We received 471 responses from a wide range of organisations across different groups, including social services, culture and recreation, and education/research. 70% of respondents represented organisations with turnover of less than $500k p.a. and only 30% had stable revenue streams, with the balance a mix of volatile (22%) and somewhere in between (47%).
It was pleasing to note that 94% of all responses received regular financial reporting on both the performance and position of their organisation.
Do you know if your organisation has a Financial Reserves Policy?
Over half of the organisations surveyed knew if their organisation had a policy in place. This represents a good level of understanding within the sector, however, it also suggests there is still room for improvement.
Do you clearly understand how your organisation’s reserves will be utilised in future?
Almost three quarters of respondents clearly understood how their reserves would be utilised in the future. The response rate to this question shows a clear link to many of the respondents having knowledge of a financial reserves policy and almost all of them receiving regular reporting on their organisation’s financial performance and position.
Do you believe your organisation currently holds too much in reserve?
Only 3% of organisations believed they held too much in reserve, and 4% didn’t know. Overall the answer to this question indicates that most organisations do not believe they have sufficient reserves. This is perhaps an unsurprising result as many would argue they could always use additional funds to further their cause.
Is your organisation’s revenue stream volatile or stable?
An organisation with a stable revenue stream is usually able to plan for future events with more certainty than one with volatile revenue. This in turn, has an impact on an organisation’s reserve policy and planning. On the other hand, an organisation with volatile revenue may be focussed on building a significant contingency reserve to cover down-turns in future revenue while still providing their community outputs. However, such an organisation may find it difficult to set these funds aside, as they struggle to meet their day-to-day commitments.
What are Financial Reserves and why are they important for NFP’s?
In broad terms, financial reserves represent an accumulation of prior year surpluses. For a NFP organisation, it is critical that reserves are carefully managed, balancing the need for a sufficient contingency fund with achieving the organisation’s mission. Reserves may be shown separately in financial reports as contingency funds, asset replacement reserves, tagged funds, sinking funds, and accumulated funds, just to name a few.
Once in place, reserves may allow an organisation to weather unexpected financial disasters, replace capital items as required, make investment decisions, deal with the outcomes of unexpected income tax audits (for those organisations that are liable for income tax), and to run one or several years deficit budgets in order to achieve a non-financial outcome.
Cash vs Net asset reserves
For an organisation that holds only one asset (cash) and has no liabilities, their bank balance shows their reserve level. However, most organisations also hold other assets and have obligations or liabilities to satisfy. For these organisations, the bank balance does not necessarily equate to the value of reserves, as measured by deducting total liabilities from total assets (net assets). Therefore, in designing a financial reserves policy, it is useful to distinguish between cash and net asset reserves.
Particularly where an organisation has tagged funds or is building reserves for a special project, it may be useful to hold the same amount as cash in a separate bank account, although this may not always be feasible.
It is also worth considering the potential impact on reserves of vehicle and property operating leases which are not included on the balance sheet. Should the organisation face a wind-up scenario, these items represent very real liabilities in the sense that contractual early termination clauses are likely to impose costs to cancel the arrangement. Understanding your organisation’s key supplier contracts and their terms is an integral part of setting a financial reserves policy.
When is enough, enough?
Based on the results of our survey, the overwhelming majority of respondents did not believe their organisation held too much in reserve. While many organisations could find ways to further their cause with access to more reserves, the reality is that after a certain point, there is a diminishing return on each dollar spent as a cause/community becomes saturated.
Each organisation will have a different level of what they believe to be an ‘excess’ of reserves. A well-crafted reserves policy could guide decision makers of an organisation on possible next steps, should a position of excess reserves be achieved.
Minimum and target reserve levels
Setting a minimum net asset reserve level, signals a Governing Board’s clear direction to the management of the organisation. The minimum level a Board chooses will reflect the scale of their organisation, and also the Board’s risk appetite. The minimum may be simply made up of a contingency amount which the Board deems suitable to cover unexpected operating events. It may also include an asset replacement amount.
Regular monitoring of actual reserves against this minimum allow a Board to easily gauge whether Governance intervention is required. When a minimum level is breached, or comes close to doing so, a financial reserve policy could specify what action the Board expects of management. For example, a written explanation to the Board summarising why the breach occurred and what action will be taken to remedy the level of reserves within a set time frame may be a requirement of the policy.
An organisation may also wish to set a target level of reserves. The target may be the same as the minimum level, but in most situations is usually a higher figure. The target level is likely to be made up of a contingency amount, an asset replacement figure, and allowance for any special projects. Once the target level of reserves is exceeded, an organisation would need to carefully determine what value was obtained by building up further reserves.
