March 2012, Catherine M. Pennington,
CPA, CGMA, Senior Manager, Renner and Company, CPA, P.C.
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Those of us who work in the nonprofit world know that our entities are very different from our for-profit brethren. Nonprofits focus on the mission, not the “bottom line.” They are generally self-funded and normally have no owners to support the organization through tough times. While our mission is constant, our funding is not. This combination of factors leads us to examine the need for Reserves.
Reserves are often loosely defined, roughly calculated and frequently unfunded. They can be donor restricted, board designated or created by a windfall of funds left over from operations. In other words they are often unintentional, and not specifically created or defined.
In 2008, a group of associations, charities, charity rating agencies, and nonprofit professionals formed The Nonprofit Operating Reserves Initiative to address the need for Operating Reserves for all levels of nonprofit organizations. Their whitepaper, “Maintaining Nonprofit Operating Reserves, An Organizational Imperative for Nonprofit Financial Stability”, defined the concept of Operating Reserves and includes many of the concepts discussed here.
In a series of three articles, we will examine Nonprofit Operating Reserves. This first article will focus on understanding of Nonprofit Operating Reserves and why they are necessary. In the second article, we will address how to determine the amount of reserves that are necessary and, finally, we will discuss ways to fund Operating Reserves and develop policies governing their use. We hope that by the end of the third article, many more nonprofit organizations will be working to define and establish the Operating Reserves that will help support and sustain their mission.
Why Do We Need Reserves?
In 2011, the Nonprofit Finance Fund, a leading community development financial institution, researched the funding status of nonprofits and found that the majority are undercapitalized. Their 2011 State of the Sector Survey found:
- 60% had less than three months of cash available,
- 28% reported that they had one month or less of operating cash,
- 10% had no cash.
Without any available cash, nonprofit organizations may have serious difficulty meeting their normal working capital operating needs, much less weathering economic downturns. In addition, they are often unable to take advantage of preferred pricing due to an inability to purchase supplies on a regular schedule.
This crisis in funding severely handicaps nonprofits in their ability to be effective in accomplishing their mission. As an industry, we must recognize the need to create sustainability in our organizations and one way to do this is to create Operating Reserves.
Operating Reserves can be defined as the portion of unrestricted net assets that Boards designate for use in financial emergencies. It does no good, however, for these net assets to be invested in buildings, furniture and equipment. Operating Reserves need to be funded in readily accessible cash.
Day to day working capital is not the same as Operating Reserves. Working capital is used to meet your normal obligations through your operating cycle which is generally one year. There are ups and downs to this cycle and working capital on hand must be sufficient to meet your organization’s needs during the lean parts of the cycle; not just the flush periods. Operating Reserves are emergency funds you hold in addition to your working capital.
Many charities with a traditional mindset accept their crisis in funding as status quo. Before dismissing the idea of Operating Reserves as a luxury item, consider how Operating Reserves would add to your ability to carry out your mission by:
- Enabling continued operations during downturns,
- Providing evidence that management is prudent, forward thinking and committed to reliable program delivery,
- Making the organization more attractive to employees,
- Adding flexibility to respond to both emergencies and opportunities,
- Creating sustainability for members or clients.
This last point is probably the most important of all the reasons to have an Operating Reserve and is best illustrated through an example:
Let’s say a preschool/daycare center provides its services to low-income families and is largely funded through local government subsidies. A natural disaster occurs in the area and a number of the parents lose their jobs. Because they no longer have two working parents, the families are not eligible for the subsidies and must withdraw their children from the school. As enrollment falls, the school is no longer viable and closes. After a few months the local economy recovers and the parents can again find work, but are unable to find affordable child care because the school has closed.
In this instance an Operating Reserve may have enabled the school to sustain its mission by remaining open until the economy recovered.
Charity rating agencies understand that an organization with funds in reserve is better positioned to carry out its mission than an organization without reserves. Some charity rating agencies give higher marks to nonprofits that hold one to three years of expenses in reserve.
Associations, even those that hold long-term reserves, also need to consider the need for Operating Reserves. Unforeseen events can lead to meeting cancellations, cancellation penalties and loss of income. Long-term reserves may not have the liquidity to meet emergency needs. Associations need to hold a portion of their reserves in investments that can be accessed quickly without incurring capital losses and disrupting long-term asset allocations.
Now is a good time for forward thinking Board Members and nonprofit executives to begin discussing the Operating Reserve concept, and how it relates to the needs of their organization.
To read more about the Operating Reserves concept, access The Nonprofit Operating Reserves whitepaper at: http://www.nccs2.org/wiki/images/3/3c/OperatingReservesWhitePaper2009.pdf.
Operating Reserves are not a luxury but a necessary component of sustaining the mission of charities and associations alike. They are Board designated and separately funded with liquid assets and are held in addition to the organization’s normal working capital. Forward thinking Board Members and nonprofit execs should embrace the Operating Reserve concept and consider the advantages it would bring their organization. In the next newsletter I will discuss methods to determine an adequate amount of Operating Reserves.
©2012 Renner and Company, CPA, P.C., all rights reserved.