Maintaining sufficient reserves is vital to establishing financial stability for any nonprofit organization. But how much is enough? Many organizations struggle with this question, and there’s no simple answer. The right amount of financial reserves is dependent upon many factors that can vary between different nonprofits.
What are reserves?
Nonprofit organizations maintain net asset balances (ie: assets minus liabilities) based on donor restrictions. Net assets that are “donor restricted” must be spent in accordance with the intent of the donor. For example, these assets may only be spent on a specific programs. “Unrestricted” net assets have no such restrictions, and are available for the general operations of the organization. These unrestricted funds are commonly referred to as “reserves,” due to their flexible nature. Some donor-restricted net assets may also be considered part of your reserves, as long as their restrictions allow for day-to-day operations of the organization. Donor-restricted net assets for nonrecurring activities should not be included in your reserves.
What is a reasonable amount of reserves?
The short answer is…it depends. One common calculation uses six months of operating expenditures. Operating expenditures can be calculated by taking an average of the prior 12 months’ expenses and multiplying by six. This can be the correct answer for many organizations; but for others it can be too much or too little, depending on the nature of the organization. Some factors that will affect your calculations include: the strategic plan of the organization, type of nonprofit (i.e. foundation, association, religious, etc.), facilities owned or leased, debt structure, future commitments, and changes to funding sources or significant expenses such as compensation and benefits.
What’s wrong with excessive reserves?
Insufficient reserves can put an organization at increased risk, but excessive reserves can also be an issue. Whether it’s right or wrong, many nonprofits have been criticized for accumulating too much wealth. It’s a common (if somewhat misguided) opinion that nonprofit organizations should be putting all the funds at their disposal towards their mission. For some nonprofits, this may very well be the case; but for most, maintaining a significant level of reserves is the best way to ensure the long-term survival of the organization. “Not-for-profit” doesn’t mean you can’t or shouldn’t operate without profits. A healthy and well-managed organization should be accumulating and maintaining an appropriate level of reserves to ensure the organization’s future.
How should we handle excessive reserves?
Many organizations like to show the intent of the funds by creating a quasi-endowment. Quasi-endowments are unrestricted funds designated by the board. These can be a good way for organizations to maintain funds in perpetuity while using the earnings of the endowment to fund operational initiatives. It also demonstrates intent and thoughtfulness by the board and minimizes the potential backlash for an excessive reserve balance.
What do we do next?
Create and adopt a formal reserve policy. This will ensure the considerations and objectives of a reserve live beyond the board or management that created it. Too often, a reserve calculation is informal and easily forgotten in the midst of staff turnover or internal changes. Formalize and enforce your policy throughout your organization - your future selves will thank you!