Why Not-for-Profits Must Prioritize Operating Reserves
In today’s challenging economic landscape, not-for-profits’ sustainability hinges significantly on their financial health. One crucial aspect of this financial well-being is the strategic management of operating reserves – a safety net of funds set aside for unforeseen monetary emergencies. We will explore the importance of operating reserves, how to establish them, and the strategies for effective management.
Understanding Operating Reserves
An operating reserve is an unrestricted financial buffer that not-for-profits create to weather unexpected financial storms. It serves as a backup for unexpected cash flow shortages, unexpected expenditures, or losses. This includes delayed payments, sudden infrastructure repairs, or adverse economic conditions. However, it is important to understand that these reserves do not cover income shortfalls. Instead, they should be used to address timing problems, not deficit problems.
The Role of Operating Reserves in Not-for-Profits
Operating reserves play a pivotal role in ensuring a not-for-profit’s long-term financial health and sustainability. It provides financial stability, allowing organizations to continue their operations amidst unforeseen financial emergencies.
Setting the Right Operating Reserves Goal
Reserve goals can vary from one organization to another, depending on their cash flow and expenses. The rule of thumb is to have reserves sufficient to cover 3-6 months of expenses. At the upper limit, reserves should not be more than two years’ budget; at the least, they should be enough to cover a full payroll.
How to Establish Not-for-Profits Cash Reserves
Setting up a cash reserve is a systematic process that requires careful planning and execution. Here are some steps to establish an operating reserve:
- Set a reserve goal: This is usually 3-6 months’ expenses. This could sometimes go up to two years’ budget, but it should be at least enough to cover one full payroll.
- Develop a reserve policy: This should outline when reserve funds can be used, who is authorized to use them, and how usage is reported to the board.
- Build the reserve over time: Gradually build up your reserve by adding excess cash to it, much like contributing to a savings account.
- Maintain the reserve: Continually monitor and maintain your reserve, replenishing it as necessary.
Operating Reserves Ratio: A Crucial Metric
The operating reserves ratio is essential to a not-for-profit’s financial stability. It represents the proportion of yearly operating expenses that a not-for-profit can cover using its reserves. There are several methods to calculate this ratio:
- Percentage basis: Divide the operating reserves by the yearly working cost, using either the previous year’s actual or the current year’s planned costs.
- Number of months basis: Divide the total annual expenses by one-twelfth.
- Set the target: Multiply the annual expenses by the target percentage. For instance, for a target of 25% or three months, multiply the annual expenses by 25% (0.25).
Developing a Cash Reserves Strategy
Strategically building cash reserves is as crucial as having them. Here are some ways to raise funds for your operating reserve:
- Include a budget line for contributions to the reserve.
- Fund non-cash depreciation expenses with cash income.
- Include multi-year capital budgets and build reserves into capital campaigns.
- Include planned giving campaigns and board contributions.
- Factor in savings from employee reduction.
- Utilize windfalls such as specific grants and gifts.
- Assign a percentage of unrestricted gifts to the reserve fund.
When to Access Operating Reserves
Operating reserves are strictly for emergencies and should not be used to supplement regular spending. Knowing when to access these funds is essential. They are temporary and should be replenished once the cash flow improves.
The Role of the Board in Managing Operating Reserves
The board of directors plays a pivotal role in establishing and managing operating reserves. They must be in agreement about the reserve policy, including when to use the funds and who can authorize their use. Instituting an annual review procedure can further ensure the effective management of reserves.
In a nutshell, operating reserves are a lifeline for not-for-profits in times of financial crises. By strategically establishing and managing these reserves, organizations can ensure their long-term sustainability and continue to serve their communities effectively.
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