Link with non-financial metrics and mission/purpose
Being able to link your financial data with non-financial measures allows for compelling story telling to interested stakeholders. Reserves are a key part of the financial data, but when viewed in isolation do not convey to the reader the full story. However, when read alongside the non-financial metrics of an organisation, a convincing and coherent narrative can emerge.
Some of the questions that could be asked during this linking process include:
- Does the reserves story you are currently telling grab the imagination?
- Is it inspiring, while being strategic?
- If you were a funder/donor, would you give money if you were presented with that story?
A visual narrative within the annual report, such as a reserves thermometer, could be one way to graphically display this information. Personalised stories about the impact of a particular project could also be incorporated.
Developing a financial reserves policy
In determining an appropriate level of reserves for your organisation, it can’t be emphasised enough that no one figure or percentage will suit all organisations – it’s important to keep this in mind when developing a policy.
We recommend that a reserves policy forms part of an entity’s internal financial policies and delegations. A policy should be reviewed at least annually and may cover the following aspects:
- Purpose of the policy
- Definition of key terms
- A clear link between the organisation’s mission/constitution and it’s financial reserve requirements, along with links with other key finance and investment policies
- Specifications of the various reserve categories including their minimum and target levels e.g. Contingency Reserve, Asset Replacement Reserve, Special Projects Reserve. Including also whether the reserves are described in dollar terms, or as a percentage (if percentage, of turnover or expenditure?)
- Criteria for use of the reserve(s)
- Monitoring of and reporting on key criteria (and who is responsible for doing so), including trigger points for breach of minimum levels
For an organisation that is in a start-up phase, the Reserve minimums are likely to be aspirational and could be reviewed more regularly, perhaps six monthly, to ascertain feasibility over the first one to two years.
The policy should also be flexible enough to accommodate any significant increases or decreases in the organisation’s turnover or expenditure, for example, when a large bequest is received. This flexibility may be achieved by stating that if such an event occurs, the policy will be reviewed within a short time frame, rather than waiting for the next annual review date.
Contingency reserves to cover unexpected operating costs and potential wind-down expenditure have been set by organisations across the country using a range of methods. The most popular method uses reference to a number of months of operating expenditure, ranging from 3-12 months, to help establish a minimum figure. Once a reserve amount is established, some organisations have utilised a percentage split as illustrated to allocate the funds.
Implementing a financial reserves policy
Once the policy is developed, it needs to be implemented and the outcomes monitored. Some key considerations around this process include:
- Board members should have a good understanding of the policy and be able to tell the story of why the funds are there or being built up
- A regular review of reserves and the policies surrounding them
- Regular financial reporting to management and the Board, which incorporates actual reserves and tracking to minimum and/or target levels. This may be most effectively achieved in a graphical format and reporting could be aligned around key funding calendar dates
- Plan to accumulate funds – what financial strategies will be pursued to achieve this, and what level of risk is acceptable to your organisation?
We present three fictionalised case studies to illustrate some of the benefits of clearly defining a financial reserves policy.
Incorporated Society XYZ
Incorporated Society XYZ is a small organisation that relies on membership funding to meet its running costs. In 2014, a basic financial reserves policy was implemented. It covered a contingency reserve of $20,000 (to cover three months of operating costs) and an asset replacement reserve to upgrade the website of $10,000. In 2015, the minimum total reserve level of $30,000 was met.
Tertiary Institute ABC
Tertiary Institute ABC has grown its reserves steadily over the last five years through prudent management of the budget. In 2013, a contingency target reserve of $250,000 was set, along with a building target reserve of $100,000 for a new building. That level was achieved in 2015. In 2016 the financial position of the entity is significantly different to that of 2013, so it is important that the reserves policy is revisited and updated in line with any changes to the long term strategic direction.
Having a policy in place has helped focus the governing body as they achieved surpluses over a three year period and were able to clearly explain to stakeholders why they pursued this result. Regular reporting on the target also prompted a change in mind-set from day-to-day survival to a longer term view of the entity’s finances.
Registered Charity 123
Registered Charity 123 has enjoyed a healthy reserve balance over a number of years, however, no formal reserves policy has ever been implemented. After putting a policy in place in 2016 Board members now have a guide to assess the answer to a question many of them had often pondered but never discussed; are the organisation’s reserves employed to best use? Understanding that after allowing for contingencies, asset replacement, and special projects, a significant balance was leftover helped focus a strategy around donating a portion of the excess reserve balance to a complementary charity serving the same local community.
Telling a convincing, transparent story about the work your organisation does to funders, donors, and other stakeholders will likely require some financial data, in particular your organisation’s level of reserves. A financial reserves policy can provide a framework for internal decision making and externally, as a point of reference to support funding applications and donor appeals. For more information please contact your local BDO adviser.