Reserve funds are very much top-of-mind for many non-profit organizations (NPOs), with good reason. By maintaining a healthy operating reserve ratio (operating reserves ÷ annual operating expenses), NPOs can ensure access to the capital and liquidity their organization requires to sustain operations through periods of increased spending or during dips in donations or grants.
What is a Reserve Fund?
Non-profit reserves are liquid assets that organizations set aside to fund planned future needs or cushion against unplanned events and expenses.
Since some grantmakers may not fund organizations with reserves, a common misconception around reserve funds is that having one can harm your fundraising efforts. In reality, the opposite is often true.
Maintaining reserves can boost your fundraising by:
- Demonstrating responsible financial management
- Increasing funder confidence in your organization’s ability to carry out its mission
So what should you do if you encounter a grantmaker whose agreement states that, to qualify for funding, you can’t have reserves?
If the dollar amount is relatively small, the risk of operating without a reserve may not make applying worthwhile. If you still want to apply for the grant despite the agreement, offer to share your reserve fund policies, and consider this an opportunity to inform the funder why non-profit reserves are necessary.
Why are Non-Profit Reserves So Important?
Non-profit reserve funds help organizations in several ways.
Weathering rainy days. Do you have the resources to continue operating in the face of a natural disaster, economic downturn, or some other interruption in the flow of revenues? Maintaining cash flow projections and performing sensitivity analyses on those projections can help you understand how much you should ideally be set aside as an operating reserve fund.
Planning for new programs: NPOs must stay relevant and adapt their programs to meet changing socioeconomics and demographics. An example was shifting to digital programming to accommodate social distancing and COVID capacity restrictions during the pandemic. Reserve funds can support program continuation if revenue for that program ever becomes uncertain.
Planning for the long-term: Does your organization have assets (transportation trucks, for example) that need to be replaced every so often? Are you planning to construct a new building to expand operations? Capital purchases and projects require significant cash outlay. Strategic planning can help you determine non-routine goods and services costs and the reserve amount you should set aside.
To summarize, a well managed reserve fund brings the following benefits to non-profits:
- Mission Continuity: Reserve funds ensure an organization can continue delivering services and fulfilling its mission even during tough financial times. This continuity is crucial for maintaining trust with beneficiaries and stakeholders.
- Donor Confidence: A well-managed reserve fund demonstrates fiscal responsibility to donors and grant-makers. It shows that the organization plans for the future and is a good steward of its resources.
- Staff Retention and Morale: Financial stability reduces the risk of layoffs or salary cuts, which can negatively impact staff morale and retention. A reserve fund helps maintain a stable work environment.
It’s worth noting that when funds aren’t reserved, your organization can appear cash-rich when the real intention is to use those funds to purchase large assets.
How to Build and Manage Reserve Funds
- Assess Your Financial Health: 1) Analyze your balance sheet, income statements, and cash flow statements to understand your current financial position. 2 )Determine if any existing surplus funds can be allocated to the reserve. 3) Recognize periods of cash inflows and outflows to plan reserve funding accordingly.
- Establish Clear Policies: NPOs should develop policies that define the purpose, target amount, and conditions under which reserve funds can be used and replenished. 1) Create a written policy that outlines the purpose, target amount, funding strategies, investment guidelines, and conditions for using the reserve fund. 2) Have the board of directors review and approve the policy to ensure organizational alignment and oversight. 3) Plan to periodically revisit and update the policy to reflect changing circumstances.
- Determine Fund Size and Goals: 1) Define whether the reserve fund is for emergencies, opportunities, capital expenditures, or a combination. 2) A common goal is to accumulate reserves equal to three to six months of operating expenses, but this can vary based on organizational needs. 3) Establish a realistic timeline for reaching your reserve fund target.
- Incorporate Reserve Funding into the Budget: 1) Include a specific line item dedicated to reserve fund contributions in your annual budget. 2) Decide on a fixed percentage or amount of revenues to allocate to the reserve each year. 3) Be prepared to adjust contributions based on financial performance and organizational needs.
- Identify Funding Sources: 1) Operating Surpluses: Allocate any annual surplus directly to the reserve fund. 2) Fundraising Campaigns: Launch targeted fundraising efforts specifically for building the reserve. 3) Cost Savings: Implement cost-saving measures and direct the savings into the reserve. 4) Grants and Donations: Seek grants or major gifts from donors interested in supporting long-term sustainability.
- Investment Strategy: Funds should be invested prudently to ensure they grow over time without exposing the organization to undue risk.
