Operating Reserves as a Key Indicator of Financial Health

Just as the gauges on a car’s dashboard provide crucial information about its performance and physical condition, operating reserves serve as a vital indicator of a nonprofit organization’s financial health and as a measure of stability. Operating reserves give a clear view of an organization’s capacity to sustain its operations and weather financial uncertainties.

By understanding and managing operating reserves, nonprofit leaders can navigate their organizations toward greater longevity and stability, ensuring they remain trusted and impactful stewards of their missions for years to come.

How Financial Health Impacts Sustainability and Trust

For nonprofit organizations, longevity is key to building trust. If an organization has the processes and structures in place that enable and support long-term successful financial and operational stewardship, chances are funders will feel more confident relying on the organization to be sustainable into the future.  With sustainability and continuity funders, donors, constituents, Board members, volunteers, and even staff can be confident that the organization is well-positioned for the long run.

A strong financial position is a key component of longevity. The best place to understand the organization’s financial health or weakness is on the balance sheet (statement of financial position). However, balance sheets can include a lot of data points, making them hard to interpret as a gauge of financial health.

Unfortunately, there is no one perfect, universal indicator of financial health. However, for me, the single best data point to assess financial health is an organization’s operating reserves. Why operating reserves? The answer lies in understanding the calculation of operating reserves and how the individual component parts of the calculation impact an organization’s financial health.

How to Find and Calculate Operating Reserves

Operating reserves reside on the balance sheet. To better understand operating reserves, head to the balance sheet and work your way through the following steps:

• First go to the net asset section on the bottom of the balance sheet.
• Next, find the unrestricted net assets (net assets without donor restrictions).
• Look to see if there are any Board-designated unrestricted net assets. These are funds set aside by the Board for a future special designated use, such as supporting the purchase of a headquarters building, acquiring a program from another organization, or funding a one-time future project, for example, a rebranding or a special event like a 100^th anniversary celebration.
• If there are Board-designated unrestricted net assets, subtract these from total unrestricted net assets. If none, go to the next step.
• Now reduce the amount in the preceding step (unrestricted net assets less Board designated net assets) by any illiquid assets listed at the top of the balance sheet. Illiquid assets are those not readily available for quick conversation to cash, such as fixed assets (property, furniture, equipment, leasehold improvements), escrows, and right-of-use special assets (e.g., operating leases).
• The net result will be operating reserves.

Stated in another way, for most nonprofit organizations operating reserves are unrestricted net assets less any Board designations and less any illiquid assets such as fixed assets.

Operating Reserve Policies

To help institutionalize operating reserve best practices and provide a pathway for a clear set of purposes, definitions, and goals, have a formal operating reserve policy in place prepared by senior management and staff and approved by the Board. A formal operating reserve policy will include these four key components or sections:

• Operating Reserve Goals Defined in Terms of “Mission”
• Operating Reserve Goals Defined in Terms of “Percent of Budget”
• “Budget Bottom-Line Planning” Actions Based on Current Operating Reserve Goal Status
• Annual Operating Reserve Goal “Status Reporting”

For nonprofit organizations that have accumulated substantial amounts of operating reserves, it is best to also add a “Spending Policy from Operating Reserves” as a fifth section in the operating reserve policy. This section allows organizations to set parameters and separate  short-term spending (emergency unexpected disruptions) vs. operating and long-term spending (investment in programs, capacity, and future growth.)

What Accumulating Operating Reserves Says About Your Organization

In general, more operating reserves is better than less operating reserves.  However, operating reserves are so much more than just a “rainy-day” fund, providing a broader window to assess the performance and reputation of an organization.

Pay close attention to what operating reserves can reveal about the perception of organization’s successes and failures, culture, and management styles. Organizations that have a track record of successfully building and maintaining operating reserves will project varying aspects of the following positive characteristics:

• Well-Managed: Operating reserves do not just magically appear. Operating reserves are the result of careful managerial and governance planning, hard work, and determination.
• Fiscally Responsible: Operating reserves are indicative of organizations that have strong operational policies, good internal accounting control systems, robust governance policies and practices, and a leadership that is focused on sustainability.
• Able to Realize Budget Surpluses: Operating reserves are often accumulated through financial planning that includes assembling operating budgets with an annual surplus, along with a track record of actual surpluses being realized most years.
• Strong Cash Position: Organizations that have built up adequate operating reserves will most likely have strong readily available cash in their operating bank accounts and not be struggling with high accounts payable and active lines of credit.
• Able to Invest in the Future: Operating reserves for nonprofit organizations act like working capital in the for-profit business world. They allow your organization to invest in future growth, start or acquire new programs, expand staffing and capacity, and be opportunistic with long-term strategic planning.
• Able to Weather Storms: Organizations that have operating reserves are less exposed to risks from unexpected disruptions, delays in programs and funding, and changing economic conditions and social perceptions.
• Financially and Operationally Stable: Operating reserves act as a highly visible measure of an organization’s stability and continuity.
• Strong Risk Management Practices: When operating reserves drop or are non-existent, the organization is more exposed to risks from expected as well as unexpected hazards. But when an organization meets or exceeds its goal for accumulating operating reserves, it improves its overall enterprise risk management and lowers exposure to risk factors.    

All these benefits will not appear to everyone at the same time. That is not important. What is important is that over time, your leadership and stakeholders will see a collective picture focused on sustainability. Operating reserves as a single easy to recognize data-point will create a strong general impression of the organization regardless of any one individual’s preferences and biases, key elements of concern, and knowledge of finance.

Planning Tip – After your organization completes its annual financial statement audit, prepare a final operating reserve status report for distribution to the Board of Directors. This report (a sample can be found here) can be used to set the stage for planning and strategic discussions about how operating reserves could be used to support opportunistic future investment in new programs, operations, and growth.

Build a Culture that Prioritizes Operating Reserve Awareness

Operating reserves are both a strategic goal and a badge of honor. Nonprofit organizations that have a plan to maintain and accumulate operating reserves will display confidence in the future and a strong commitment to fiduciary stewardship and financial health. Building a culture that emphasizes operating reserve awareness will project steadiness, good management and governance policies, and trust in the organization’s ability to be around for a long time.

To learn more about the role of operating reserves for your organization, check out our two-part webinar series, The Crucial Impact of Operating Reserves on Your Organization’s Financial Health and Sustainability.

Operating reserves are a crucial part of a healthy financial statement, and there are several ways to calculate, hold, and manage those funds. Consult your auditor and CPA to identify the options that work best for your organization.