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It’s not uncommon for nonprofit organizations to face financial issues, such as funding unforeseen operational needs or working with an insufficient cash flow. Moreover, navigating financial hardship presents a barrier to achieving long-term sustainability, which 32 percent of nonprofits claim is both their greatest goal and most difficult challenge.

While every organization must arrive at its own definition of financial stability, prioritizing the management of financial assets can allow organizations the freedom to provide their vital programming and eventually achieve sustainability.

Typically, a nonprofit’s net assets will be divided into three categories: unrestricted, temporarily restricted and permanently restricted. Within an organization’s unrestricted net assets are its operating reserves, which consist of funding set aside for periods when cash flow is tight and money is needed for unexpected expenses.

Operating reserves are unrestricted funds that provide a cushion against unbudgeted expenses, losses of income and other unforeseen financial events. They are usually accumulated over time by generating an unrestricted surplus and designating the excess funding as reserves.

At the lowest point during any revenue cycle, The Nonprofit Operating Reserve Workgroup suggests three months of an annual operating expense budget as the minimum reserve ratio. At the high end, operating reserves should not surpass the amount of two years’ budget. At the low end, operating reserves should be enough to cover at least one payroll cycle, including taxes.

Assembling operating reserves will ultimately support the fulfillment of a nonprofit’s mission, acting as sufficient working capital during fiscal emergencies and improving cash management. As you work to implement an operating reserve fund, it is important to first develop a policy that can guide the management and usage of these unrestricted funds.

Key Steps for Developing an Operating Reserves Policy

Once your organization has set a target amount for operating reserves, the board should work to draft a policy that includes guidelines for using the fund.

There are several steps a board should follow while documenting a formal reserves policy to streamline the process:

1) Provide proof of concept – First, the case must be made for the operating reserve fund’s need. The board should understand why operating reserves are needed and how the fund will aid the pursuit of your mission.

2) Draft policy – After the board concurs with the need for an operating reserve fund, the finance committee or a related group should draft the reserves policy. The draft’s financial breakdown should address the working reserve ratio, the protocol for usage and the plan for regular replenishment, among other action items.

3) Request board feedback – To help ensure the board is aligned with the policy, it is critical to request its feedback once the policy has been drafted. The board should be allowed to offer revisions before final approval is sought.

4) Propose final draft of policy – After working through the board’s feedback, a final draft should be presented to the board. The policy should then be finalized and approved.

5) Implement policy – The guidelines for using the operating reserve fund should be shared with any relevant members and staff of the organization so the policy can be put into practice.

After following these steps, nonprofits will be poised to oversee the operating reserve fund in a manner that underscores long-term financial stability. Overall, operating reserves should aid nonprofits in dealing with various factors that may be affecting cash flow without disrupting regular programming and operations.

Do you have questions about creating a successful operating reserves policy? Please contact Henry Martin at hmartin@dbllp.com.