As you can imagine, our accounting teams stay pretty busy throughout the year presenting financial statement audit and review results to hundreds of clients – for-profit and not-for-profit, alike. While we cover a lot of topics during these review sessions, we’re always sure to dedicate a significant portion of time to review the organization’s reserve balances, specifically with regard to its operating reserve.
We believe that analyzing an organization’s operating reserve balance at any point in time is absolutely critical in understanding the organization’s ability to manage its cash flow on a day-to-day basis. Moreover, the organization’s operating reserve balance helps paint a picture of its flexibility, which will help determine its overall resilience if it’s ever faced with a need to change its strategic direction, expand programming or eliminate certain initiatives.
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How To Calculate Your Operating Reserve
The first thing you’ll have to do to calculate your organization’s operating reserve is to determine its financial reserve, which is, quite simply, the number that is left on your balance sheet (or statement of financial position) after your liabilities have been subtracted from your assets. You will then need to subtract your organization’s long-term and restricted assets from the amount found in your financial reserve. Finally, to determine how long your operating reserve could fuel your organization if no other sources of income were available, your operating reserve balance would have to be converted into units of time (month, years, etc.).
For example:
Let’s say that, after subtracting your long-term and restricted assets from your organization’s financial reserve, you are left with an operating reserve of $12 million at year-end. Let’s also say that your organization’s monthly expenses total $4 million. With “months” serving as our unit of time, it can be determined that you will have three months of operations in reserve.
Is that enough?
How Long Should Your Operating Reserve Last
We regularly field questions from clients wanting to know how long their organization’s operating reserve should last. The short answer is, it depends. But since that answer doesn’t help anybody, our recommendation would be to set a solid goal of building an operating reserve that could fund 3-6 months’ worth of operating expenses. Every organization is different and it’s ultimately up to you to determine your nonprofit’s optimal operating reserve. We’ve seen a range of goals, all of which are justified by the organization’s unique circumstances. In our experience, at the high end, your operating reserve probably won’t exceed three years. At the low end, your operating reserve should be able to cover at least one pay period.
How To Develop An Operating Reserve Policy
In order for your operating reserve to function effectively, the American Institute of Certified Public Accountants recommends that your organization’s board should adopt a formal policy that addresses each of the following items:
- The purpose of building and maintaining the reserves.
- A calculation of the target amount.
- The intended use of the reserves.
- Who will have the authority over the use of the reserves.
- How the reserve account will be monitored.
- A plan for replenishing the reserve balance.
The calculation of your operating reserve and the policy you will set should be customized to reflect your organization’s cash flows, expenses and funding sources.
Email your Rea advisor to learn more about operating reserves or to start developing your organization’s financial policies.
By Ben Antonelli, CPA (Dublin office)
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