Nonprofit Ratios: Operating Reserves

     Financial ratios are essential metrics that can help you evaluate the oversight needed for the bigger picture of your organization's finances. Today, we’ll discuss the operating reserve ratio. This ratio answers the question, “How long can your nonprofit operate on the reserves that you currently have?” An operating reserve ratio is the ratio between an organization's unrestricted net assets and its annual operating expenses. Please note, this is not a measure of cash on hand, so we’re not answering the question, “ How much cash do we have?” This is about all the resources that are available. Those resources could be in cash, (or cash-equivalent money market funds), but they could also be in investment accounts. 

Finding Your Minimum Operating Reserve Ratio

       The operating reserve ratio indicates the number of months that your nonprofit would be able to operate without income. Let’s apply this to an example: 

     First, let’s assume that your nonprofit has unrestricted net assets of $250,000. Well, if your annual operating budget or annual expenses are $1,000,000, we’d calculate this ratio by dividing $250,000 by the $1,000,000, which gives us a ratio of 25%. Now, I use that as an example because 25% is also the industry standard for a nonprofit 501c3, and it's a great place to start. So that means that you’ve got one fourth of your budget (or 3 months’ expenses) available if needed. and that’s a good starting point. 

Is 25% Right for Your Nonprofit?

     Depending on your situation, you may need to set a different target ratio. Here's some examples that might necessitate an alternate reserve ratio: .

•   If your organization is very small, it might be hard to get to a reserve ratio of 25%.
•   If your organization is extremely large, you may need a lot more than 25% to ensure the scope of your budget and prevent any interruption of your mission.
•  If your nonprofit receives grant funding on a reimbursement schedule that takes 3-6 months, you may need to cover a longer period of time, which will increase your reserve ratio accordingly to address your specific cash flow concerns. 
•  If your funding sources are exposed to greater risk of interruption, you may want to adjust your reserve ratio to compensate for that increased risk.  

Why Finding the Right Reserve Ratio Matters

    When your nonprofit is prepared with appropriate reserves, you’re able to weather a storm without compromising your mission. We don’t have to look very far back to see evidence of this principle impacting reality. Whether you are funded primarily through grants or individual donations, there are so many factors that can interrupt your funding. Grants end, economic downturns impact donors, and of course, the pandemic lockdowns affected everyone. Economic impacts of any nature often translate to nonprofit revenue impacts.

How to Build and Maintain an Adequate Operating Reserve

1.   Make the decision. What's your board's position or your organization's policy on the operating reserves you choose to maintain? 
2.  Determine your current reserve ratio. Do the math. Keep in mind that this ratio is based on unrestricted net assets, not total net assets. If you're unfamiliar with the difference, or if you're not currently preparing or receiving your financials in a way that makes this distinction clear, click here to see all my previous posts related to net assets. That’s really important. If you don't know the difference, you really need to.
3.  Next, budget to increase your reserves. Plan for situations where your income will exceed your expenses- in other words, don’t spend every dollar you bring in. It sounds obvious, but  that's ultimately how you grow your operating reserve. I highly recommend that you set a goal and then you work towards it with an intentional budgeting strategy. 
4.  Manage your existing expenses, cash flow, and spending, so that you avoid having operating deficits. This will help you to grow your operating reserve ratio. 

     I hope this has been helpful to you. If so, I invite you to subscribe to my weekly financial tips. This month, I'm going to be breaking down several other ratios every nonprofit should know!