Operating Reserves Can Help Cushion Financial Blows
First the COVID-19 pandemic wreaked havoc on nonprofit organizations’ finances and operations. Now, many organizations are worried about how high inflation and a possible recession might interfere with plans. To help prevent service disruptions and other negative outcomes, focus on building up operating reserves. Even if it’s only possible to divert a small amount to reserves right now, should the organization need it, you will be grateful for the cushion.
A Policy to Help Weather Storms
Strong reserves can help nonprofit organizations survive unexpected financial blows (or, in better times, take advantage of sudden opportunities). Review the short- and long-term risks the organization faces. For example, is it heavily reliant on a handful of funding sources that, if cut off or reduced, would jeopardize the future?
If the organization does not already have a formal written reserves policy, develop one. If it does, review the policy to see how it holds up in light of the recent years.
Among other things, the policy should set the target amount to hold in a separate fund. Although no universal benchmark applies, most organizations should aim to set aside six months of operating expenses. Leadership risk appetite and current financial position may dictate a lower or higher target. Avoid setting the target too high, though. Donors and grantmakers generally do not favor stockpiling of funds that could otherwise be used to pursue an organization’s mission. A policy also should establish triggers for when the organization can dip into reserves.
A Plan for Funding
Assuming the current reserve level falls below the target, develop a plan for getting it back on track. If the organization has received increased donations over the past couple of years, the organization might be able to fully fund reserves with unrestricted net assets - or use large bequests or unexpected windfalls.
Most nonprofits, however, need to include a line item for contributions to the reserves in its budget. This amount should not hinder day-to-day operations, but it will help begin to make real progress toward reserve goals. It may be necessary to cut expenses, cancel projects, or divest investments to free up funds.
Remember to leave illiquid fixed assets (buildings and equipment), endowments and temporarily restricted funds out of the equation.
Building or replenishing operating reserves takes time and stakeholders must understand that it is an ongoing, long-term project. In general, it takes several years to build months of reserves, and that is if everything goes according to plan.