April 29, 2011

What Operating Reserves Are and Why They Matter

My most recent post noted that one of the reasons nonprofit boards don't have more conversations about operating reserves is because there isn't a commonly understood definition of reserves.

The Nonprofit Operating Reserves Initiative Workgroup—an all-volunteer group of nonprofit leaders, financial-management consultants, and others—recognized this problem in 2008 and since then has produced a white paper and a toolkit to help nonprofits and their boards better understand what reserves are and why they need them.

Those resources propose several useful and detailed definitions of operating reserves.

Here's my own simplified version: operating reserves are liquid, unrestricted assets that an organization can use to support its operations in the event of an unanticipated loss of revenue or increase in expenses.

"Liquid" means that operating reserves are either cash or investments that can be quickly converted to cash. "Unrestricted" means that the funds haven't been designated for any other purpose by a donor or the organization itself.

Part of the confusion around operating reserves grows out of the many different words and phrases board members use when discussing finances and sustainability—some of which are related to operating reserves.

For that reason, it's also helpful to discuss what operating reserves are not.

  • Operating reserves are not endowment. Endowment funds are restricted and only the investment income can generally be used to support operations.
  • Operating reserves are not equity in a building.  Granted, equity does show up as an "unrestricted net asset" on an organization's balance sheet. However, equity is not the same as operating reserves because it can't readily be converted to cash. A line of credit secured by a building may serve some of the same functions as operating reserves and can be part of a strategy for managing cash flow. However, equity lines of credit for organizations come with the same risks as home-equity loans for individuals: If the value of your house goes down, you may find yourself owing more than the property is worth. And if you fall behind on the loan, you risk losing your house.
  • Operating reserves are also not "cash on hand." Many organizations use "months of cash in the bank" as a measure of their financial stability. However, much of the cash an organization has on hand at a given moment is likely to be restricted for specific projects and future uses and doesn't constitute a "rainy-day fund" that can be used wherever the organization needs it most.

In the simplest terms, operating reserves are savings accounts—and organizations should have reserves for the same reasons that people should have savings: to serve as a cushion against unexpected but necessary expenses or a sudden loss of income and to build up money for long-term goals and future plans.

All the arguments for having savings apply to nonprofits and operating reserves—some with even greater urgency. As an example, government contracts often require nonprofits to hire staff and deliver services for 30 to 60 days before receiving any reimbursement. Private funders may reduce or delay grants with very little warning. Major fund raising events get delayed or canceled.

With so much uncertainty associated with so many of their sources of income, operating reserves are essential to give nonprofits and their boards breathing room and the ability to respond to a rapidly changing environment without lurching from one financial crisis to the next.

However, operating reserves are more than a safety net for catastrophic circumstances. They also allow organizations to respond to unanticipated opportunities, such as the development of new programs, purchase of property, or even acquisition and merger.

Given the compelling arguments for adequate reserves, why do so few organizations have them? That question will be the focus of the next post in this series.