Operating Reserves: The Key to Building Financial Flexibility

The Nonprofit Operating Reserves Initiative Workgroup (NORI) first began meeting in 2007 to address the alarming lack of liquidity among small and midsized nonprofits. For nonprofits and for-profits alike, the 2008 recession and its lingering effects resulted in many of these undercapitalized groups having to close their doors, significantly curtail services, or merge with other entities.

NORI’s 2009 whitepaper posited that lack of liquidity made these groups financially fragile and that building sufficient reserves is an imperative for sustainability of program delivery and organizational fiscal health.

In 2009 and 2010, NORI workgroup members built and launched the “Operating Reserve Policy Toolkit for Nonprofit Organizations” to help staff and board members talk about operating reserves and working capital. It aimed to answer questions such as:

• What should a reserve target amount be? Where would the money come from?
• How should the funds be managed?
• Could it be invested?
• How could they best communicate the importance of building and maintaining such a fund while still striving to meet annual operating revenue goals?

Following are some highlights from the toolkit.

Setting a Target

There is no one-size-fits-all target; “it depends” is the applicable mantra. For most organizations, setting a target amount for an operating reserve depends on a variety of key factors including:

• How reliable or volatile is the revenue stream?
• What is the mix of fixed versus controllable expenses?
• What is the likelihood that demand for program services would spike unexpectedly?
• Is there a facility involved that may need emergency repairs?
• Is there a time of the year when cash flow is chronically low?
• Would the organization be able to sustain through a natural disaster?

The NORI Workgroup suggested that 25 percent of annual operating expenses (three months of expenses on average) would be a good baseline but that each organization should determine the right amount for its own circumstances. For example, the higher the risk factors, the higher the operating reserve should be.

Typically, associations have a steady stream of membership dues, so revenue may not be as volatile as for other groups. But, if there is a significant dependence on a single large sponsor, grant, or conference, it might indicate that a larger reserve would be more prudent. In a bad economy, members may consider dues and conference attendance as a discretionary expense that can be skipped until better times. This downside risk should be analyzed and a reserve target set accordingly to sustain through lean income periods.

Setting Policy

Having a written plan for how the fund will be managed once it is established is an important component that should not be overlooked. A good policy will provide clarity for current and future board and staff. Basic components of the policy would address:

• intended purpose of the fund
• target amount expressed in percentage of annual expenses
• authorizations required and procedures to access the funds
• time horizons for replacing borrowed funds
• priority use between the reserve versus a line of credit
• investment guidelines and disposition of interest earned
• reporting requirements
• oversight and monitoring
• frequency for updating the target and policy.

Funding the Reserve

Nonprofit does not mean “no surplus allowed.” Organizations that have regular surpluses (as opposed to chronic deficits or break-even years) will gradually build financial strength and sustainability. Strategies to raise money to fund an operating reserve include:

• budgeting for operating surpluses annually
• including a “contribution to reserve” budget line item
• funding noncash depreciation expense
• creating special member assessments in good economy years
• including as component of capital campaigns or planned giving campaigns
• designating board contributions
• designating staff vacancy savings
• designating windfalls.

Making the Case

There are compelling reasons for having adequate working capital and a board-designated operating reserve. A right-sized operating reserve does not make an association “rich” but rather makes it stable and sustainable, inspiring the trust of current and potential members and sponsors. When an organization is experiencing chronic cash flow stress it can lead to staff burnout and penny-wise but pound-foolish expenditures.

The presence of a board-designated operating reserve is a strong indicator of prudent, forward thinking management. Having a reserve supports fulfillment of mission and program objectives, promotes long-term planning, and fosters strategic decision making. The real question is: Can your organization afford not to have an operating reserve?

Find more info on Nonprofit Operating Reserves Initiative Workgroup, including the “Operating Reserve Policy Toolkit for Nonprofit Organizations” at the National Center for Charitable Statistics Wiki