Five Minutes for Finance - Operating Reserves
Understanding Operating Reserves for Nonprofit Organizations
Operating reserves are a critical component of financial health and sustainability for nonprofit organizations. These reserves represent unrestricted funds set aside to stabilize an organization’s finances in times of unexpected revenue shortfalls or unanticipated expenses. By maintaining an adequate level of operating reserves, nonprofits can ensure continuity of services, retain staff, and avoid hasty decisions during financial uncertainty.
What Are Operating Reserves?
Operating reserves are unrestricted net assets that are readily available to support the day-to-day operations of a nonprofit. Unlike restricted funds, which are earmarked for specific projects or purposes by donors, operating reserves are flexible and can be used at the organization's discretion. These reserves are typically held in cash or cash-equivalent accounts to ensure liquidity.
Why Are Operating Reserves Important?
Financial Stability: Reserves act as a financial cushion, allowing nonprofits to continue operations during periods of delayed grant payments, drops in donations, or economic downturns.
Cash Flow Management: Even well-managed nonprofits can face temporary cash flow gaps. Reserves help cover expenses such as payroll, rent, and utilities without disruption.
Strategic Flexibility: Reserves provide the ability to invest in new opportunities, pilot programs, or respond to emerging community needs without jeopardizing existing services.
Donor and Board Confidence: A healthy reserve fund signals responsible financial stewardship, which can enhance the credibility of the organization with funders and stakeholders.
How Much Should Be Reserved?
There is no universal rule for the appropriate amount of operating reserves, as it depends on the organization’s size, complexity, and revenue volatility. Many financial experts and watchdog organizations suggest maintaining reserves equivalent to three to six months of operating expenses. However, this guidance may not account for the specific needs and circumstances of many nonprofit organizations.
A new line of thinking takes into consideration the differing risk profiles of each business line of a nonprofit to determine the appropriate amounts of reserves for each. Then, taken together, these specific business line reserves comprise the total operating reserve. This approach involves:
Identifying the distinct lines of business which the nonprofit operates. These could be specific program areas or specific funding streams. For example, a museum would have business lines such as entrance fees, museum store sales, class and seminar fees, and government or foundation grants. Each of these lines of business could exhibit differing cash flow characteristics and needs.
Analyzing the risk factors in each business line and determining the appropriate reserve amount. Some examples:
A program that is heavily dependent on government contracts that reimburse expenses 60-90 days in arrears may necessitate a reserve sufficient to cover potential delays in receiving payment.
A program that relies on grant funds that are paid in full or in installments up front may face less risk.
A program that relies on relatively few donors or grants would face higher risks than one that relies on many donors.
A performing arts organization that expends a significant amount of cash to prepare for a performance may need to have enough reserves to cover the gap between the payment of expenses and the sale of tickets.
A program that is involved in politically sensitive activities may face increased risks if government policies or priorities change.
Organizations that own significant real property (buildings, equipment, vehicles, etc.) will need funds for repairing or replacing these assets.
Boards should regularly assess the adequacy of reserves during budgeting and strategic planning processes.
Establishing and Managing Reserves
Creating an operating reserve requires intentional planning:
Policy Development: Nonprofits should adopt a formal operating reserve policy that defines the purpose, funding level, usage criteria, replenishment plan, and oversight responsibility. This policy ensures consistency and accountability.
Board Oversight: The board of directors plays a key role in approving and monitoring reserve levels. They should review the policy annually and ensure compliance.
Funding the Reserve: Building reserves may require incremental contributions over time. Surpluses, one-time grants, or unrestricted donations can be earmarked for this purpose. In the budgeting process, the board of directors should establish the reserve accumulation goal (also known as the net surplus) for the year.
When to Use Operating Reserves
Operating reserves should not be used for routine deficits or poor budgeting. They are meant for exceptional circumstances such as:
Delays in government or foundation funding
Unanticipated facility repairs
Legal or compliance emergencies
Transitional periods between executive leadership
Clear criteria and board approval should govern the use of reserves, with a plan for restoring them after use.
Conclusion
Operating reserves are not just a financial buffer—they are a vital part of a nonprofit’s risk management and long-term sustainability strategy. With proper planning, governance, and discipline, reserves empower nonprofits to weather storms, seize opportunities, and continue serving their missions with confidence and resilience.
About this Series
Subsequent articles in this series will cover other topics related to nonprofit financial management. Here is a list of, with links to, previous articles:
About the Author
For over 30 years, Robert Pascual has been a leader in nonprofit financial management as a CFO, consultant, conference speaker and educator. He holds an MBA from the Haas School of Business at the University of California and is the founder and principal of Robert Pascual, MBA LLC. He has worked with small, mid-size, and large nonprofit organizations spanning the fields of education, workforce development, housing, health, philanthropy, social services, media, fiscal sponsorship, nature, and the environment. Each of these organizations has faced both unique and common challenges, some of which are probably similar to ones that you wrestle with.