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Recent tax law harshly affects the level of donations for many nonprofits. Combine that with uncertainties about government funding, and it’s easy to see that operating reserves are more important than ever for long-term sustainability. Yet studies show that organizations often fail to maintain adequate reserves, which could potentially lead to financial disaster. If your reserves aren’t up to snuff, now is the time to address the situation.
Why are reserves important?
Operating reserves — generally, unrestricted assets 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.
For starters, solid operating reserves demonstrate responsible financial stewardship to your stakeholders. They also increase the odds that you can achieve 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 can protect against staff or program cost reductions that would cut into attaining 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 they are to deficit issues.
What’s 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 nonprofit but too little 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 nonprofit should have robust reserves. But, if you have multiple, diverse revenue streams, you probably can get away with less substantial 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 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 hike certain expenses? For how long?
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.
Quantify your risks. Setting your operating reserves is one good reason to undergo a comprehensive risk assessment that identifies your risks, including those related to:
- Your mission, sector and geographic location,
- The economy, and
- Pending or potential litigation.
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. Your stakeholders want to see you using funds to achieve your mission, rather than accumulating stockpiles of money. Charity watchdogs often monitor nonprofits’ reserves so potential donors can check on your financial stability. If your reserves are too high, donors may conclude that you don’t truly need their money.
The reassurance of reserves
Successfully managing operational reserves takes time. However, the end result is worth it: a financial safety net and peace of mind for your stakeholders.