Reserves: how much and how to build them

Learn how to calculate a target reserve level, build a funding plan, and create a policy to manage your organization's cash cushion.

When It Matters

A reserve is an unrestricted fund balance set aside to cushion an organization against unexpected events, lost income and large unbudgeted costs. That word "unrestricted" is the point. Restricted grant money must be spent as the grant agreement says. A reserve can be used however management and the board decide.

The most common reason to draw on a reserve is that a reliable income source has been reduced or withdrawn. Others include bridging payment delays, covering a large cost nobody budgeted for, or paying a one-time capacity-building cost. In the worst case, a reserve can fund an orderly shut down.

What a reserve cannot do is fix a permanent problem. It is meant for temporary gaps, and one sample policy aims to use and replenish it within a year. If income has fallen for good, or the budget has a standing hole, you need a change in revenue or in spending.

How It Works

Going from no cushion to a governed one takes six steps.

  1. Score your risks. List the revenue risks, which are the things that make income volatile. One example is relying on a few funders for 70 to 90% of revenue, and another is grants that give no general operating support. Then list the spending risks, meaning the things that make it hard to scale costs back. Give each risk one point, and more for a larger risk.

  2. Read the target from the matrix. With 1 to 5 points on both revenue and spending risk, the target is 3 months of expenses. With 5 or more on both, it is 6 or more months. The source lists 5 in both bands, so it leaves a score of exactly 5 on the boundary. A mixed result lands at 3 to 6 months. A score of six on revenue and three on spending, for instance, falls in the mixed band of 3 to 6 months.

  3. Work out your monthly expenses. Take average monthly operating expenses, including recurring costs such as salaries, rent, travel and program costs. Leave out depreciation and in-kind expenses. Multiply by your target months.

  4. Write a funding plan. Put it in the policy, with incremental payments and a schedule. Ask whether you have cash to set aside now, whether a funder could make a one-time reserve grant, how large a surplus you can budget, and whether fundraising can help.

  5. Adopt a written policy. Without a policy and procedure, reserves tend to be spent down gradually and are not there when needed. The policy covers five areas: purpose, definitions and target calculation, authority to use each type of reserve, reporting responsibilities, and any investment rules.

  6. Monitor and review. Management and the board should watch the balance regularly. Review the policy in the annual board cycle, since it is a living document.

Key Components

A sound reserves policy is flexible and easy to access. Reserves exist to help run programs, and a balance nobody dares touch defeats the purpose. It should include:

  • Purpose. Say why the reserve exists, for example as an internal line of credit for cash flow, to sustain operations through payment delays, or to pay one-time capacity-building costs.
  • Definitions and target calculation. State the reserve amount and the agreed level as a ratio to annual operating expenditure, with reasons. Most organizations set the minimum as a fixed number of months of operating expense or a percentage of annual operating expenses.
  • Authority to use each type of reserve. Say who can authorize a draw, and at what level.
  • Reporting responsibilities. Say who reports the balance and its use, and to whom.
  • Investment rules. Add these if you need them.

Be clear about what counts. Free reserves are the part of unrestricted funds that is freely available to spend on any of the organization's purposes. In the UK charity guidance, fixed assets that are essential to delivering the mission may be left out when you calculate them. Also tie reserve levels to your strategic plan and budget: a 12-month budget for short-term needs, and 2 to 5 year forecasts for longer-term ones.

Best Practices

Set the target from your own risks. There is no universal number. Stable, predictable income needs fewer reserves, and uncertain income needs more. The target can be a range or a value made up of several components. A commonly used goal is three to six months, though it depends, with a floor of at least one full payroll including taxes and a ceiling of two years of budget.

Express it as months of expenditure. This gives a sense of proportion and lets your board and other stakeholders compare the sum with the size of the organization.

Budget for a surplus or reserve line each year. Reserves are usually built over time by generating an unrestricted surplus and deliberately designating part of the excess cash.

Keep approval tiers so access stays easy. Let staff leads draw below a set amount or payback period, with the treasurer or a committee approving. Bring the full board in above that level. Too much process and the reserve stops being useful.

Set a rebuild trigger. Many organizations act when reserves fall to 50 to 75% of target. After setting a target, compare it with your position. If you are short, make a plan. If you are above it, ask whether the money is doing the most good for beneficiaries.

Review the policy regularly. The board or an overseeing committee should look at it on a schedule, not only after a crisis.

Common Mistakes

Copying one number from someone else. Saying every organization should hold six months is wrong. Reserves that are too high tie up money that should fund activity, and reserves that are too low put the future at risk.

Using reserves to cover a structural gap. Reserves solve temporary problems. Use them to bridge, and fix the underlying revenue or costs.

Moving unspent restricted money into reserves. Leftover funds from a restricted grant cannot go into reserves. Return them to the grant-giver, or get permission to use them for another specified activity.

Accepting a reserve gift with conflicting restrictions. A donation designated for reserves can end up carrying restrictions that clash with your policy. Ask the donor to restrict it to reserves and let your policy alone govern how it is used.

Having no written policy. The balance drifts down through small, reasonable-looking draws. Write one that covers the five areas above.

Assuming all funders think alike. Some insist that applicants hold reserves as assurance of viability. Others treat reserves as a reason not to fund, and some apply blanket rules refusing grants above a set amount, which pushes organizations to worry about what a funder finds acceptable rather than what they need. Know how each funder sees it before you apply.

Example

Take an organization with six revenue-risk points and three spending-risk points. One score is high and the other low, so the matrix lands on a target of three to six months of operating expenses.

To turn that into a sum, take average monthly operating expenses, leaving out depreciation and in-kind items, and multiply by the months chosen. The funding plan then goes into the policy, with a schedule of incremental payments.

Further Reading