Nonprofit Reserve Funds: Guide to Financial Stability

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Nonprofit Reserve Funds: Guide to Financial Stability

With the giving ability of some donors hampered, and in-person fundraising programs no longer a viable option in many cases, not-for-profit organizations must find new ways to adapt, stay afloat, and preserve financial stability.

Reserve funds are very much top-of-mind for many NPOs, with good reason. By maintaining a healthy operating reserve ratio (operating reserves ÷ annual operating expenses) you can ensure access to the capital and liquidity your organization requires to sustain operations through the pandemic and beyond.

What is a reserve fund?

Basically speaking, nonprofit 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 provide funding to 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 doing 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 your opportunity to educate the funder about why nonprofit reserves are necessary.

Why are nonprofit reserves so important?

Nonprofit 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 pandemic? Maintaining cash flow projections, and performing sensitivity analyses on those projections, can help you understand how much you should ideally be setting aside as an operating reserve fund.

Planning for new programs. NPOs need to stay relevant and adapt their programs to meet changing socioeconomics and demographics. An example of this would be shifting to digital programming to accommodate social distancing and COVID capacity restrictions. 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 many years? 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, along with the amount you should be setting aside as a reserve. 

It’s worth noting that, when funds aren’t reserved, it can make your organization appear cash-rich when the real intention is to use those funds to purchase large assets. 

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 uses the earnings generated by the investment to fund their mission or operating expenses.

If a wealthy entrepreneur were to donate $5M to a university for the purpose of providing low-income students with financial scholarships, for example, the funds would be invested, and the returns generated 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.

On the plus side, 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 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 wish to de-prioritize in the future
  • Market volatility can lead to unexpected changes in investment returns

To mitigate the impact of fluctuating returns especially, you should consider diversifying your reserves with unrestricted or even 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 nonprofit 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 on goals with your funder so both parties are clear on 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 nonprofit 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 up for future capital purchases like new buildings, new 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 they were created for.

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

Nonprofit 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.

Alex Oulton, CPA, CA
About Alex Oulton, CPA, CA
Alex Oulton is the Director of Service Delivery at Enkel Backoffice Solutions. Headquartered in Vancouver, Enkel provides bookkeeping, payroll, accounts payable and accounts receivable services to over 200 businesses and not-for-profit organizations Canada-wide.