How much do you need in your Operating Reserve?
In Part I of this three part series, we discussed “What is an Operating Reserve and why is it necessary?” I examined the definition of an Operating Reserve, and the benefits of such a reserve. I established the idea of an operating reserve as a specific, defined asset that is set aside in readily accessible cash, to be used in financial emergencies, and not as part of the organization’s normal operating cycle.
In this installment I will focus on “How much do you need in your Operating Reserve?” I will provide options for determining the amount of an Operating Reserve that is appropriate to the organization. The final part of this series will examine methods for establishing and funding the Operating Reserve.
Anyone involved in the nonprofit industry knows that there is no standard formula that fits all nonprofit organizations. The ratios used to evaluate one nonprofit may not apply to another. The lack of standardization reflects the diversity of the industry, from trade groups, to charities, to political organizations. These organizations receive their funds from a variety of sources, they spend their money on very different programs, and they have different stakeholders. Because of this diversity, there is no one way to establish the appropriate amount of Operating Reserves for an organization; but there are options.
Are you a “grasshopper” or an “ant”? To begin to develop the appropriate amount of Operating Reserves for your organization, you should first consider your organization’s attitude toward spending and saving. Are you a “grasshopper” spending your funds on current needs, or are you an “ant” saving funds for the future? Do you prefer to fund your programs using all available resources to meet as many current needs as possible, or do you prefer to fund your programs in a way that ensures the sustainability of the program into the future. Your philosophy on saving affects the amount of reserve that is right for you.
What are YOUR risks? Next you should brainstorm possible events that could arise that would create a cash need for your organization, and then evaluate how much cash you would need to overcome it? Would a significant portion of your support disappear? Would you go without funding for a period of time? Are there other resources you could access in an emergency? The Nonprofit Operating Reserves Initiative Workgroup concluded that your Operating Reserve target should be expressed as an Operating Reserves Ratio. Your ratio can be either a percentage of annual expenses, or a number of months of expenses. Your organization’s own potential emergency needs affect the percentage of annual budget or the number of months’ expenses you need in your Operating Reserve.
The Operating Reserve target is a minimum standard the organization should strive for to maintain its financial health. There is no need to establish a maximum, as the other competing demands of the organization will preclude the temptation to overinflate the Operating Reserve. The Better Business Bureau Wise Giving Alliance does recommend that no more than three time the past year’s expenses be maintained in all types of reserves, although their definition of reserves includes more than just the Operating Reserve. For example, their definition includes opportunity reserves, to be used for new programs and building reserves for expansion of existing facilities.
The Nonprofit Operating Reserves Initiative Workgroup, which was comprised of a number of individuals with extensive experience in the nonprofit industry, recommended a minimum Operating Reserve of 25%, or three months of annual operating expenses, and this is in addition to any other types of reserves.
What Should Your Board Do?
Whatever your target, it must be approved by the organization’s Board. In any nonprofit organization, it is the Board’s responsibility to monitor and evaluate the organization’s financial health, and management’s responsibility to implement policies to achieve the Board’s goals. Establishment of the Operating Reserve target is a key step for the Board to take in ensuring the future financial health of the organization.
Operating Reserves should be governed by a comprehensive, Board-approved policy that includes criteria for spending the reserve. If the policy requires Board approval for withdrawals, the Board must be prepared to meet quickly to authorize access to the Operating Reserve in an emergency. The time needed for the Board to respond to an emergency may influence the size of the Operating Reserve target.
Another issue for the Board is implementing corrective action when the Reserve falls near or below the target level. To do this, the Board needs to have regular status checks on the level of the Operating Reserve, and may want to develop a plan that can be quickly put into place should the need arise.
Next Steps With the guidance above, you should be able to help your organization identify the Operating Reserve target that is right for you, and help your Board approve an appropriate Operating Reserve policy.
In the final part of this series, I will address methods for funding the Operating Reserve and polices for governing the safeguarding and spending of an Operating Reserve.
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