Reserves for your not-for-profit can be a valuable resource when unexpected challenges arise. Not-for-profits can use their reserve funds to address these unexpected situations and remain financially stable. Additionally, reserves demonstrate to your community and donors that your organization can continue to fulfill its tax-exempt mission during periods these challenging periods.
Your organization’s reserves must come from a designated pool of unrestricted, liquid assets. Other than that, the Internal Revenue Service (IRS) does not have standard guidance about what an organization’s reserve level should be. The appropriate amount will vary from organization to organization because the reserve should reflect specifics about your level of risk, financial performance, corporate structure and business model.
It is important that an organization is able to defend its reserve level determination because it is an area of public and regulatory scrutiny. A high reserve amount may look like an organization is “hoarding” funds in its reserves and draw criticism.
Since each organization is different, there is no single benchmark for determining the appropriate reserves that applies to all not-for-profit organizations. However, below is a five-step process to help you determine a reasonable reserve level for your organization.
Step 1: Project Your Financial Position
To estimate the amount your organization should set aside in reserves, you first must understand the full scope of your organization’s financial performance. Financial modeling can illustrate the trends that affect your organization and how those patterns might influence your financial position in the future. Be sure to include an analysis of how your organization will fund its reserves to verify the method you selected will produce the right level of capital.
Once you have the financial model in place, compare it to the risk model to determine what additional reserves you may need to cover your operating risks.
Step 2: Analyze Your Potential Risks
During the risk analysis phase, both management and the Board need to build consensus about the risks your organization faces, both internal and external. Consider fraud, governance, financial, operational, compliance, technology and other external risks in your evaluation. We also recommend you meet with the various program departments within your organization to discuss the key budget line items where variance from the financial plan would affect your organization’s overall performance.
After you have identified the risks, determine the probability that these risks will occur. Create scenarios for each risk that consider the likelihood of occurrence and establish a range of potential outcomes.
Step 3: Quantify Annual Risk Exposure
Use your financial model as an input, and examine your risks to determine the potential financial impact over a specific time. Include all downstream results that may come from the risk. Then, calculate the net present value (NPV) based on the likely adjusted impact by year. The NPV will help you determine the average annual risk exposure.
The annual risk exposure calculation can be complicated. Everyone involved may not agree on the risks, degree of financial impact and the probability those risks will affect your organization. Your underlying assumptions can guide the process along. If your assumptions are sound, you will receive a good overall approximation of your annual risk exposure.
Step 4: Establish a Target Reserve Level
Your organization’s annual risk exposure provides a good base for the reserve amount your not-for-profit should keep. The following can also guide your decision-making:
- The time it takes your organization to make adjustments to operations;
- The ability to generate additional margin if needed;
- The aggressiveness of your budget (the more aggressive, the higher the reserve level should be); and
- The likelihood your organization will have a higher risk year.
When you determine your reserve level, be sure to identify which unrestricted liquid assets your organization will use to fund its reserves. Set these funds aside from the unrestricted assets used in general organizational spending.
Step 5: Document Your Process
An organization’s reserve policy serves as a roadmap that will keep reserve determination consistent year-to-year and throughout periods of staff turnover. Record how you determined the organization’s current reserve level in the policy.
Other elements of the policy should include:
- Why the organization has a reserve;
- When the organization draws from its reserve;
- How it monitors reserve spending; and
- The other steps the organization takes to respond to risk events.
Examine and update your reserve level each year to ensure it meets your organization’s changing needs. For more information about how to determine the appropriate reserve level for your organization, please contact your local CBIZ Tofias & Mayer Hoffman McCann advisor, or you may reach us here.