Nonprofit operating reserves is revenue set aside for future use. Planning for this ensures long-term financial heath. Where does this money come from and how can nonprofits plan for the future?
Establishing nonprofit cash reserves
Nonprofit operating reserves are unrestricted cash set aside for unexpected financial emergencies. Like any business, unplanned events can cause a finance crisis. Keep in mind, reserves are not intended to solve low revenue problems. Cash reserves are for when unforeseen circumstances cause cash flow problems. A good example of this is the Covid-19 pandemic.
Operating reserves ratio
Reserves set aside money for emergencies. A good reserve goal is 3 to 6 months of expenses. A good operating reserve ratio is about 25%, which is about 3 months of the annual expense budget. Cash reserves should not be more than two years of the budget. At the very least, reserves need to cover at least one full payroll.
An operating reserves formula calculates the time it can operate before it runs out of funds. There are many operating reserve calculations. Here are three methods:
- Percentage basis: Divide operating reserves by yearly working cost. Use the previous year’s real costs or current year’s planned costs.
- Number of months Basis: Take the total annual expenses divided by one-twelfth. For example, if the annual expenses is $600.000, divide this by 12 which equals $50,000. This leaves a ratio of 1.5 or one and a half months.
- Set the target: To arrive at a target of 25% or 3 months, multiply the annual expenses by 25% (.25).
Developing a cash reserves strategy
Reserves can build up over time. Using excess cash and adding it to the reserve much like putting money in a savings account for a rainy day. Put into practice by including a line item to the budget.
The best strategy is to use your budget and raise funds for your operating reserve. Here are some suggestions:
- Include a budget line for contributions to reserve.
- Fund non-cash depreciation expenses with cash income.
- Include multi-year capital budgets.
- Build reserves into capital campaigns.
- Include planned giving campaigns.
- Include board contributions.
- Factor in employee reduction savings.
- Add windfalls such as specific grants, gifts, etc.
- Assign a percentage of unrestricted gifts to build the reserve fund.
- Use diversified revenue streams to add to cash reserves.
When to access operating reserves
The important thing to know is when to access the reserve fund and when not to use it. In other words, you’re either financially savvy or guilty of poor stewardship of funds. Use cash reserves for emergencies only, not to supplement spending. Reserve funds are for temporary use and replenished once cash flow improves.
The Bottom Line
For cash reserves to work best, your board of directors need to be onboard with an agreement and policy. Includes when to use and who may allow access to funds. Put in place a procedure for annual reviews. This protects your nonprofit from the unexpected going forward.
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