In the annual State of the Sector Survey, Nonprofit Finance Fund reports that recovery of the US economy hasn’t addressed the systemic and perpetual funding challenges facing nonprofits (2015). While they note that “we are seeing some positive economic indicators,” they also observe that, in many cases, “nonprofits are still hampered by insufficient funding and a lack of investment in long-term sustainability.” More than half of nonprofits report having 3 months or less of cash-on-hand and 12% had less than 1 month of cash-on-hand.
There has long been a popular misconception—if a nonprofit has money, it must not need money. However, “not-for-profit” does not mean “no surpluses allowed.” As the saying goes: It’s a tax status, not a business model. Fortunately, many nonprofit donors and charity watchdog groups are moving away from this way of thinking and are now acknowledging that operating reserves play a vital role in building an organization’s long-term sustainability. An operating reserve can help ensure that an organization can continue its vital programming activities even during uncertain economic conditions.
What are operating reserves?
A nonprofit’s net assets are divided into categories of unrestricted, temporarily restricted, and sometimes permanently restricted. An Operating Reserve Fund is a discrete component of unrestricted net assets that are set aside by the board for availability when cash flow is tight or funds are required for unforeseen operational needs. They are designed to be built up to a target amount, and the funds must be replenished per the policy established by the board.
The Cases for Building Operating Reserves:
- Support fulfillment of mission. Operating reserves provide sufficient working capital when cash flow is unreliable and reimbursable grant payments are coming late. It helps organizations avoid a fragile state, which can compromise program quality or quantity.
- Provide financial flexibility and foster strategic decisions. Reserves do more than allow you to react to fiscal emergencies. If you have reserves and enough positive cash flow, you can make sensible choices like making bulk purchases to take advantage of better prices. They also position you to seize opportunities that you may not have been able to take advantage of otherwise.
- Reduce stress through improved cash management. Many nonprofit staff members experience burnout as a result of consistent cash flow stress, which often leads to low morale and increased staff turnover. Losing and replacing dedicated staff members is and expensive and exhausting process.
- Demonstrate proactive, prudent management and planning. It’s hard to think ahead and make sure the organization is sustainable when you’re living hand-to-mouth. The presence of a board-designated operating reserve indicates the organization’s explicit intention to deliver on its promise for the long term.
- Promote donor confidence. As I mentioned earlier, many funders were once of the mindset that an organization with money is not in need of additional funding. This thought has led nonprofits to shy away from building up their cash because it would weaken their position in grant applications. However, it became evident after the market crashed in 2008 that many under-capitalized organizations were so financially fragile that they didn’t make it through. Now, many more funders are looking to invest in financially stable organizations who are thinking ahead and appropriately managing their funds.
How should we communicate with funders, donors, and board members about operating reserves?
It’s important to communicate using both numbers and narrative. On internal reports, make sure to include information about your reserves. Display each reserve as a separate line item on the balance sheet in the net asset section. If it was accessed, it should show as due to and from the reserve in the liabilities section. I always advocate for providing narrative notes to explain clearly what’s going on in those sections of the report.
In audit or external reports, you can choose to show the operating reserve balance separately in the net asset section of the balance sheet or Statement of Financial Position page and/or you can provide narrative and a breakdown of that section of net assets in the notes section—another opportunity to explain the intention behind creating reserves.
To learn more about this topic, make sure to download this Brief Intro to the Nonprofit Operating Reserves Initiative.