Operating Reserve Policy: Why Your Nonprofit Needs One and Considerations for Implementation

A nonprofit’s operating reserves are similar to the retained earnings of for-profit businesses in that they represent several years’ worth of accumulated operating surpluses, which are available for use by the organization at the discretion of its board of directors (i.e., they are not donor restricted). In today’s uncertain economic environment, maintaining sufficient operating reserves is more important than ever and is a key element in successfully managing liquidity and providing your organization with the funds it needs to re-invest in its programs and constituents.

Purpose of Operating Reserves

Nonprofit organizations must strike an appropriate balance between fulfilling their mission or exempt purpose and generating revenue in order to survive. Achieving this balance year after year is a considerable challenge due to unpredictable funding sources, economic uncertainties, etc.

Whether for-profit or nonprofit, most organizations can expect to incur operating deficits at some point. Operating reserves can provide the cushion necessary for an organization to survive the lean periods and unexpected events that might drain funds. Specifically, operating reserves should be utilized to:

• Enable an organization to survive operating deficits caused by economic conditions or other unforeseen circumstances. Without such reserves or the use of other assets, the survival of an organization during a steep or protracted budget deficit may be threatened.
• Enhance the flexibility of an organization when used as “venture capital” to develop new programs, replace outdated programs, or expand the organization’s interests and services.

Target Reserves

The operating reserves an organization needs will depend on its individual characteristics and circumstances. Typically, an organization seeks to establish a certain number of months of desired operating reserves. The “number of months” can be determined based on actual or budgeted operating expenses or some subset thereof, such as the sum of personnel and other essential fixed costs. While there is no hard and fast rule as to an appropriate number of months, a minimum of six months of operating expense is generally considered a good place to start.

A nonprofit’s management and board of directors, as well as appropriate committees, will need to arrive at a threshold that seems appropriate to address any risks on the horizon that may affect their organization. Benchmarking your nonprofit against others can help you determine the right target to set for operating reserves. Whatever optimal reserve balance is deemed appropriate for your organization, it is imperative that a reserve policy be put in place and adopted by the board of directors. This policy should establish procedures for funding the reserve, using the reserve, replenishing the reserve, and maintaining optimal reserve levels.

Factors to Consider When Implementing an Operating Reserve Policy

Below is a partial list of challenges and risks nonprofit organizations should consider while developing an operating reserve policy:

Political environment, regulatory risk, and legislative challenges

One of the main focuses of nonprofit organizations is to guide their respective membership base through the various regulatory risks and legislative challenges in today’s environment. Failure to successfully respond to hot button issues could not only cost the nonprofit organization its reputation but also have an adverse effect on its membership retention. Accordingly, nonprofit organizations need to have adequate reserves so they are able to leverage the resources required to champion the interests of their membership, as necessary.

Industry risks

In today’s world, things can change in the blink of an eye. Whether changes occur as a result of new technology, legislation, or a significant negative event, nonprofit organizations may suddenly find themselves in the midst of serious challenges such as declining revenue, negative publicity, or even declining relevance. Nonprofit organizations need to be on the lookout for these risks and ensure that they maintain adequate reserves to meet these emerging challenges.

Economic risk

Nonprofit organizations always need to be prepared for a downturn in the economy. It is not a matter of “what if” but rather a “when,” so organizations need reserves to help get through the inevitable “rainy days.” Nonprofit organizations must strive to have adequate reserves to remain effective and operable even when the economy is faltering.

Increased competition

In today’s environment a plethora of organizations, nonprofits and for-profits alike, are competing for the same resources they need for revenue generation. Accordingly, nonprofit organizations must be continuously mindful of ensuring they have the resources available to make strategic investments that will help them maintain their competitive edge.

New strategic initiatives

Nonprofit organizations need to be proactive meeting the needs of their membership, constituents, and donor base. To that end, the identification and creation of new strategic initiatives is essential for their success. Accordingly, organizations need to maintain adequate reserves to fund these initiatives.

Leadership transition and succession planning

Maintaining the continuity of key employees can be a major contributor to the overall success of a nonprofit. However, since no one can stay in leadership positions forever, organizations need to prepare for leadership transitions and plan for succession challenges before they occur. Not only will there be significant costs associated with the search for new leadership but operations often sputter or decline during leadership transition periods.

Legal issues

Whether legal issues stem from an internal matter, contractual issues involving a business vendor, or an adversarial outside party, each nonprofit organization needs to take into account the threat of litigation. An analysis of the likelihood and magnitude of potential litigation is an important factor when considering the reserve policy for any nonprofit organization.

Technology upgrades

The importance of technology and data management grows every year, and each nonprofit organization needs to constantly evaluate whether it has the proper technology to ensure its operational success. The modification of current systems or the purchase of new technology can require significant cash outlays, so nonprofit organizations need to plan for these purchases when determining their reserve policy.

Member consolidation

In recent years, merger and acquisitions activity has increased across industries. These transactions can have a significant long-term impact on nonprofit trade associations as market consolidation leads to a reduction in revenue as member organizations combine and dues shrink accordingly.

Funding concentration

An organization with only a few members contributing disproportionately high amounts to its revenue base will be at risk should those contributions fall. Therefore, nonprofit organizations need to maintain adequate reserves to offset reductions in dues or contributions as a result of unfavorable changes affecting key members or donors.

Investment income

Many nonprofit organizations maintain a dependence on investment earnings in order to achieve a balanced budget or eliminate a potential operating deficit. Recent economic trends illustrate the importance of having the resources necessary to withstand a down market coupled with operational losses.

Unexpected events

If the last few years under COVID have taught us anything, it is that nonprofit organizations need to prepare for the unexpected. No one knows what sort of challenge is around the corner, but it is important for each organization to have adequate resources available when unexpected challenges occur.

New revenue resources

In today’s environment, and given the factors noted above, nonprofit organizations should be looking to continually expand and diversify their revenue base. As the initial years of any new programs often generate deficits, nonprofit organizations must have the resources to build and nurture their service lines until surpluses can be achieved. Additionally, nonprofits should be evaluating member and/or constituent needs on an ongoing basis and developing programs to address these needs. Once again, nonprofits should implement operating reserve policies that ensure adequate funding for investments in important new programs, even under unfavorable financial or economic circumstances.