- Establish Oversight and Accountability: 1) Designate a finance committee or staff member to monitor the reserve fund. 2) Include reserve fund status in financial reports to the board and stakeholders. 3) Maintain clear records of all transactions related to the reserve fund.
- Communicate with Stakeholders: Transparency: Be open about the reasons for building a reserve fund and how it aligns with the organization's mission. Donor Education: Explain to donors how reserves contribute to financial stability and program continuity. Reporting: Provide updates on the reserve fund's progress in annual reports and meetings.
- Plan for Accessibility: 1) Clearly outline scenarios under which the reserve fund can be accessed. 2) Establish who has the authority to approve the use of reserve funds (e.g., board approval). 3) If reserves are used, have a plan in place for replenishing the funds.
- Monitor and Adjust: 1) Periodically assess whether the reserve fund is meeting its goals and serving its intended purpose. 2) Be willing to adjust the target amount or policies based on changes in the operating environment. 3) Ensure all activities related to the reserve fund comply with legal and regulatory requirements.
Challenges in Maintaining Reserve Funds
- Resource Limitations: Non-profits often operate on tight budgets, making it challenging to allocate funds to reserves.
- Perception Issues: Some donors might question why an organization is holding onto funds instead of using them for immediate needs.
- Balancing Act: Organizations must balance saving for the future and addressing current programmatic needs.
Different Types of Reserve Funds
Reserve funds differ based on an organization’s needs and requirements.
Endowment Funds
Endowment funds are an investment made by, or on behalf of, a nonprofit foundation like a hospital or university. The foundation funds its mission or operating expenses from the investment's earnings.
If a wealthy entrepreneur were to donate $5M to a university to provide low-income students with financial scholarships, for example, the funds would be invested, and the returns would be given to 30 low-income students to fund their tuition.
Nonprofits and funders work together to establish endowment fund policies, including:
- How the funds will be invested
- Annual withdrawal limits
- How the funds can be used
While many organizations believe that endowment funds offer the best route to nonprofit financial sustainability, that’s not always true.
These funds can provide continuous financial support for a specific component of your organization’s activities. This may be as broad as supporting operations or as narrow as providing scholarships to a specific course of study.
But endowment funds can also pose problems over the long run:
- Additional, long-term governance and stewardship are required by management teams
- Endowments can force your organization to remain focused on an activity you may wish to de-prioritize in the future
- Market volatility can lead to unexpected changes in investment returns
To mitigate the impact of fluctuating returns, you should consider diversifying your reserves with unrestricted or internally restricted funds.
Externally Restricted Funds
These funds have restrictions imposed by an external funder or donor. Imagine, for example, a local business that gives a non-profit organization a $30K grant specifically to fund hot lunches for students in Vancouver’s lower socioeconomic neighbourhoods.
When establishing an externally restricted fund, it’s important to align goals with your funder so both parties know what the funds can and can’t be used for. You should also understand your funder’s reporting requirements so you can set up your books and reporting frequencies accordingly.
Internally Restricted Funds
These funds have restrictions imposed by an internal board of directors and can only be used for the specific purpose outlined in the board resolution.
When you establish an internally restricted fund, it’s important to create a policy that clearly outlines:
- The purpose of the funds
- A definition of the fund, its intended use, and a calculation of target amounts
- Assignment of authority for fund usage
- Responsibilities around reporting fund amounts and their use
- Specific rules regarding fund investment
Internally restricted funds may be set up as a non-profit operating reserve or a capital reserve.
Operating reserves, which can also be unrestricted, help cover your organization’s operating expenditures in the event of an unexpected funding shortfall. Much like a savings account, they’re great to fall back on but should only be dipped into when necessary.
Capital reserves help you save for future capital purchases like new buildings, equipment, or major renovations.
Throughout the year, management teams and nonprofit boards should review internally restricted funds together to ensure balances are sufficient to achieve the specific purpose for which they were created.
You should also prepare and review financial information and reports on both internally and externally restricted funds to:
- Support board members in their governance duties
- Strengthen your organization’s strategies and goals
- Ensure compliance and audit-preparedness
Non-profit reserves are a great way for organizations to manage and plan for the long term or adapt to unforeseen circumstances.
To benefit from reserve funds, first, engage in discussions with your stakeholders about creating reserves, then make sure your bookkeeper understands what those funds are and how they need to be tracked and reported.
At Enkel, we help dozens of not-for-profit organizations track their expenses and create accurate financial reports for various stakeholders. Learn more about our bookkeeping and accounting services for nonprofit organizations and charities.
