Nonprofits must ensure there’s cash in reserves for unexpected bills

Published in the February 16, 2007 edition of Columbus Business First

While endowment is getting the most attention in the nonprofit world, it would be better to shift the spotlight to cash reserves. I attribute this lack of attention to hopelessness and confusion.

Hopelessness comes from the tension a nonprofit manager faces between managing for stability and being responsive to donor and constituent pressures to expand. The passion and community need that form the backbone of the nonprofit sector create a relentless pressure to always do more. And the more recent emphasis in the donor community on restricted grants, seed funding and other tools of the “effective philanthropy” movement also adds to the pressure to do more. 

Stable management requires financial resiliency, which is provided by having sufficient cash to weather temporary crises. Managers contemplating asking donors to contribute to cash reserves or asking constituents to be patient so operating surpluses can accumulate cash can be forgiven for throwing up their hands.

Confusion comes from the utter inadequacy of nonprofit accounting in making it easy to assess a nonprofit’s need for cash. One of my most popular workshops helps the lay reader to interpret nonprofit financial statements. In that workshop we show a balance sheet that would be considered healthy if it were a for-profit company but which indicates near-insolvency for the nonprofit it represents. 

The reasons for this confusion are the numerous restrictions nonprofits face on how its money can be used.

If a for-profit business has a lot of cash and securities on its balance sheet, or if its current assets far exceed its current liabilities, one can be pretty sure the company could weather a sizable storm.

One can’t be so certain when it comes to nonprofits. Cash can be completely unavailable for operations if it is held in an endowment, or it can be unavailable to help in a crisis if it is part of a grant that restricts it to uses unrelated to the crisis. Only that part of reported cash that isn’t subject to any limitations is comparable to cash on a for-profit’s balance sheet. The same warning applies to securities and to current assets. In fact, it is quite possible for a nonprofit with large cash balances and net current assets to have insufficient resources available to pay its bills or weather a crisis.

When cash truly is king

Cash and liquidity can get adequate attention from executives, boards and donors only if hopelessness and confusion can be overcome. One way to start is to clearly and simply define:

• What assets do we consider for inclusion in the cash reserve that contributes to stability in a nonprofit?

• How should we define the need for cash reserves?

• How large a cash reserve is enough?

The answer to the first question is straightforward: Only the cash and securities that can be made available for any purpose within one to two days should be considered part of the cash reserve. Immediately available, unrestricted cash is likely to be substantially less than the amount shown as cash or current assets in the nonprofit’s financial statements.

The definition of cash need must take into account that large corporations have different needs than small businesses; similarly firms with large seasonal fluctuations have different needs than companies with steadier environments. 

The most basic definition must address the routine challenges of any seasonal business. Identify the months with the lowest revenue and sum up the amount they fall short of your expenses in those months. Then look at the lowest two revenue months you have had in the past several years and add the shortfall in those two months to the sum. This is the minimum amount of cash you should have at all times just to sustain your operations through normal fluctuations.

But the minimum is not enough because surprises happen. Boilers break, roofs fail, computers crash, pledges come in late and overtime or temporary workers must be paid. To deal with surprises, establish a bank line of credit sufficient to deal with unanticipated repairs of systems or equipment that are critical to maintaining daily operations. If that isn’t possible, the nonprofit’s cash reserve must also be able to support the largest one or two surprises.

Having working capital reserves equal to 5 percent of expenditures is commonly recommended, and the Greater Columbus Arts Council recently has required 10 percent of expenditures be held as working capital by its operating support grantees.

Rather than rely on rules of thumb, managers should evaluate the types of risks they face and establish target reserves accordingly. I suggest a cash reserve large enough to deal with normal seasonal revenue fluctuations and the possibility of a one- to two-month delay in receipt of the major donations or grants that are included in your budget. 

Being reliable and stable is perhaps more important to fulfilling a nonprofit organization’s mission than growing and adding programs.

Remind donors that, with regard to cash reserves, lean can sometimes be too mean – for your mission and for the people who rely on your nonprofit being there when they need you most.

Allen J. Proctor was chief financial officer of Harvard University and is the author of “Linking Mission to Money, Finance for Nonprofit Board Members.”  www.proctorconsulting.org

Copyright 2007. Reprinted with permission, Business First of Columbus Inc.