Not-for-profit leaders have, in recent studies, identified the establishing and maintaining of operating reserves as a top priority for their organization. In today’s ever changing environment and economic climate, many not-for-profits may face potentially unforeseen challenges and issues that can be a drain on financial resources. The use of operating reserves may help not-for-profits better manage these risks and achieve financial stability. Although many not-for-profits agree that the establishment of operating reserves and policies is a best practice, many organizations currently do not maintain such reserves, or worse, already have negative reserves and are at risk.
There are various definitions of what reserves are and how they are established. Quite simply, a reserve is a not-for-profit’s liquid net assets. Not-for-profit boards view operating reserves as a portion of unrestricted net assets accessible for financial emergencies, economic down shifts, or unexpected events within its organizations or “rainy day” funds. Other reserves created by not-for-profits are things like a building repair reserve or a programmatic opportunities reserve. It’s important for organizations to understand that reserves are different than restricted funds. Restricted funds are typically grants or contributions that were provided for a specific program or project and often times are “restricted” by donor or grantor agreements. Reserves on the other hand are “unrestricted” funds that either management and/or the Board of the organization can utilize at its discretion.
There are various external and internal forces that not-for-profits must contend with daily. As an organization becomes more self-reliant, it must evaluate its operations’ performance and prospective outlook. Recent constrictions in funding from federal, state, and local sources have caused not-for-profits to reevaluate previously stable revenue streams and how they now impact its mission and programs. Furthermore, the turbulent investment market, where investment performance for major indices fluctuates vastly above past results, has caused reliance on investment earnings and portfolio growth to be unreliable. Coupled with the desire of most not-for-profits to utilize funds to the maximum in an efforts to carry out their programs and mission, oftentimes with limited resources, the environment for financial security against unanticipated interruptions may become difficult to manage.
There are host of ways by which not-for-profits can measure liquidity. Some organizations rely on the use of a current ratio (current assets divided by current liabilities) with a ratio of 2-3 being generally favorable. Others may choose to measure against liquidity factors, where an organizations’ expendable net assets are divided by an average monthly expense. This provides an indication of how many months a not-for-profit has before it consumes its liquid assets. On average, not-for-profits should strive to attain coverage of expenses for a minimum of three months, although many larger nonprofits tend to strive for greater than six months.
Establishing ratios and benchmarking against other, peer not-for-profits for your organization is often recommended as a best practice in the industry. While every not-for-profit is different, understanding how your metrics compare to others may be helpful as you consider your short-term and long-term financial plans.
Another critical consideration in the establishment of reserve policies is the organization’s budgeting process. Not-for-profits that exhibit more conservative forecasts tend to have less financial exposure than those of other not-for-profits that utilize more aggressive budgeting assumptions.
Finally, not-for-profits should consider performing a self-assessment of the financial and operational risk the organization faces, perhaps in conjunctions with an enterprise risk management assessment, in order identify potential exposure for target reserve levels.
Choosing the correct ratio and reserves is just as important as establishing a formal written policy related to the reserve. Written policies help to ensure that the board and management clearly understand how the reserves are to be maintained, funded, and used by the organization. In general, most reserve policies address the purpose of the reserves, who has authority to make use of the funds, reporting any changes to the reserves, and any relevant definitions or ratio formulas related to obtaining the targeted reserve levels.
While there is no one-size fits all approach to reserve setting, not-for-profits should take the time to analyze its financial liquidity as it relates to its long-term outlook. Even the smallest of not-for-profits can cost-effectively implement a reserve policy by assessing its monthly cash flow requirements and the need for any unforeseen cash requirements in the short-term. Achieving financial sustainability will ultimately not only lead to the furtherment of your not-for-profits’ mission, but will also help to create the opportunity to attract additional resources from donors and grantors.
Citrin Cooperman’s Not-for-Profit Practice professionals can assist you in benchmarking and developing your optimal reserve and liquidity ratios.