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Operating Reserves

An operating reserve is an unrestricted fund balance set aside to stabilize a nonprofit's finances by providing a cushion against future unexpected cash flow shortages, expense or losses. In other words, an operating reserve is a rainy day savings account.

How are cash reserves used?

Delayed payments, timing of grants, or seasonal cash swings can cause a cash shortage for a nonprofit. Reserves are used to cover these short-term problems. Reserves can also be used to pay unexpected and unbudgeted expenses like building repairs or technology upgrades or for increases in budgeted costs like utilities or insurance. Reserves should not be used to make up for income shortfalls, unless the organization has a plan to replace the income or reduce expenses in the near-term future. In short, reserves should be used to solve timing problems, not deficit problems.

Reserves are different from restricted funds. Restricted funds are contributions that have been received for specific programs or projects. These funds are "restricted" for use according to the grant agreement or donor's instructions. Sometimes this means that restricted funds sit idle in the bank for a while and the nonprofit cannot use those funds for some other purpose. Reserves, on the other hand, are "unrestricted" funds that can be used in any way that the nonprofit decides.

Where do reserves come from?

Occasionally, a nonprofit will receive a grant or contribution to create or add to an operating reserve fund. Usually, though, reserves are built up over time by generating an unrestricted surplus - more income than expenses - at the end of the year and setting the cash aside in a segregated account.

How much?

There are some rules of thumb for setting operating reserve goals. These are usually based on the premise that nonprofits need to have enough unrestricted cash to cover operating expenses for a number of months. A commonly used reserve goal is three to six months' expenses. At the high end, reserves should not exceed the amount of two years' budget. At the low end, reserves should be enough to cover at least one full payroll.

Keep in mind that standard calculations don't take some important variables into account, like the stability of the nonprofits cash receipts. Organizations that have contracts or fees with regular and reliable payments don't need as much in cash reserves as organizations that rely on periodic grants, fundraising events or campaigns, or seasonal activities.

For more on this debate, you can read The Cash Reserves Myth.

Managing operating reserves

To be a viable operating reserve, there should be a board agreement and policy about how reserve funds can be used. The purpose of the policy is to describe when these cash funds can be used, who is authorized to use them, and how this is reported to the board. Some boards go so far as noting it as a "Board designated reserve" on their financial statements. This helps to communicate that reserves are in place. Without a policy and agreement, reserve funds tend to be gradually spent down over time, and are not available the next time the funds are really needed.