In this article we explore what reserves are, how much should be held in reserve and what reserves should be used for.
So what are reserves?
Reserves are unspent unrestricted income. You might designate some reserves (i.e. saving up for a major capital expense) however these are still unrestricted reserve funds.
So how much should be held in reserve?
Reserve levels should not be simply based upon a formula (e.g. 6 months running costs) but should be based upon an assessment and judgement of the risks and commitments facing the charity.
So what are reserves for?
Reserves are there to help charities manage their risks but should only be seen as a last resort. Developing better risk management strategies will protect reserves for those times when they really are needed.
Risks that should not be managed using reserves
Reserves should not be used to simply prevent the charity from closure. If a charity has to close then it shouldn’t come as a surprise. Trustees and the CEO/Leader should be aware of the financial forecasts and other risks facing the organisation with energies focused on thinking “how can we improve financial sustainability” as opposed to thinking “we need to keep reserves so we don’t have to close”.
When the long-term future of a charity looks uncertain, trustees should always consider seeking a merger with another charity with similar/shared objectives. In fact, the Charity Commission criticises trustees who don’t consider merger as one of their first options when considering an organisations viability.
Bad business models – A charity is a business, and a bad business model is where demand, and therefore expenditure, increase without any matching increase in income. Charities need to be especially careful of this, as there are often more people that need help than the charity has resources to support and it can be hard to say no.
Under-pricing – Charities can often feel that they have to bid low in order to win funding. However, if your bid is below what it actually costs you to deliver the service (full cost recovery) then it can leave you with a requirement to subsidise the costs of a service. Under-pricing can also creep up on you. Charities may have long standing agreements/contracts to provide services and over time whilst the financial value of those agreements remains static the delivery costs increase often leaving the service under-priced and giving the charity a funding gap
Concentration risk – If you are dependent on one major funder, then you face the risk that your organisation will have to close if that funder withdraws funding. To replace such a funder using reserves would no doubt require an impossibly high levels of reserves and would certainly not be sustainable. Using reserves to fund some focused time limited work on how the charity can expand its income streams would a be a better way of managing this risk.
Reputational damage – If all your stakeholders lose faith in the organisation and the reputational damage is severe then the best action to take may be to close the charity and transfer reserves to another likeminded charity.
External events – No matter how carefully risks are identified and managed, events can simply happen which are outside a charity’s control e.g. fire, natural disaster. Charities may simply need to close as the impact is too severe or too expensive to recover/replace or the need or market has just disappeared.
Risks that should be managed by reserves
Reserves levels and what to spend reserves upon are factors that need to be addressed, but only after careful consideration and monitoring of the risks the charity needs to manage.
Unexpected drop in income – Income is unpredictable at the best of times and circumstances entirely out of your control can happen which completely disrupt your income. It is for unprecedented times such as these that reserves are there to be used. However, how long are you going to use reserves to address the income drop? Over 12 months into the COVID-19 pandemic that income drop is not a sudden one anymore.
Bridging funding gaps – . Here you may find yourself with a good service and team in place, but with a delay in the timing of funding streams ending and beginning. If new funding is looking very likely or is already secured but just hasn’t started being drawn down yet, then it would be appropriate to keep the service going from reserves.
Unforeseen termination of funding/income – In such circumstances the charity may need to use reserves to create the time to seek alternative sources of funding. However, trustees again need to be mindful of how long to use reserves in this way before making the often-difficult decision of reducing or stopping services.
Cash flow – Through accurate forecasting of the value and timing of receipts and payments, charities can see the level of reserves needed to provide sufficient working capital.
The Charity Commission regularly scrutinises charities “pleading poverty” whilst holding significant levels of reserves. Some commentors highlight that this focus by the Charity Commission comes from the politicisation of the Commission by the current government – a claim denied by the Commission. Regardless of this, it is a subject the Commission continues to highlight.
We hope this article has enabled you to explore the subject of reserves. There is no set formula on how much to have and no strict answers as to when they should be used and what they should be spent upon. Reserves should be seen as a last resort. The best way to protect your charity is not to just increase reserve levels but through effective risk management.
A longer version of this article, exploring the above headings in more detail is available here.
If you would like to discuss any aspect of your organisations reserves, managing risks or any other issues raised by this article then please contact us at Visionary and an experienced member of the team will contact you.
Andy Haynes – Knowledge Research and Compliance Lead at Visionary