organization can achieve self-sufficiency, making your organization less vulnerable to unpredictable or cyclical revenue streams and government funding cutbacks.
Adequate reserves put your organization in a better position to handle market-based swings in investment income and enable it to cover unbudgeted expenses (for example, a roof replacement not covered by insurance). Reserves can protect against staff or program cost reductions that would prevent you from meeting your mission. And reserves can empower your organization to take advantage of opportunities (such as the availability of new facilities).
On the other hand, you generally shouldn’t rely on reserves to make up for income shortfalls – unless you have a realistic plan to quickly replenish the reserves fund. Reserves are better applied to income – timing problems than they are to deficit issues.
Finding the right amount
Every nonprofit’s circumstances are different, so you shouldn’t base your reserves level on a rule of thumb, such as three to six months of operating expenses. Six months of expenses may be too much for one organization but not enough for another. At a minimum, though, your organization should at least have enough reserves set aside to cover one payroll cycle. Also look at organization-specific factors. If you’re heavily dependent on government grants, public donations or fundraising events – each can experience dramatic shifts due to political or economic winds – your organization should have robust reserves. But, if you have multiple, diverse revenue streams, you probably can get away with less reserves.
To determine the right amount of reserves for your organization, prepare a long-term financial forecast. Review your latest budget and how your strategic plans will affect the budget going forward. It’s essential to develop a realistic financial forecast for all aspects of your organization, including every revenue stream and expense. Is any revenue stream in jeopardy or uncertain? Is a new program launch expected to hike certain expenses? For how long? Make sure you don’t limit the financial forecast to a single year. Taking a longer view — say, five years — will help you recognize trends and key influences that might not stand out in a one-year snapshot.
Among other best practices, quantify your risks. Setting your operating reserves is one good reason to undergo a comprehensive risk assessment. This should include risks related to your mission, sector and geographic location; the economy; and pending or potential litigation.
Also assess the likelihood and potential downside financial impact of each risk. These estimations of risk exposure can help you determine appropriate reserve amounts. Once the target level has been determined, develop a plan to fund your operating reserves.
Bear in mind that, while it might seem counterintuitive, your operating reserves can become too large. Most stakeholders want to see an organization using funds to achieve its mission, rather than accumulating stockpiles of money. Charity watchdogs often monitor nonprofits’ reserves so potential donors can check on financial stability. If your reserves are too high, donors may conclude that you don’t truly need their money.
Financial safety net
With tax laws affecting the level of donations for many nonprofits and uncertainties about government funding, operating reserves may be more important than ever for long-term sustainability.
Failure to maintain adequate reserves could potentially lead to financial disaster. As with most financial policies, your operating reserves policy should be regularly revisited to ensure it remains current and relevant to your organization’s situation. Now is the time to address operating reserves.