A sufficient operating reserve is recognized as one of the key ingredients to the financial stability of a nonprofit organization and can serve as an internal line of credit when needed to cover the normal fluctuations of day-to-day operations. However, many organizations are completely lacking these funds and putting themselves at risk. One of the main difficulties in determining the appropriate operating reserve stems from the diversity of nonprofits. Since all nonprofits are unique, there is not a monetary amount of operating reserves that every organization should strive to reach. In 2008, a Nonprofit Operating Reserves Workgroup created the Operating Reserves Ratio to provide a point of reference for organizations to use when determining the amount of operating reserve needed. This ratio enables any nonprofit to easily gauge its financial stability.
The Operating Reserve Ratio can be calculated in two ways: as a percentage (operating reserves divided by annual expenses) or as number of months (operating reserves divided by average monthly expense). Either method can be used, depending on the organization’s preference. It is recommended that an organization has a minimum goal of 25 percent or 3 months of the annual expense budget. However, it is also suggested that each organization set up their own Reserve Policy, outlining the ideal operating reserve ratio based on its specific needs.
Before calculating the Operating Reserve Ratio, it is crucial to understand what makes up an organization’s operating reserves. Operating reserves are a component of “available unrestricted net assets”. A simple definition of, “available unrestricted net assets” is unrestricted net assets less fixed assets, net of related long-term debt. A more conservative definition of “available unrestricted net assets” would also exclude other non-current assets and non-liquid current assets such as receivables, inventory, prepaid expenses, and deposits held by others. Each organization needs to determine if the simple definition can be used reliably for measuring Operating Reserves of it needs to use a more conservative definition. From the “available unrestricted net assets”, the operating reserves are set aside to cover unexpected expenses. These may come in the form of unbudgeted operating expenses, revenue losses, or any other unanticipated issues.
A portion of an organization’s “available unrestricted net assets” may also be reserved for strategic purposes and optimal mission accomplishment. These non-operating funds may be designated by the organization’s board for purchase of fixed assets, development of new programs, taking advantage of unexpected opportunities, investment in quasi endowment and other specific purposes. It is important to note that, as a general rule, building an adequate operating reserve is viewed as the first priority over other board designated funds.
