Remembering the Long-Term Purpose of Operating Reserves
No one questions whether it is important for nonprofit organizations to build and maintain adequate operating reserves. This is a best practice that is not only widely accepted, but also an expected goal for senior management and governance to pursue and protect. However, there often is a tendency to focus too much on the short-term reasons for building and maintaining operating reserves causing us to lose sight of the often more important long-term purpose for building operative reserves.
Many people equate operating reserves with “rainy day” funds – meaning that operating reserves primarily exist to act as a safety net for emergency protection against negative unforeseen circumstances and other temporary short-term disruptions. Indeed, providing emergency short-term funding that serves as a temporary lifeline back to the status quo is one important purpose of operating reserves.
However, operating reserves actually have two important roles. In addition to providing for short-term protection, operating reserves have an even more important long-term purpose: to ensure strong and enduring financial health for a nonprofit organization. As we discussed in Integrating Financial Health Assessments into Your Organization’s Planning Process, financial health is necessary to “support, protect, and ensure long-term organizational sustainability and continuity.” Operating reserves are one the most important and highly visible indicators of financial health.
These two primary roles for operating reserves are not always of equal importance. For new organizations (or for mature organizations that have little to no operating reserves), the initial focus is to build enough operating reserves to protect against short-term disruptions. This amount is usually equal to about 3 months of the most current annual operating expense budget.
As an organization matures, the focus then shifts from building reserves to protect against short-term disruptions to a longer-term goal of building reserves to provide a stable base of working capital to support growth, opportunistic expansion, and longer-term sustainability and financial health. For most organizations, having a target goal of 6 months to 12 months of operating reserves is an accepted best practice.
I recently participated in an interview for an article by the American Society of Association Executives (ASAE) covering the topic of operating reserves and how perceptions related to operating reserves have been changing. One key point I emphasized in this interview was that “no operating reserve is built to bridge a long-term or permanent change.”
Consequently, it is best to use funds from operating reserves only to cover short-term temporary disruptions of about 3 to 4 months but not to support longer-term disruptions that will last 6 months or more. A temporary disruption lasting more than 6 months could be extremely expensive and may not reverse or end for many months or even years.
A few examples of situations where using operating reserves could be appropriate to bridge short-term disruptions include: An unexpected two-month delay in receiving continuing grant funding;
A one-time cancellation of a regularly occurring event; and
To provide funds to cover the hiring of a consultant needed while a key employee is on temporary medical leave.
The following excerpt from the ASAE article highlights another key point:
“Rather than look at reserves as a bulwark against catastrophe, Gellman says, associations would do better to look at them as an opportunity to support the need for business diversification—a key lesson from the pandemic, as associations relying on meetings revenue were hit hard. ‘You might want to reserve an additional five to 10 percent for special projects, to invest in technology, or invest in a new program,’ he says. ‘That way you don’t always have to run out to the members or donors for money to do something new.’”
Thinking about operating reserves from a “life cycle” perspective, the tactics and strategies are similar to financial planning for an individual. At the beginning of your working career, the focus is on providing for essential short-term needs such as for food, housing, and healthcare. We try to set aside a savings fund equal to about 3 months of living expenses as a safety net to cover day-to-day expenses during unexpected emergencies. If we are fortunate enough to satisfy this initial persona goal, we can then start dreaming and planning for future aspirations, comforts, and perhaps even luxuries.
In many ways, this evolutionary path is the same for a nonprofit organization. In the beginning, “socking away” the initial 3 months of operating reserves to cover short-term safety net needs is the priority. As an organization matures, the focus inevitably shifts to building working capital for future operational growth and programmatic expansion.
Planning Tip – Establishing financial reporting systems that provide understandable and easy-to-monitor financial information on both historical (recent past) and current operating reserve status will be most beneficial for a nonprofit organization’s Board members, senior management, and staff. This can best be accomplished by including regular operating reserve status updates as part of the key performance indicators (KPIs) listed on the organization’s monthly financial dashboard reports. Also, it is a good practice to issue an update on operating reserve status after the completion of the annual financial statement audit process each year as an additional reminder for how operating reserves have been trending.
Operating reserves fill a unique role as the key indicator of financial health for nonprofit organizations. Beyond that, operating reserves can also serve as both a strategic benchmark goal and the guardian for a brighter future, supporting a sustainable, long-term operational life.
