Determining the appropriate level of reserves your organization should maintain

Does your not-for-profit organization maintain operating reserves? If it does, has a formal reserves policy been established and has your organization gone through the process of determining what level of reserves is appropriate? These are important questions that should not be overlooked.

With so many people relying on the work of your organization, you want to make sure that you have adequate resources to maintain your programs and have the liquidity to avoid a disruption of service. Operating reserves will help to ensure the long term sustainability of your not-for-profit organization and its programs by providing a cushion to deal with operating deficits that arise from unexpected events and economic uncertainties. These situations could be the result of unexpected shortfalls in revenue or unexpected demands on your resources. They can also arise from unanticipated strategic opportunities that may present themselves.

Consideration needs to be given to what your organization can use as reserves. Unrestricted funds (free from donor restrictions) can potentially be counted. Temporarily restricted net assets that are to be used for a specific purpose and permanently restricted net assets should not be counted as being available for reserves. In addition to being unrestricted, the funds also need to be liquid, so your net investment in property, plant and equipment would need to be excluded. Potential sources for building up your reserves would be a designation of a portion of existing unrestricted net assets as well as a designated amount from annual operations. It may take a while to build up your reserves to the desired level, but the important thing for your organization to do is to start the process.

It is important to determine what level of reserves in appropriate for your organization, and to also effectively communicate the necessity of your reserves. While maintaining insufficient operating reserves can put your organization at risk, maintaining too much in reserves can potentially draw criticism of your organization. There is no single correct solution for all organizations. Each organization should have its own reserve goal based on its cash flows and projected expenditures. Organizations with reliable cash flows may not need as much in reserves as organizations that rely on periodic grants or fundraising campaigns. Additionally, organizations that have a large number of buildings may need to establish higher levels of reserves as those facilities age.

In order to determine what level of reserves makes sense for your organization, begin by examining the factors that affect your operations. Focus your attention on factors that create risks for your organization from both a revenue standpoint and an expenditure standpoint. From a revenue perspective evaluate how reliable your grants and contracts are, how collectable your pledges are, your dependence on major donors, as well as regulatory changes that may change future reimbursement methodologies. From an expenditure standpoint you should evaluate the extent to which external events affect the demand for your services, your organization’s debt service requirements, how dependent your programs are on consistent funding streams, as well as how quickly your organization can adjust the scale of its operations. In addition to revenue and expenditure risks there are other factors that should also be considered. How vulnerable your organization is to fraud, certain personnel considerations, and compliance risks also need to be evaluated.

Consideration of these factors in conjunction with your organization’s long-term financial forecast will help your organization to develop a range of variables that will factor into the determination of the appropriate reserve level that should be in place. The extent to which your organization is subject to the variables, and how much of a financial impact the variables could have, will influence how far above a recommended minimum baseline the operating reserve level should be set. A commonly used minimum baseline for operating reserves is three months of the annual expense budget. It is important to remember that the minimum baseline for operating reserves needs to be adjusted based on the risks that are unique to your organization.

In addition to determining the appropriate level of operating reserves, it is also very important to develop a written policy with respect to those operating reserves that is approved by your organization’s board of directors. The reserve policy should include the objectives that are to be achieved, how the reserve will be funded, and how it will be administered.

The process of determining the appropriate level of reserves based on your long-term financial forecast as well as the weighting of the risk factors your organization is exposed to can be a complex process, but is one that will help your organization make sure it maintains its ability to fulfill its mission.

For more information on this topic, or to learn how Baker Tilly not-for-profit team specialists can help, contact our team.

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