April 26, 2011

Four Things Boards Should Understand About Operating Reserves

With so much uncertainty over the future of federal, state, and local government support for nonprofit organizations, it's more important than ever that nonprofit organizations have operating reserves as a cushion against sudden and unexpected losses of income.

Yet the subject of operating reserves doesn't get much play in nonprofit boardrooms, and I'm not sure why.

OK, maybe I do have a few ideas.

The general aversion of many boards to talking about finances in any detail creates an initial roadblock to conversations about reserves.

And the lack of a widely understood and commonly used definition of operating reserves doesn't help. It's hard to talk about something if you don't know what it is.

Finally, common misconceptions about operating reserves—not just among board members but also among nonprofit executives, funders, and even financial-management experts—complicate matters further.

However, boards can't afford to go on ignoring this critical issue. Operating reserves are essential to the financial and programmatic stability of almost every nonprofit organization. And far too many organizations have insufficient reserves or none at all.

Early in the economic downturn, the Meyer Foundation (my employer) paid for an Urban Institute study of 2,500 locally focused nonprofits in the Washington region. The researchers found that nearly 60 percent of the organizations examined had reserves totaling less than three months' worth of operating expenses—a level generally cited as the minimum level of reserves any organization needs. And 28 percent had no reserves at all.

The consequences of not having operating reserves can be dire. At the very least, nonprofits without reserves face cash-flow problems if a grant request is unexpectedly declined or a government agency falls behind in its contract-reimbursement process. Cash-flow problems distract an organization's managers and demoralize its employees, especially if the organization misses payroll.

If cash-flow problems persist, they compromise and eventually erode an organization's ability to fulfill its mission.

Which is why board-level conversations about operating reserves are mission critical—and in many cases, long overdue. At a minimum, every board needs to understand the following four things about operating reserves:

  • What operating reserves are—and are not.
  • Why operating reserves are important.
  • How organizations get operating reserves.
  • And that there is no "penalty" for accumulating reserves.

Each of these areas is worth additional discussion, and my next three posts will deal with them in turn. Stay tuned—and join the conversation.