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Healthy Operating Reserves Are Essential For Non-Profit Organizations

October 12, 2011

Michelle Y. Hatch, CPA
Director
BlumShapiro

Non-profit organizations truly don’t differ much from for-profit businesses when it comes to building for the future – all businesses/organizations want to succeed and often are forced to endure major economic challenges.

We are currently in one of those challenging economic times – anyone who operates any kind of business or organization is no doubt aware of that.  And in times such as these, it is important for non-profit organizations to ensure that they have the operating reserves available to endure the difficulties and keep moving forward.

The importance of maintaining strong operating reserves really cannot be overstated.  Operating reserves are essentially rainy day funds for non-profits, an accumulation of unrestricted surplus funds that are liquid (i.e. not invested in fixed assets) and available for use at the discretion of the board.  These funds are primarily used in case of an emergency – an unanticipated, unbudgeted event like a significant increase in expenses or reductions in operating revenue.  And a problem caused by a period of economic uncertainty, such as the one we are currently in, could certainly qualify as an emergency situation.

How does a non-profit organization calculate its reserves?

  • Start with unrestricted net assets.
     
  • Subtract from unrestricted net assets the net book value of property and equipment, less related notes payable and capital lease obligations. The result is commonly referred to as “liquid net assets”.
     
  • Divide liquid net assets by total expenses, either for the fiscal year that has passed, or better yet, the budgeted expenses for the subsequent year and multiply by 365 days to calculate number of days of liquid net assets.

How many days of liquid net assets are enough?

This varies substantially among different types of non-profits. Trade associations tend to be at the high end of the spectrum, with many having more than a year of liquid net assets on hand.  Human service agencies tend to be at the low end of the spectrum, with many having less than thirty days of liquid net assets.  A commonly used goal is 3-6 months, but again this depends on the organization.

How does a not–for-profit increase its liquid net assets? Liquid net assets can only be increased by achieving increases in net assets (support and revenue in excess of expenses). Like a business, non-profit organizations need to budget for an increase in net assets each year, no matter how small. A break-even budget will not accomplish this goal.  Further, non-profit organizations should set a target for number of days of liquid net assets and, through budgeting each year, move towards the target.

Here are some other good tips:

  • Maintain regular financial reporting and budget monitoring;
     
  • Reconsider the organization’s ability to fund programs that lose money;
     
  • Obtain strong finance committee/board involvement;
     
  • Plan for the long-term mission of the organization;
     
  • Try to reduce borrowing as much as possible (i.e. don’t fund losses through borrowings, determine what expenses need to be cut to avoid the losses or how to increase revenues).

Consulting a financial professional, of course, is also a wise move during times like this.  Making sure a non-profit’s operating reserves are funded at an appropriate level could be just what an organization needs to get through the hard times and still plan for a bright future.

Michelle Y. Hatch, CPA, is a Director with BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in West Hartford and Shelton, CT and Rockland, MA.  The firm serves as business advisors for today’s leading companies, non-profit organizations and government entities, working to strategically tailor and consistently deliver tested solutions for unlocking an organization’s full potential. For more information about BlumShapiro, visit blumshapiro.com.

 

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