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not for profit
Building Financial Reserves

Building financial reserves

The general definition of ‘not for profit’ on the Australian Tax Office website is:

“An organisation that provides services to the community and does not operate to make a profit. A few examples are childcare centres, art centres, neighbourhood associations, medical centres and sports clubs.”

The ATO further stipulates that: “All profits must go back into the services the organisation provides and must not be distributed to members, even if the organisation winds up.”

It’s a widespread misnomer that not for profits can’t make a profit. They just can’t make a profit for distribution amongst members or employees or stakeholders – any profit or surplus must be redirected back into the organisation.

A quote we are fond of (but aren’t sure where it comes from) is “not for profit is a tax status – not a goal”. We couldn’t agree more and believe that not for profits can, and should, aim to make a profit in order to build financial reserves.

Building Financial Reserves

Financial reserves play an important role in the long-term financial stability of any organisation. Reserves are particularly important to not for profit organisations who don’t always have steady or long-term funding streams, and whose demand for services can also be difficult to predict.

Accumulating financial reserves must therefore be a critical strategic objective.

What are financial reserves

What are Financial Reserves?

Before we get too much further ahead, it’s probably wise to determine exactly what is meant by ‘financial reserves’. Without getting too technical, it’s important to understand that for not for profit accounting purposes there are generally two types of reserves: ‘operational reserves’ and ‘restricted reserves’.

Operational reserves are like a ‘rainy day’ fund – they are savings which provide a financial buffer if something goes wrong. Restricted reserves are typically funds which are set aside for a particular purpose – they are usually earmarked funds and can’t be spent on anything else.

Because many not for profit organisations operate on a shoestring, it can be tough sometimes just to make ends meet. But it’s simply good fiscal governance to have a savings plan. Every not for profit organisation should have one, and over time, aim to build solid financial reserves.

What is an appropriate level of reserves

What is an appropriate level of Reserves?

The ‘right amount’ of operational reserves differs from organisation to organisation and needs to be determined by the Board, typically by the finance committee and risk management committee working together. These ‘Responsible Persons’ have responsibility for ensuring that the organisation’s financial affairs are managed responsibly. The ACNC governance standards – along with common law – requires all organisations – for profit or not – not to operate while insolvent. Having reserves provides a safety net and gives the Board confidence that the organisation can meet its debts as they fall due.

As a general rule of thumb, an organisation needs to accumulate enough money to cover major expenses in the event of something unforeseen – this would include funds to cover necessary outgoings, all those bills that need to be paid so the organisation can remain ‘operational’ – rents, wages, other resources.

However, many organisations also seek to build funds over time that can be used, for example, to pay for ‘operational and strategic risks’ – examples of these might be potential changes to compliance, the cost of IT and infrastructure upgrades, a new planned service or project. This is perfectly acceptable too, and it’s very likely that the amount of reserves your organisation requires will change over time.

Adequate, but not excessive

There’s no real right or wrong way to determine how much your organisation will need, but your organisation needs to strike a balance between building a ‘safety net’ and going overboard to ensure you’re covered for every eventuality. While a healthy reserve is good, it’s important also to remember that it is the expectation of donors and stakeholders that your organisation will focus most of the finances available to it on the purpose and mission. And of course, most funding bodies have a requirement to return any unspent funds so it is important to understand what portion of your surplus funds you are able to keep as profit.

Stockpiling reserves without adequate justification can cause concern that funds are not being managed appropriately.

Have a ‘reserves’ policy

Have a ‘Reserves’ Policy

As part of good fiscal governance, it is important to develop a financial reserves policy. This should articulate clearly what the organisation considers to be an appropriate level of reserves, and why. It should set out how the funds will be accumulated and the ongoing funds management strategy. It should also outline who is responsible for the funds, how often they will be reviewed and the circumstances under which they can be used.

How much? We find many not for profits set a reserves benchmark of 12-26 weeks of normal operating expenditure – some have much more if they receive bequests and some have less if their capacity to generate unrestricted income is limited.

The ACNC website has some good resources which outline how not for profits develop a reserves accumulation strategy and also how to ensure the funds are represented appropriately in the annual report and governed under the appropriate guidelines.

If we can help, contact us. Read more not for profit governance articles.

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