"How can our not-for-profit (NFP) board establish an appropriate level of reserves for the charity’s circumstances, and develop a strategy for building up and spending reserves in a way that is consistent with the charity’s purposes?"
All organisations, no matter what sector or type of business they are, must build up adequate “reserves” to be financially sustainable. So what are “reserves” and what is adequate?
In this context, many people mean cash reserves. An organisation’s wealth or financial surplus does not need to be held as cash, it will also include most current assets, such as receivables and inventory, and non-current assets you are able to sell. What we really mean is that the business must have sufficient liquid assets to cover the liabilities when they fall due for payment, within the risk appetite set by the board.
For the NFP sector, it can be difficult to establish an adequate surplus of assets over and above the level of liabilities if the organisation relies heavily on grant funding. This is because most grants do not allow a surplus to be generated. If funds are not committed to expenses, in accordance with the accounting standards and grant guidelines, many funding bodies require the return of surplus funds or the deduction of surplus funds from the next year’s funding amount.
How does an NFP generate equity in the business?
NFPs are limited in this space. They do not issue shares, so equity cannot be generated directly from owners. And many do not hold assets that may generate growth in value over time, for example, by the revaluation of assets. This only leaves building up retained surpluses, meaning an untied excess of revenue over expenses kept by the organisation.
NFPs must generate alternative income streams rather than relying heavily on grant funding. These other revenue sources must then generate surpluses and, over time, equity will build.
Once equity is at such a level that the board feels comfortable that the liabilities can and will be covered, then the NFP can start to budget for a net zero result. Small surpluses and deficits can offset over time. If the business continues to generate surpluses, then equity will continue to grow.
How much equity or, more specifically, liquid assets over the liabilities, is enough?
This will depend on the risk appetite of the board and the cash flow of the business. Does cash come into the business regularly or only a few times each year? Infrequent cash receipts will mean the business should hold a higher level of liquid assets to feel comfortable they will remain solvent.
NFP boards should develop a policy outlining what level of coverage they think necessary for the organisation to achieve and maintain. This should be complemented with a strategy outlining ways to apply the excess to the charity’s purposes. Organisations may use any deemed excess to further deliver services over and above what is being funded for the year, or they may have a service they wish to provide that does not attract a separate funding source. Surplus liquid assets could be used to develop a business opportunity that can generate untied surpluses in the future to allow more opportunities for the organisation and the freedom to deliver the services they want to provide, not just those that attract funding.
Risk appetite statement
Boards need to implement (a) a risk appetite statement that articulates what level of short-term coverage the organisation needs to attain. For example, this might be a requirement to maintain a current ratio of 2:1 or even 3:1; and (b) a strategy to achieve diversified income streams of untied funds, such as donations and a bequest program, sponsorship program, a range of events or other business ventures.
Depending on your core purpose there may be a related fee-for-service opportunity or even something more removed, such as second-hand clothing stores, where the surpluses are applied to your core purpose.
Think outside the box and be creative while discussing different opportunities. But sound strategies need to be developed, as alternative opportunities must generate a surplus.
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