By: Joseph Brennan, CPA
In our article from last month, Confused About Reserves?, we explored different ways an organization might define their reserves. The true accounting definition for reserves is an organization’s net assets. While this is the most comprehensive measure, the complexities of accounting for net assets lead many organizations to define and measure their reserves differently - an investment portfolio of non-operating cash and investments for example. While organizations might argue about how to best define reserves, all organizations will agree that establishing and maintaining reserves are critical to long-term success.
When considering the importance of establishing and maintaining reserves, it is helpful to divide reserves into two categories: operating reserves and programmatic reserves.
A general operating reserve exists to provide essential financial stability to an organization. In the short-term, the general operating reserve might be necessary to ensure adequate cash flow is maintained during lean periods of the entity’s operating cycle. Even an entity who achieves a balanced budget might have periods where cash outflows are greater than cash inflows. With a general operating reserve in place, organizations can fall back on their own resources as opposed to turning to more expensive, external sources.
In the longer term, the general operating reserve is necessary for the organization to survive extended periods of economic downturn. Today, more than ever, we are acutely aware of how unstable our economy can be. Common sense tells us how sensible it is to establish a substantial general operating reserve. Our constituents, on the other hand, might even tell us how irresponsible it is to not!
In addition to the general operating reserve, organizations might want to establish more defined operating reserves. Examples of these include:
Reserves for various capital expenditures (building purchases, significant building renovations, new membership database software)
Reserves for self-funded insurance plans
Programmatic reserves relate to mission specific activity. These reserve funds support future growth initiatives and might include items like the following:
Establishing a new member accreditation program
Lobbying efforts related to proposed legislation
Development of a scholarship fund for worthy recipients
The importance of each type of reserve, and specific purposes in particular, depends on many factors. With guidance from their boards, management should consider their resources, along with the needs of their staff and constituents in order to determine the relative importance of each of their organization’s reserve needs. The establishment and maintenance of the general operating reserve should nearly always be given priority over more defined operating or programmatic reserves. While new programs might be important (even critical to preserve or increase membership levels for example), maintaining adequate cash flow and financial sustainability trumps all else.
Your organization is constantly changing. Of course, as the organization changes, so too do your goals, directives, and programs. With this in mind, it’s logical that prioritizing your organization’s reserve needs is an analysis that should be done on a recurring basis. Organizations should be aligning their budgets annually with their strategic plans. For this reason, performing this analysis in conjunction with your budgeting process makes the most sense.
Once you’ve established your reserve needs, how do you achieve them? The short answer is - make a profit! We all know that just like all for-profits entities, nonprofits need to make profits to survive too. The most prudent way to achieve your reserve targets is to budget annually for reasonably attainable surpluses. That’s the first step. The second, and perhaps harder step, is to maintain the discipline to set aside all budgeted (and unbudgeted) excess earnings until your reserve needs are met.
Nonprofit organizations have to strike a balance between establishing big enough reserves and providing a continuously high level of service to their constituents. So how do we measure the adequacy of our reserves? Stay tuned for next month’s newsletter in which we will address this question.
Joe Brennan is a chief financial officer in Tate & Tryon’s Outsourcing Services department and can be reached at firstname.lastname@example.org.