Nonprofit Accounting Basics

Measuring the Adequacy of Reserves

Over the last two months, we have explored different ways an organization might define its reserves and the importance of establishing and maintaining those reserves. By sustaining an adequate level of reserves, your organization can weather lean operating periods and even survive extended periods of economic downturn. But how much is enough? How does an organization know its reserves are sufficient? While these are important questions, they are hard ones to answer.

Create a Formal Policy

The first step in this process is to establish a formal policy. A formal policy will help ensure your organization remains disciplined enough to build and maintain reserves. A well thought-out and defined policy will do the following:

  • Identify a particular target for your organization’s reserves so the organization has a measurable goal for which you can strive.
  • Create parameters for the organization’s use of reserves once they exceed the identified target.
  • Outline a plan for replenishing your organization’s reserves should they fall below the reserve target.

According to ASAE’s Operating Ratio Report , 66.1% of their respondents have established a formal reserve policy. The median reserve target established in these policies is 50% of the entity’s annual operating budget. Let’s suppose your organization also decides to identify your reserve target at 50% of your operating budget. This target is meaningful in two ways. First, it is an exact amount that can be calculated year after year. Second, it is an easily understood goal for management and something it can appreciate. Surely board members are comforted by the fact that their organization could continue to exist under normal operations for six months despite the fact their annual convention (and largest revenue generator) was just canceled due to a hurricane!

Without a formal policy in place, it is especially tempting to overspend excess reserves or to neglect a shortfall in reserves. When times are good and resources are aplenty, it’s easy to make rash decisions and spend irresponsibly. Conversely, when resources are sparse, it’s easy to avoid the tough decisions and sacrifices necessary to rebuild a weakened reserve pool. A formal reserve policy could help keep an organization from doing these things. Of course, as managers of your organization’s assets, your job is to make sure formal policies are adhered. This is the second (and critical!) step in the process. So, back to the original question: does your company have appropriate reserves? It’s tempting to compare your reserve levels to your industry peers. While this is generally smart, it’s important to ensure you are comparing your organization with others of similar characteristics. Keep in mind different types and sizes of organizations warrant different levels of reserves. An organization relying heavily on one or two revenue sources might require a higher level of reserves than an organization whose revenues come from a variety of sources. In other words, the more diverse an organization’s revenue streams are, the less susceptible they are to potential shortcomings. Naturally, there are many other factors affecting your appropriate reserve target as well, including your long-term plans and capital requirements.

Final Considerations

More is better, right? This certainly sounds logical, but is it? Nonprofit organizations have to strike a balance between establishing big enough reserves and providing a continuously high level of service to their constituents. An organization’s members who feel they are not getting satisfactory return on their dues will be quick to criticize the association’s management. Worse, dissatisfied members may not renew their memberships. A charitable organization which saves considerably more money than it spends is going to have a hard time raising new funds.

So, more is not necessarily better. Your organization needs to weigh all these factors when considering the adequacy of your reserves. Careful planning, discipline, and follow through will keep you on the path to financial stability.