From time to time, we share previous blog posts with enduring significance for nonprofit organizations. The following content was originally published on 9/7/16 and has been lightly refreshed.
To ensure the financial stability of your nonprofit organization, you must maintain sufficient reserves. A healthy reserve balance will help your organization weather lean periods, and will minimize your risk in the face of emergencies or unexpected costs. 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.
“Reserves” are essentially any unrestricted funds that are available for the general operations of the organization. Reserves are your financial safety net – funds that you can draw upon to cover any necessary expenses. While donor-restricted funds must be spent in accordance with the intent of the donor, unrestricted funds are more flexible and can be spent however the organization deems appropriate. You may occasionally receive donor-restricted contributions that can also be considered part of your reserves, as long as their restrictions allow for use in the day-to-day operations of your organization. However, any donor-restricted funds meant for specific, non-recurring activities should not be included in your reserves. For example, if a donor contributes $10,000 to purchase new computers for a youth after-school program, you cannot spend those funds on rent, staff salaries, or anything other than computers – so they should not be counted as part of your general reserves.
What is a reasonable amount of reserves for an organization to maintain? The answer depends on the nature of your organization, as well as other factors, such as your strategic plan, your type of nonprofit (foundation, association, religious organization, etc.), whether your facilities are owned or leased, your debt structure, future commitments, and potential changes to funding sources or significant expenses like salaries and employee benefits. Many organizations feel comfortable with reserves that amount to six months’ worth of average expenditures. In other words, if you can pay six months of expenses out of your reserves, you’re probably on the right track. However, for some organizations this it can be too much or too little to keep on hand. Only you can decide on an appropriate amount of reserves for your organization.
While insufficient reserves can put an organization at risk, excessive reserves can pose problems as well. In the past, some nonprofits have been criticized for accumulating too much wealth. It’s a common (if somewhat misguided) opinion that nonprofit organizations should be putting every single dollar at their disposal towards their programs and mission. “Not-for-profit” doesn’t mean you can’t or shouldn’t operate without profits. In fact, a healthy and well-managed organization should work towards accumulating an appropriate level of reserves. For most organizations, maintaining a significant level of reserves is the best way to ensure their long-term survival.
One way you can avoid backlash over excessive reserves is to show the intent of the funds by creating a quasi-endowment. Quasi-endowments are unrestricted funds designated by the Board of Directors. This 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.
It’s also a good idea to create and adopt a formal reserve policy. This will ensure the considerations and objectives of your reserves will live beyond the Board or management that created it. Too often, the decision to retain “X” amount in reserves is informal and easily forgotten in the midst of staff turnover or internal changes. Protect future reserves by formalizing and enforce your policy throughout your organization.