Operating reserves — generally, unrestricted assets you can easily tap — are often called “rainy day funds.” But stable reserves are critical for far more pressing reasons than the metaphorical rainy day.
Many nonprofits, for example, have drawn on their operating reserves since the spring of 2020 to cope with the economic backlash of the COVID-19 crisis. And many organizations wished they had had larger reserves to draw upon. Now, if you’re able, take steps to replenish your reserves.
Reserves are critical
Solid operating reserves demonstrate responsible financial stewardship to your stakeholders. They also increase your odds for self-sufficiency, making you less vulnerable to unpredictable or cyclical revenue streams and government funding cutbacks.
Adequate reserves put you in the position to handle market-based swings in investment income, too, and enable you to cover unbudgeted expenses (for example, a roof replacement not covered by insurance). Reserves also can protect against staff or program reductions that would prevent you from achieving your mission. And they can empower you to take advantage of sudden opportunities (such as the availability of new facilities). In the direst scenario, a financial cushion can allow you to wind down operations in a more orderly fashion.
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 fund. Reserves are better applied to income-timing problems than to deficit issues.
Target amount varies
Every nonprofit’s circumstances are different, so don’t base your reserves level on a strict rule of thumb. At a minimum though, your organization should likely strive for enough reserves to cover six months of operations, including payroll, fixed costs and other necessary expenses.
Also factor in 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 nonprofit should have robust reserves. But, if you have multiple, diverse revenue streams, you probably can get away with a less substantial stash.
You can estimate your target
To determine the right amount of reserves for your organization:
Prepare a long-term financial forecast. Review your latest budget and determine how your strategic plans will affect budgets going forward. It’s essential to develop a realistic financial forecast for all aspects of your nonprofit, including every revenue stream and expense. Is any revenue stream in jeopardy or uncertain? Is a new program launch expected to boost certain expenses? For how long?
Don’t limit your 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.
Quantify risks. Setting your operating reserves goal is one good reason to undergo a comprehensive risk assessment that identifies threats, including those related to:
- Your mission, sector and geographic location,
- Macroeconomic conditions, and
- Pending or potential litigation.
Assess the likelihood and potential negative financial impact of each risk. These estimations of risk exposure can help you determine appropriate reserve amounts. Once the target level has been decided, develop a plan to fund your operating reserves.
There’s another side of the coin. Although it might sound counterintuitive, your operating reserves can become too large. Stakeholders want to see you using funds to achieve your mission, rather than accumulating stockpiles of money. Charity watchdogs often monitor nonprofits’ reserves and make this information easy for potential donors to view and assess. If your reserves are too high, donors may conclude that you don’t need their money.
One last thing
The size of your operating reserves is somewhat moot if your organization doesn’t have a related policy in place. Your policy should address a number of issues, including the minimum amount to be held in reserves at all times. The plan for funding reserves might include budget surpluses, investment income, unrestricted contributions and even contributions solicited specifically for establishing a reserve fund. We can suggest other factors that should be included.
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