The operating reserve is cash to be used in the organization. It is part of an overall cash flow plan. Reserves can be for a specific purpose; such as, fixed asset purchase or program expansion. General operating reserves are for use in the day to day operations to bridge budget shortfalls.
Expert advice is to maintain an operating reserve of at least three months of budgeted expenses. Nonprofit operations are different across their missions and the communities they serve. This requires each nonprofit organization to consider their unique circumstances and goals to properly analyze and determine an appropriate operating reserve. Nonprofit auditors do not analyze as part of the audit.
As part of your analysis you will want to determine your working capital ratio [(Short Term Assets – Short Term Liabilities) / 12 Months Expenses] as a starting point for cash reserves. This ratio provides an idea of how long the nonprofit can continue operating using only the net liquid assets. Generally the goal is a ratio of 1 or greater.
Specific risk to the organization is considered next. Risk such as: reliance on one large funder for the majority of the organization’s support, political environment, and seasonal or other fluctuations. There are also considerations that are unpredictable: Such as the sudden departure of an Executive Director. Nonprofit auditors will consider this a risk when considering risk assessments.
Basically you want to consider reliability and predictability of all sources of revenue and expenses. The operating reserve can keep the organization going while dealing with the unexpected or capitalize on unexpected opportunities that present themselves.
A word of caution: operating reserves can be too large and become detrimental. Some funders may decide to reduce a grant award if the cash reserves are too large. The grantor may determine the organization does not need the support. Public scrutiny and reporting may cause potential donors to erroneously conclude their money is being held by the organization and not going to the stated mission.
The organization can combat these risks by establishing specific reserves for intended purpose rather than reporting in the general operating reserve. The general operating reserve is for sustaining the organization. Have an explanation ready for funders and donors as to why the operating reserve is maintained at that level. It may be a simple explanation. The reserves may appear high in dollar amount but actual only amount to one year of operating expense. In any case, keep the analysis performed when setting the target reserve to aid in preparing the explanation.
The target reserves should be approved by the board and supported in the board minutes. The reserve should be revisited when risk or circumstances change and on a reasonable periodic basis determined by the organization.
Contact us, Nonprofit Auditors, to discuss your organization's audit and attestation needs.