How to View Operating Reserves
Published:
by Jennifer McVey, CPA and Amanda Meko, CPA | Team Members of the NFP Services Group
Nonprofits often ask their advisors how to look at an operating reserve: Is it cash set aside for a rainy day? Is it the same as an organizations net worth? How much is too little or too much? Nonprofits often ask their advisors how to look at an operating reserve: Is it cash set aside for a rainy day? Is it the same as an organizations net worth? How much is too little or too much
What an operating reserve is and isnt
An operating reserve is a portion of an organizations net assets that is unrestricted in nature and relatively liquid. But it shouldnt be defined so narrowly that only cash or cash equivalents can meet its definition. That would make it a working capital reserve created to ease routine cash flow swings. Funds that shouldnt be considered part of an operating reserve include:
- Endowments and temporarily restricted funds that your organization doesnt have the prerogative to use as it sees fit,
- Monies that have been designated for specific use by the Board of Directors or other governing body, and
- Net assets tied up in illiquid fixed assets used in operations, such as your buildings and equipment.
Rather, an operating reserve is more long-term in nature. It generally spans a period of years and usually comes from operations that create a surplus. Receiving unrestricted contributions, generating investment income and budgeting for a surplus are all ways to create unrestricted net assets. And that, in turn, can be considered your operating reserve.
Who should be in the loop?
Involve your Board of Directors in determining your nonprofits policy on building an operating reserve, the desired fund amount, and the circumstances under which it can be drawn down.
Determining how much should be in your operating reserve depends on your organization and its operations. Generally, if you depend heavily on only a few funders or government grants, your nonprofit would benefit from a larger reserve. Likewise, if personnel costs make up a significant part of your expense budget, your organization could use the cushion a healthy operating reserve provides.
How much is right?
On the other hand, there are nonprofits that need less in reserve: for example, those with diverse funding, or whose expense budgets are less personnel-intensive. Also included are nonprofits whose expenses are more heavily pass-through expenditures that can shrink with a reduction in funders awards.
If there is any generally accepted benchmark for operating reserves, its usually three to six months of operating expenses. Three months is typically considered a minimum accumulation and six months a more sought-after amount. But rather than thinking of this as a benchmark, its better to consider it a safe-harbor range established to cover any emergency. This would enable an organization to continue its operations only for a relatively brief transition in operations or funding. Or, in the worst-case scenario, it would allow for an orderly winding up of affairs.
An operating reserve of more than six months of expenses provides more flexibility. For example, it might give your nonprofit funds to pursue a new program initiative thats not fully funded, or to leverage debt funding for needed facilities or equipment.
Accumulating more than a years worth of expenses in reserves, not designated by the Board of Directors for specific purposes, must be approached carefully. You should look at it through the eyes of your donors and the general public: How would they perceive that kind of nest egg?
Whats next?
As your nonprofit establishes its operating reserve, its important to consider all factors that impact your organizations finances. Whats right for one organization might not be right for another. Take into account the variables mentioned above and tailor-make an operating reserve thats right for you. Please contact us if you would like more information on how to establish an operating reserve policy for your organization.