Understanding Financial Ratios: The Operating Reserve Ratio
An important data point on the financial health of a nonprofit organization
When I talk to leaders of nonprofit organizations, they often have a healthy grasp of operations and donors, but sometimes eyes glaze over when the conversation turns to statement of activities and balance sheets. Most of us in this line of work didn’t come to lead these small shops because of our financial acumen; rather, we had a heart for the work being done, and we know what it takes to get the job done.
And the more we are in these jobs, the more we realize that funds are a critical part of that puzzle. Today, we are kicking off a new summer series where we will talk in depth about a tool we can use to lead our organizations — financial rations.
Today’s tool, the operating reserve ratio, stands out as a critical measure of an organization’s financial health. This ratio provides insight into the organization’s ability to continue its operations during periods of financial uncertainty. Today we will delve into the operating reserve ratio, its calculation, significance, and what constitutes a good standard for small nonprofit organizations.
Definition and Calculation
The operating reserve ratio measures the liquidity available to a nonprofit to sustain its operations during periods of financial stress. It essentially indicates how many months of operating expenses the organization can cover with its unrestricted net assets. The formula for calculating the operating reserve ratio is:
Operating Reserve Ratio = Unrestricted Net Assets / Annual Operating Expenses
Unrestricted Net Assets: These are assets that are not subject to donor-imposed restrictions. They represent the resources available for the organization's general use.
Annual Operating Expenses: These are the total expenses incurred by the organization in its regular operations over a year. This includes salaries, rent, utilities, program costs, and other operational expenses.
For example, if a nonprofit has unrestricted net assets of $150,000 and annual operating expenses of $600,000, its operating reserve ratio would be:
Operating Reserve Ratio= 150,000/600,000=0.25
This ratio of 0.25 means the organization has enough reserves to cover three months of operating expenses.
Importance of the Operating Reserve Ratio
The operating reserve ratio is vital for several reasons:
Financial Stability: It provides a buffer against unexpected financial shocks, such as sudden drops in funding or unanticipated expenses.
Operational Continuity: Ensures the organization can maintain its operations and continue delivering services even during periods of financial instability.
Donor Confidence: Demonstrates financial prudence to donors and stakeholders, potentially leading to increased trust and more funding.
Strategic Flexibility: Allows the organization to seize opportunities, such as new program initiatives or investments in infrastructure, without compromising financial health.
Standards and Best Practices
Determining a good standard for the operating reserve ratio can vary based on the size, type, and specific circumstances of the nonprofit. However, financial experts and nonprofit associations generally recommend maintaining a reserve ratio equivalent to three to six months of operating expenses.
The National Council of Nonprofits suggests that a minimum operating reserve ratio of 25% (three months of operating expenses) is a prudent threshold for most nonprofits. This standard provides a sufficient cushion to address short-term cash flow issues and unexpected expenses. Some organizations might aim for a higher ratio, especially if they operate in highly uncertain environments or have substantial fixed costs.
Building and Maintaining an Operating Reserve
For many small nonprofits, building an adequate operating reserve can be challenging due to limited funding and resources. However, several strategies can help achieve and maintain a healthy reserve:
Budgeting for Reserves: Incorporate reserve building into the annual budgeting process. Allocate a portion of surplus funds each year towards the reserve.
Diversifying Funding Sources: Reduce dependence on a single source of income by diversifying funding streams. This can include grants, donations, fundraising events, and fee-for-service programs.
Expense Management: Regularly review and manage expenses to ensure they are aligned with the organization's financial capacity. This might involve cost-cutting measures or improving operational efficiencies.
Board Policies: Establish board-approved policies for reserve funds, including the minimum reserve level, conditions for use, and replenishment strategies.
The operating reserve ratio is a crucial financial metric that helps nonprofit organizations navigate through financial uncertainties and sustain their operations. For small nonprofits, aiming for a reserve ratio of three to six months of operating expenses is a good standard, providing a balance between financial stability and operational flexibility. By understanding and actively managing this ratio, nonprofit leaders can ensure their organizations are well-prepared to face challenges and continue making a positive impact in their communities.
Building and maintaining an adequate operating reserve requires deliberate planning, disciplined financial management, and a commitment to long-term sustainability. By doing so, small nonprofits can enhance their resilience and continue to fulfill their missions even in the face of financial adversity.