May 03, 2011

How Nonprofits Build Operating Reserves

My two most recent posts flagged operating reserves as an important issue that is often neglected by nonprofit boards and gave an explanation of what they are and why they matter.

Since 2009, when the Meyer Foundation supported an Urban Institute study of the operating reserves of nonprofits in Washington, I've spoken about the topic of operating reserves at numerous conferences and other gatherings. I usually try to make most of the same points and arguments covered in the two earlier blog posts.

Whenever I speak about this topic, the reactions from board members and executive directors in the audience are almost always the same. They look bewildered, as if I'd just suggested that they try to obtain a pound of enriched uranium or an albino giraffe. And then, hesitantly, someone will ask, "How do we get these 'operating reserves' you keep preaching about?"

My answer almost always seems to disappoint, perhaps because of its simplicity. The most reliable way to build reserves is by operating at a modest surplus (bringing in more money than you spend) consistently over time.

Consider this illustration: If an organization with an annual budget of $1-million runs a $50,000 surplus (5 percent of its budget) every year for five years, its accumulated surplus would be $250,000—or three months of operating expenses. If $50,000 seems too ambitious, even half as much would get the organization to $250,000 in 10 years.

To build reserves in this way, an organization needs to have healthy sources of unrestricted revenue, since restricted grants or funds from government contracts can't just be banked at year-end. To operate at a surplus consistently over time, an organization also needs the fiscal discipline to make hard choices and the ability to resist putting all "extra" money immediately into expanded programs and services.

There are, of course, less reliable ways to build reserves. Nonprofits sometimes receive unexpected large gifts or bequests, for example. Or the sale of property sometimes produces a windfall. Even then, few organizations have the discipline simply to put money in the bank to build operating reserves.

Which is too bad, because money set aside during good times can help organizations weather hard times—when community needs often increase—without cutting programs or services.