1. Determine an appropriate reserves target
Nonprofits commonly set fundraising goals, since establishing a specific target enables nonprofits to track their fundraising progress, whether the primary objective is to solicit major gifts or collect in-kind contributions.
Determining a target for your operating reserves is similarly necessary, but the process can be more complex. The appropriate amount for your nonprofit can be influenced by your organization’s size, funding model, and cash flow needs. Additionally, you must choose a balanced amount to avoid reserving too little for the fund to provide an effective safety net or too much so that you struggle to cover your usual expenses.
Set an amount that is large enough to cover payroll and other recurring expenses, plus some extra funding in case you incur any unanticipated costs. Avoid an excessive target to ensure you continue allocating the appropriate resources to other initiatives, such as member retention efforts or program activities and fundraising. No single standard applies to all organizations, but many nonprofits reserve three to six months’ worth of expenses.
2. Include all necessary provisions
According to Chazin & Company, operating reserves policies should “outline not only the high-level purpose and goals of the reserve but also the mechanics of its maintenance.” Once your target amount is set, draft a list of policy provisions needed to support this goal.
Your policy should include the following considerations regarding reserve funds:
- The purpose: Transparently articulate the purpose of the funds, both to reassure stakeholders that you have a clear need for these reserves and to guide decision-making and ensure proper governance. By stating a clear purpose for your operating reserves, the policy will foster responsible use of the funds.
- The source: Identify specific sources of funding in your policy to delineate how your nonprofit should allocate its resources to reach its reserves target. For example, will you add a new line item to your nonprofit’s budget? Or, will you designate a consistent percentage of unrestricted gifts to your operating reserves?
- The limit: While it’s important to ensure your reserve fund is large enough to cover unexpected expenses, you must also be careful to avoid setting aside excessive funds that could otherwise be used for your operations. Provide a specific maximum at which your organization should stop reserving funds.
Leverage donation and financial data to inform your policy. You may glean insights from your nonprofit’s donor database to identify sources of income that could support your reserves target. Your financial data may also help you forecast expenses that your reserve fund should cover.
3. Review policy examples
Just as your reserves target will be unique to your organization, so will your policy. However, to develop an effective policy, it can be helpful to look at successful examples or templates.
Double the Donation provides the following general sections that should be included in an effective policy, which we’ll expand on:
Purpose
Start by defining the purpose of your operating reserves in one clear statement:
[Nonprofit Organization Name] will maintain an operating reserve to manage cash flow, cover unexpected expenses, and address financial emergencies. The reserve is intended to ensure the continuity of essential services and programs during periods of financial instability.
Definition and goals
Next, provide any necessary definitions to clarify the policy’s contents and clearly lay out your reserves target:
The target for the operating reserve will be set at six months of [Nonprofit Organization Name]’s average operating expenses. This target will be reviewed annually and adjusted as necessary based on changes in the organization’s financial situation and strategic goals.
Funding of the reserves
Briefly list the source (or sources) of the funding:
Operating reserves will be funded through annual budget allocations and surplus funds from year-end financials.
Use of the reserves
Define any conditions for using the funds:
Use of reserves is restricted to situations where normal cash flow is insufficient to meet operational needs, or in the event of unforeseen financial emergencies.
Authority to use the reserves
Call out the specific individuals or committees with the authority to use or approve use of the funds:
Funds may only be used with the approval of the Board of Directors.
Reporting and monitoring use
Assign the responsibility of monitoring your operating reserves and the procedure that should be followed for reporting its usage:
The Finance Committee will monitor the reserve levels on a quarterly basis. The reserve policy will be reviewed annually by the Finance Committee and any recommended changes will be presented in a report to the Board of Directors for approval.
4. Consult a professional nonprofit accountant
Every aspect of your nonprofit’s operations—from investing in new technology to crafting donor communications to developing financial policies—can benefit from the expertise of a professional consultant. Such guidance can help your organization develop a plan of action that is uniquely tailored to your mission, operations, and resources.
Nonprofit accountants provide specialized knowledge in financial management to help your team navigate budgeting, compliance requirements, and other challenges. With this guidance, you’ll have the financial context you need to create a realistic and effective operating reserves policy.
Additionally, nonprofit accountants can help your organization with the following activities:
- Developing compliant processes
- Recording transactions
- Monthly financial close
- Creation of financial statements
- Audit preparation
- Budget assistance
- Grant tracking and reporting
With expert financial guidance, your organization will be well equipped to set an accurate target and develop a policy that helps you achieve that goal. In the end, you’ll not only have an effective policy in place for your nonprofit’s reserve funds but also the expertise needed to enhance your long-term financial health.
