Adding Spending Provisions to an Operating Reserve Policy
Virtually all nonprofit organizations aspire to accumulate operating reserves to help bridge short-term disruptions and funding gaps and to provide working capital for the future. What most people do not think about is how these operating reserves could be used or spent when the need arises. Misunderstandings can be avoided by making sure your organization’s operating reserve policy has provisions for the future allowable use (spending) of operating reserves.
Accumulating operating reserves to provide working capital to support future operations, expansion, and to enhance sustainability is a generally accepted best practice and an important financial health goal. Usually no one complains or even notices when an organization adds to operating reserves.
What does get a lot of attention is when an organization proposes drawing down some of their operating reserves to support budget deficits and funding gaps, or for special projects, expansion efforts, and program acquisitions. From a positive perspective, these requests to use operating reserves often lead to increased Board awareness and hopefully more in-depth questions and greater engagement with operational capacity planning.
However, the lack of guidelines for allowable future use of operating reserves in most operative reserve policies can cause confusion and acrimony. Without provisions addressing how operating reserves can be used, you will end up with widely differing individual opinions and no consensus approach for management and the Board to follow and rally around. Adding spending provisions to an operating reserve policy will solve this dilemma.
To start, spending provisions should be kept as simple as possible with just a few overarching elements that generally act as brakes so that the future allowable draws of operating reserves will be limited in any one fiscal year. This ensures that most of the organization’s operating reserves are protected to support future sustainability, financial health, and meeting the policy’s targeted goals.
I like to structure the spending provisions in an operating reserve policy around four “definitional” elements:
Eligible categories of use
Percentage of funds available per category
Cap on total annual percentage use
Who is authorized to approve use
1. Eligible Categories of Use
Start with two or possibly three categories of allowable use of operating reserves.
Set the first usage category to provide limited annual operating budget funding support and to bridge related proposed budget deficits. However, this category should only be used by organizations that have accumulated operating reserves significantly in excess of their operating reserve target goal (for example, for an organization that has a 12-month target goal for operating reserves and have accumulated more than 24-months of operating reserves).
Organizations should not be allowed to use operating reserves to fund annual budget deficits if they have not, at a minimum, reached their operating reserve target goal as set forth in their operating reserve policy. Consequently, this first category should not be eligible for use until the operating reserve target goal is significantly exceeded by the organization. However, for organizations that have not yet met their operating reserve target goal, this first category remains important as an aspirational objective to spur organizations to continue to accumulate operating reserves to be in a better position to provide future budget support.
Categories two and three are established for special purpose future use of operating reserves. Set the second usage category to provide working capital for expansion and growth, such as investments in new programs (for example, adding more advocacy initiatives) and expanding operational capacity (for example, major IT system upgrades).
An optional third usage category can be added to fund specific elements of a long-range strategic plan, such as funds to cover specialized costs associated with a planned merger, acquisition of intellectual property, relocation of office headquarters, and other similar one-time undertakings.
2. Percentage of Funds Available Per Category
After setting the two or three categories of eligible usage as described above, establish a spending range that sets a cap on the amount of operating reserves allowed to be used for each category.
For the first category related to allowable annual operating budget support, set a range from 0% to a maximum of 5% of annual operating budgeted funding. The purpose of this specific range is to limit how much an organization will lean on operating reserves to close a future funding gap in any one year.
For categories two and three, set a range from 0% to a maximum of 10% of operating reserves per category such that for each of these categories the requests for operating reserve funds support will not deplete total operating reserves by more than 10%.
3. Cap on Total Annual Percentage Use
In addition to the cap on each usage category, there should be an overall cap on the total amount of operating reserves used during any one fiscal year.
The maximum three-category total annual percentage use of operating reserves should be set not to exceed 15% of total operating reserves. This ensures that at least 85% of the organization’s operating reserve funds are protected for the future. The cap on total percentage use in any one fiscal year is the most rigorous overarching definitional element. How an organization defines and sets spending limits for each of the categories is flexible to meet the needs of that organization but having a total usage cap is a best practice requirement to ensure sustainability and to protect financial health.
4. Who is Authorized to Approve Use
Clearly designating the line of authority for approving the use of operating reserves (management and/or Board) is a crucial component of an operating reserve policy.
Often it is senior management and the Board working together through standard budget building and budget approval processes. However, some longer-term projects may require multi-year commitments that are not included in the annual operating budget and related budget approval processes. These multi-year uses of operating reserves should be designated for separate Board approval. Smaller intra-year operating reserve use requests, on the other hand, could be authorized and approved by the chief executive staff position (CEO or Executive Director) with notification to the Board but without direct Board approval required.
Reporting Requirements
In the interest of transparency, operating reserve policies should also require regular reporting on the status of operating reserves. These reporting requirements are an important complement to spending provisions in an operating reserve policy, and help to keep the Board, staff, and other interested parties informed and engaged,
Reports on the use of operating reserves and current operating reserve levels should be required as a regular part of the organization’s monthly financial reports. Additionally, the operating reserve policy should require a separate annual operating reserve status report to be prepared and made available to the Board after final completion of the annual audit of the financial statements, showing both historical as well as current financial status of operating reserves.
Planning Tip – It is best to have the Board delegate formal oversight and reporting responsibilities over operating reserves and the operating reserve policy to the finance committee so this important factor of financial health is given proper management consideration. Have the finance committee report to the Board of Directors twice a year on the status of operating reserves and impact on the current year’s budget and next year’s proposed budget. The timing of these reports should generally be just before the next fiscal year budget building process begins and just after the audit of the financial statements is completed and final approved.
Adding spending provisions to the operating reserve policy will have many benefits. First, it will act as a powerful reminder of why it is so important to build operating reserves and will give Board members and staff a glimpse of what a well-funded organization can accomplish in the future. Second, spending provisions stress the point that operating reserves are not just a one-way street where funds are added but not allowed to be taken out for future use.
Last but not least, spending provisions help to ensure that the hard work and dedication needed to accumulate operating reserves is protected, thereby enhancing sustainability, while also providing support for future growth, and having working capital to take advantage of new opportunities when they arise.
