In part one of this series, “5 Cases for Building Nonprofit Operating Reserves,” I outlined how reserves provide stability and promote strategic decision making for nonprofit organizations. This week, let’s examine common factors that organizations should take into account when considering how much to set aside for their operating reserve.
How much should you designate for the operating reserve?
In classic consultant speak, I’m going to say “it depends.” The Nonprofit Operating Reserves Initiative (NORI) Workgroup suggests that the minimum operating reserve ratio at the lowest point during the year should be 25% – in other words, about 3 months of the annual operating expense budget. However, this is not a set standard by which organizations should be judged. This is not a benchmark, and it really does depend on the needs of your individual organization.
The Workgroup concluded that each organization must arrive at its own rationale for what it considers adequate for financial stability. There is no single correct solution – one size simply does not fit all when it comes to setting the amount for operating reserves.
The real takeaway here is to be able to articulate why the particular reserve funds exist for your organization and what their purposes are, rather than getting hung up on the aggregate number. Being able to defend, explain, and educate around why you’ve chosen a specific reserve amount is the key.
How To Calculate Your Operating Reserve Ratio:
The Workgroup set forth formulas for calculating operating reserves ratio at the most basic level. However, combining revenue volatility factors with spending control factors may lead you to determine that 25% is enough or that a higher target should be set.
- Percentage Basis Formula – The reserves ratio is equal to your operating reserves divided by annual operating expense. The figure used for annual operating expense can either be the prior year’s actual expenses or current year’s budgeted expenses.
- Number-of-months Basis Formula – Here the reserves ratio is equal to your operating reserves divided by 1/12th of annual operating expense. For example, if your annual expense is $600,000, divide that amount by 12 to get $50,000. Then divide your operating reserves (we’ll use $75,000 in this example) by $50,000. The result is 1.5 – or one and a half months.
- Setting the Target Formula –To set the target of your reserves to 25% – or 3 months – multiply your total annual expense by 25% (.25).
In order to determine a target amount, you must consider the common factors at play in your operation. Whether or not each of the following factors applies to your organization will help determine how large your reserve needs to be.
Besides wildly uneven cash flows, these can include:
- Revenue volatility factors – How volatile are your revenue sources?
- Spending flexibility factors – How much control do you have over spending?
- Governance & Management factors – How does your Board feel about how much you should have in reserve vs spending on programs?
- Level of programmatic risk – How much programmatic risk do you experience?
- Organization life cycle stage – What stage of the organization’s life cycle are you in?
The most significant of these factors are revenue volatility and spending flexibility.
Typical Revenue Volatility Factors
The level of revenue volatility your organization experiences can greatly affect the planning of your operating reserves. The more dependable and regular your funding is, the less risk and the lower your reserves might safely be. Key revenue volatility factors to consider:
- Stability of donated revenue from primary sources
- Predictability of pledge collections
- Reliability of grants and contracts for services
- Level of dependence on one or two major donors
- Level of dependence on a single fundraising event
- Funder policies on support of overhead, indirect expenses (operating vs. restricted/project-only support)
- Economic health of the community
- Publicity that could adversely affect current or future revenues
- Likelihood of severe weather or natural disasters that would affect implementation of programs (e.g. event cancellations)
Typical Spending Flexibility Factors
In some cases, spending may be dictated by external restrictions imposed on contributed funds. A reserve can provide the flexibility necessary to pay for items that aren’t covered by restricted grants. In general, the less control you have over spending, the higher the risk and the higher your reserves might need to be.
Factors that may affect how much control you have over spending may include:
- Ability to downsize operations quickly and still sustain core programs
- Balance of full-time permanent staff vs part-time temporary staff and/or contractors
- Extent to which economic or environmental events may affect demand for services
- Long-term leases with substantial penalties for cancellation
- Obligations to labor unions, union contracts
- Organization’s importance in community crisis situations (e.g. if the organization’s mission involves disaster relief)
- Dependence on key person
- Obligations resulting from funding commitments made for longer than one year
- Amount of unsecured debt carried by the organization
Overall, operating reserves can help you deal with the different factors that affect your organization’s cash flow without disrupting regular operations.
To learn more about this topic, make sure to download the whitepaper, Maintaining Nonprofit Operating Reserves.