Knowledge and Insights

Why and How a Nonprofit Should Establish an Operating Reserve

Puzzle Piece

Congratulations!  The nonprofit organization you manage, or represent as a member of the Board of Governance, has made the strategic decision to establish an operating reserve.  Making this decision is the easy part, now the hard work begins.  Decisions need to be made about the appropriate amount of reserve to be established and the best way to fund it, without sacrificing the quality of the services your organization provides.

An operating reserve is a portion of available unrestricted net assets designated by those in charge of governance as a buffer, or a type of rainy day fund, against unexpected increases in operating expenses or loss of revenue from funding sources. As you look at your balance sheet and focus on your current unrestricted net assets, decision makers should be mindful to exclude the portion of unrestricted net assets that represent equity in capital assets, purchased with unrestricted funding, from the equation.  The equity value of capital assets is the cost of capital assets less accumulated depreciation on the capital assets (book value) less the associated debt that was incurred in the purchase of capital assets.

Operating reserves should be funded with liquid investments that can be converted to cash easily when needed.   It is also important to remember that restricted endowments are not unrestricted net assets and, therefore, should not be part of the calculation when determining unrestricted net assets available.  While not mandatory, it is a good idea to accumulate operating reserves in advance of the establishment of other board-designated reserves (if possible).

Organizations should consider the following factors, among others, when trying to determine an adequate operating reserve amount.

  • The true makeup of unrestricted net assets –  the amount available to begin to establish an operating reserve, and if previously-designated board reserves can be reallocated.
  • Current economic conditions – the effect on current and potential contributors.
  • The fundraising efforts that will be needed –  the best way to raise unrestricted revenues, and the associated increase in expenses that effort will require.
  • The opportunity to reduce expenses – take a hard look at any potential cost reduction opportunities.
  • Vulnerability to unforeseen budget overruns – Unfortunately, budget overruns are, by nature, difficult to predict or quantify. Organizations should plan for the worst and hope for the best when estimating these and in evaluating an adequate operating reserve amount goal.

There is no hard and fast rule as to the amount that should be earmarked as an operating reserve.   Some organizations may determine that a percentage of the annual expense budget, say 20%, is an appropriate reserve level to achieve.  Others may strive to set an operating reserve level sufficient to meet expenditures for a period of time, for instance, two or three months.  Whatever method is used, it is important that the expectation be reasonable.   Those charged with governance should strive to establish realistic goals and projections about future performance, based on the financial history of the organization.  Reaching a goal should not be easy and should take time, perhaps several years.  An overly-ambitious goal could sacrifice the quality of services provided or have a negative impact on the overall morale of the organization, while a goal that is too-easily achievable may not go far enough to protect the organization.

Once the parameters applicable to the establishment of an operating reserve are determined, a policy stating the goals should be written and closely monitored.  The policy should include, among other things, the investment strategy of the investments supporting the operating reserve and the method that will be used to monitor results.  Reevaluation of policy and goal amount should also occur on a regular basis, based on actual results and changes in expectations going forward.

Mercadien’s Nonprofit Services Group has extensive experience assisting nonprofits with financial and strategic issues.

The author of this article, John Trench, is a former employee of Mercadien.