The Importance of Operating Reserves for Nonprofits

What is an operating reserve, and why does every nonprofit need to address this issue?

These are unprecedented times. The COVID-19 pandemic has negatively affected many organizations, and the long-term effects are yet to be seen. Whether faced with potential reductions in contributions, the inability to conduct in person programming, or the cancellation of planned events, it is no surprise that many organizations are simply trying to survive. Establishing or maintaining a reserve, while a prudent fiscal policy, has fallen to the wayside for many nonprofits closely watching their cash flow.

In reality, factoring an operating reserve into the organization’s plans is more essential now than ever before. Despite the importance of operating reserves, studies show many nonprofits have insufficient or negative reserves, putting them at serious risk. Maintaining a healthy operating reserve signals that the nonprofit has a well thought-out sustainability plan, which can be attractive to potential funders.

It is a misconception that nonprofit organizations should not make a profit. In fact, the goal should be to build a solid base for the organization by accumulating net asset balances without donor restrictions and investing them in the organization’s programs. Accordingly, the greater the net assets without donor restrictions balance, the greater the organization’s ability to enhance and expand current programs and further promote the organization’s tax-exempt purpose.

Alternately, recurring deficits that result in negative or insignificant net assets without donor restrictions balances may raise red flags to existing or potential donors. Some nonprofits have inadequate net assets without donor restrictions, while others have been using net assets with donor restrictions to cover current operating expenses. Using funds restricted for a different purpose is risky because it will affect cash flow. Ultimately, these “borrowed” funds will have to be paid back to the net asset with donor restrictions accounts, or the organization will run the risk of defaulting on donor wishes.

Operating reserves are the portion of the net assets without donor restrictions designated for use in emergencies. The reserves sustain financial operations and allow an organization to continue its programs when faced with unexpected situations (like a global pandemic or economic downturn) that result in significant unbudgeted increases in operating expenses or reductions of operating revenues. These reserves should not be confused with the board-designated funds set aside for special projects or future ventures. They should also be separate from the undesignated net assets without donor restrictions primarily made up of noncurrent, non-liquid net assets.

The initial question most nonprofits struggle with is, “What is the appropriate amount to be set aside in an operating reserve?” Unfortunately, no single set benchmark applies to all nonprofit organizations because each is different. Therefore, the appropriate operating reserve balances differ depending on a variety of factors.

The rule of thumb suggested by the Nonprofit Operating Reserves Initiative Workgroup is a minimum reserve of 25% or three months of the annual operating expense budget. Many organizations strive to increase that reserve to six months once the three-month reserve is achieved.  

In determining the appropriate reserve amount, which may vary from year to year depending on the organization and its strategic goals, key members of management and the board of directors must evaluate the internal and external factors that could potentially affect their organization. The factors may include stability of revenue and expenses, the maturity of the organization, and future plans of the organization, which may include new ventures, new programs, etc. This could be assessed as part of a broader business continuity plan.

Once the optimal operating reserve balance is determined, the Board should identify a plan to begin to build the reserve, assuming it does not already have the resources available to set aside. For some this may seem like a lofty goal given the current circumstances, but putting this plan in place now as the organization works through the current crisis will result in a stronger and more resilient organization to handle the next one. Some organizations decide beforehand that a percentage of each year’s excess will be set aside until the goal has been achieved. Other nonprofits wait until the end of the year to decide what they can set aside based on how well the organization performed that year. More fortunate nonprofits that already have significant net assets without donor restrictions just need to formally segregate these funds from the undesignated funds and internally designate the segregated funds for the operating reserve. Nonprofits should also address how and when reserve funds can be accessed.

The operating reserve balance should be evaluated on an annual basis in order to ensure the nonprofit is properly safeguarded from the unexpected. This should be a priority for all nonprofits, especially now while there is so much uncertainty. An operating reserve can mean the difference between just surviving and building a strong future for the organization and the community it serves.