Technical Assistance: Three Common Operating Reserve Myths

Posted on by Hilda Polanco

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How LUNA Could be the Key to Long-Term Sustainability

 A recent study of the financial health of New York City nonprofits uncovered some disturbing trends: 10 percent are insolvent and 40 percent exist with virtually zero cash reserves. For nonprofit leaders, these statistics play out in the form of daily anxieties: struggling to make payroll, defaulting on vendor payments, and reacting to never-ending fires.

Operating reserves — liquid savings readily available for opportunities and emergencies alike — would be a game changer in these scenarios. And yet, Fiscal Management Associates often encounters skepticism when we advocate for operating reserves to nonprofit executives and Board members. Here are three common misconceptions that we hear about building operating reserves.

Myth One: Endowments are the best route to financial sustainability.

Endowments — permanently restricted funds that are invested to produce an ongoing income stream for an organization — are typically seen as a safe solution for nonprofits looking to bolster financial sustainability. However, as a general rule of thumb, an endowment only has a meaningful impact if it is large enough to provide at least 5 percent of an organization’s annual operating budget. This requires a hefty-sized endowment, usually an amount that is at least equal to the budget size of the organization, which may be difficult—if not impossible—for the average community-based nonprofit to raise.

There is a better way. Liquid and unrestricted net assets in the form of operating reserves may be a more realistic and attainable way to boost financial sustainability for most small to mid-sized nonprofits. Not only that, these types of resources provide flexibility—endowments, by definition, restrict financial resources—which is critical for leaders of ever-changing organizations. Operating reserves usually take the form of cash, receivables, and liquid investments that an organization has on hand that are not designated for specific purposes by an outside funder or donor. At FMA, we call them liquid unrestricted net assets—or LUNA.

Liquid operating reserves can empower the leaders of nonprofit organizations to manage routine cash flow, support future programming or new opportunities, invest in and maintain facilities and other capital assets, and weather economic downturns or (financially) unsuccessful ventures. Rather than raised in a full scale capital campaign, LUNA is either built up slowly over time—by generating modest operating surpluses each year—or, increasingly, the result of foundation grants targeted for the purpose of building a reserve.

Myth Two: Operating surpluses are counter to mission.

We meet many nonprofit leaders who subscribe to the general sentiment that nonprofits should never make a “profit” on the services they provide. On the contrary, without a surplus—some excess in revenue above your actual cost of providing services—there is virtually no way to generate reserves that can carry you over rough patches in funding or help launch new and vital programmatic initiatives. The “balanced budget” for which so many nonprofits strive can in fact be part of the problem, not the solution.

The first step toward building a financial reserve is to create an organizational culture that accepts and strives to generate operating surpluses. It requires buy-in from the Board of Directors and acknowledgement from line staff. Nonprofits can be transparent in their plans to establish reserves by developing a long-term plan that outlines financial goals and clear policies regarding how reserves will be used to strengthen the agency and better achieve its mission.

The board can determine how much of its unrestricted net assets to make available for management to use as needed (“Operating Reserve”), how much to set aside for a rainy day (“Board Designated”) and how much to earmark for a specific strategic goal (“Special Purpose”). This culture change will not happen overnight, but addressing these assumptions is key to moving the needle on your organization’s financial health.

Myth Three: Building reserves is not a priority for organizations with chronic cash challenges.

In situations where an organization is faced with consecutive years of operating deficits and chronic cash flow shortages, building an operating reserve can feel not only daunting, but perhaps even unrealistic. In fact, it is the organizations in this category that stand to benefit the most from a culture of financial management oriented towards long-term stability.

One organization that FMA is currently partnering with has a history of taking out loans to bridge operating deficits, without having the ability to pay back the debt. This vicious cycle has resulted in a particularly grim financial outlook and a general fatigue among the organization’s board and staff. With FMA’s help, the organization has come to an understanding of what needs to be done to restore stability and reduce cash flow-induced anxiety, and has committed itself to a rigorous financial fitness plan. Over the next 5-7 years, it will strive to generate modest operating surpluses each year. This will allow it to incrementally move itself to a more financially sound position—first, by paying back its debt, and then, by slowly building up an operating reserve that will serve as an internal line of credit to bridge those inevitable cash flow shortages.

We offer this story as proof. Though it may be a slow and incremental process, it is possible for any organization to embark on the path of building financial reserves. What matters most is having the long-term vision, commitment, and tenacity to build and maintain operating reserves, even in the face of other obligations and distractions.


 

Hilda_polanco2

Hilda Polanco is the Founder and CEO of Fiscal Management Associates, the go-to advisor foundation and nonprofit leaders seek when addressing nonprofit financial management capacity. Hilda provides capacity building, training and coaching services to foundations and nonprofits throughout the country. 

 

One Response to Technical Assistance: Three Common Operating Reserve Myths

  1. This is a very important topic. I wrote a blog post about what happened to a charity that didn’t have a big enough rainy day fund to see it through a tough time. http://blog.charitynavigator.org/2012/07/a-charity-suddenly-closes-its-doors.html

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