Financial Reserves
Why your organisation should consider developing a Financial Reserves Policy.
Discussion paper from Pat Hanley, Social & Civic Policy Institute, Wellington, March, 2006. Reproduced by permission.
As a member of the Wellington/Wairarapa Lottery Committee I recently received a very useful paper on Financial Reserves. This is a topic which to my knowledge has received very little attention within the community and voluntary sector.
What are reserves?
Reserves are defined as “surplus funds built up over a number of years when an organisation’s income is greater than its expenditure.” These reserves are typically held as cash deposits in a bank or as investments. These reserves may be set aside for “a rainy day” or for some planned activity or project in the future. If the funds are tagged for a future project or activity they may not be able to be accessed for everyday running expenses. On the other hand, if the funds are set aside for an unspecified purpose there may be the temptation to dip into the funds to meet any and every shortfall in available funds.
A surplus is not a profit
The opportunity to develop financial reserves of course is dependent on the ability of an organisation to generate a surplus. The ability of a non-profit organisation to generate a surplus should not be confused with making a profit. The surplus, that is the excess of income over expenditure, must be set aside for future use consistent with the organisation’s charitable purpose or activities beneficial to the community. The surplus cannot be used for the financial benefit of any individual. This would constitute profit distribution which non-profit organizations cannot do.
Why have a Policy?
To avoid confusion in the future, organizations should therefore develop a financial reserves policy. The policy should state whether the funds are being set aside for a specific purpose or to meet an unexpected shortfall in income. Sometimes an organisation will receive a grant, donation or bequest that is specifically tagged to a specific project such as a building fund. Such funds cannot be used for day-to-day operations and this should be clearly stated in the organizations financial reserves policy and financial reports.
Setting a realistic target
An organisation should also set some target for its reserves. How big a “nest-egg” should it aim to realize? A starting point could be to estimate how much money is required to keep the organisation operating for say six months during which time no additional income is received.
If your annual operating expenditure is $100,000 you would aim to build up financial reserves of $50,000 over several years. In some countries there are limits on the amount of untagged reserves a non-profit organisation can accumulate. This tends to be in the range of the equivalent of 1 to 2 years operating expenses. In our example this would be a limit of $100,000 to $200,000 in financial reserves based on annual expenditure of $100,000.
So the amount of reserves to be set aside should relate to the size of the organisation and its annual operating expenditure. The reserves policy should also take into consideration unavoidable financial commitments such as a long-term lease commitment and the amount of funds required to meet redundancies should you have to reduce staff numbers.
Advantages of a Reserve
Having financial reserves can provide for unexpected emergencies, meeting increased needs within the community or target group with whom you are concerned, and provide support where income is less than had be anticipated for a specific project or activity to which your organisation is committed. Financial reserves can reduce stress on boards and staff. They can also give the organisation a stronger negotiating position when dealing with sponsors or contracting agencies and reduce reliance on a single source of funding.
Funders need a policy too
Funding organizations should also consider establishing a financial reserves policy to assist in allocating funding. Funders should not discourage prudent financial management because an organisation has succeeded in establishing healthy levels of reserves. Funders should assess eligibility based on the level of reserves relative to the size of the organisation, the cost of the project for which funds are sought, and whether or not the reserves are for a specified purpose or not. In addition funders should accept that a small portion of the funds granted may end up in the recipient organizations reserves fund.
Conclusion
Organisations which are able to establish even modest levels of financial reserves will be better able to manage short term crisis and unexpected developments while also focusing on the long-term achievement of their goals and mission. For this reason community organizations and funders ought to develop Financial Reserves Policies.
Pat Hanley: lawler.hanley@paradise.net.nz
Member, Wellington/Wairarapa Lottery Community Committee
Chair, Social & Civic Policy Institute