Nonprofit Accounting Basics

About Operating Reserves for Nonprofits

Apr 07, 2021

About Operating Reserves" - What are they and why have them?

The "what and why" of having operating reserves are intertwined and fundamental. Sometimes referred to as a rainy-day fund, operating reserves can provide shelter from a storm in the form of financial resilience and flexibility.

Operating reserves are essentially the accumulation of surpluses without restrictions that are liquid (as opposed to invested in fixed assets) that are available for use at the discretion of an organization's board. Having both adequate day-to-day working capital plus operating reserves increases an organization's ability to take mission-related risks and to absorb or respond to temporary changes in its environment or circumstances, such as the unanticipated event of significant unbudgeted increases in operating expenses and/or losses in operating revenues.

Numerous small and midsized nonprofits are founded by entrepreneurial visionaries who are in many ways comparable to their counterpart for-profit business owners. Nonprofits are in fact businesses whose profits (surpluses) remain with the (nonprofit) corporation rather than going to individuals or shareholders as in the for-profit business model. Note: "not-for-profit" does not mean "no surplus allowed." Just as for-profit businesses need working capital and operating reserves to function at peak capacity, so do nonprofits need the equivalent.

Without operating reserves, an organization can be thrown into cash flow stress and become distracted from good long-term strategy or be forced to make expensive short-term crisis-based decisions; or worse, it may not have the resources to continue delivery of its programs. Organizations with sufficient operating and other designated reserves can focus beyond day-to-day cash flow needs and more effectively plan for the long-term health of the organization.

What is a Board-designated Operating Reserve?

By consciously and proactively setting the financial goal of building an operating reserve (and potentially other specific-purpose reserves) an organization's staff and board take responsibility for the long-term financial stability of the organization, preserving its continued capacity to deliver its mission programs and services.

Building and maintaining a board designated operating reserve helps to ensure that sufficient funds are available to manage cash flow on a day-to-day basis and maintain financial flexibility. For example, an operating reserve could allow an organization to accept reimbursable grants because it could handle occasional delayed grant payments. Building additional purpose-designated reserves, based on the particular needs of the organization, would position the organization to seize opportunities to enhance mission programs, respond to spikes in demand for services, or to sudden decreases in program revenue, and to make planned capital purchases, among many other purposes.

What level of Operating Reserves is appropriate?

In spring 2008, a Nonprofit Operating Reserves Initiative (NORI) Workgroup comprising experienced individuals representing multiple facets of the nonprofit sector was convened with the objective of defining an "Operating Reserve Ratio" and using the ratio to focus attention on the importance of nonprofit financial stability.

Workgroup member Richard Larkin had previously concluded and written that the answer to what constitutes adequate operating reserves is: "it depends." Drawing on Mr. Larkin's insight and experience, the workgroup concluded there is no one-size-fits-all ratio or benchmark. However, the minimum operating reserve ratio at the lowest point during the year suggested by the NORI Workgroup is 25% or 3 months of the annual expense budget.

Precisely because "it depends," the Workgroup recommends that every nonprofit organization have a written Reserve Policy that determines its own "adequate" operating reserve level, defines how its operating reserves are calculated, and provides the rationale that led staff and board to this conclusion. In general, for calculating the Operating Reserve Ratio, the Workgroup is strongly biased toward the simplest and most widely applicable formula suggested above. The group also felt that operating reserves in an amount determined by an organization's board to be "adequate" should be accumulated in advance of other board designated funds and in advance of pursuing an endowment campaign. The Operating Reserve Ratio is one of a number of important and useful financial viability indicators that address various aspects of financial health.

Final note: Unfortunately, the loss of many small and midsize nonprofits in the 2008 financial crisis is now echoed by the conditions of the pandemic crisis. Those with reserve funds have been better able to sustain so far. Rebuilding reserves will be a continuing but critically important challenge as we return to normalcy.

For more information regarding establishing a reserve and related policies for its use and replenishment, please see the Nonprofit Operating Reserves Initiative (NORI) webpage, the Operating Reserves and Reserves Policy Toolkit, released September 15, 2010, and the whitepaper Maintaining Nonprofit Operating Reserves, An Organizational Imperative for Nonprofit Financial Stability, December 2008, by the Nonprofit Operating Reserves Initiative Workgroup, a collaborative effort of the Nonprofit Operating Reserves Initiative Workgroup.

See also:
Nonprofits Imperiled By Low Reserves
In Tight Times, Lack of Cushion Can Mean Failure

By Megan Greenwell, Washington Post Staff Writer, Wednesday, June 24, 2009

© 2021 Elizabeth Hamilton Foley