If you ever hear of a charity that “is facing financial challenges” or had to close then you’ll almost certainly hear people saying “they didn’t have enough reserves”. But it is not as simple as that.
Unsurprisingly, for many charities and their trustees, the topic of a charity’s financial reserves has become a more frequently discussed matter. 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.
You might be holding some restricted funds in your reserves, for example an unspent legacy, donation to buy specific items or funding already received for specific activities. For any funds to be classed as restricted then the “restricted” designation must have been made by the giver of those funds. You can’t simply “restrict” reserves you are holding just because you are saving up for a specific reason, such funds are still unrestricted reserves.
So how much should be held in reserve?
More often than not charities set their desired reserve level in relation to their income/expenditure, with the most common formula being a minimum of 6 months running costs. However reserve levels should not be simply based upon a simple formula but should be based upon an assessment and judgement of the risks and commitments facing the charity.
With an increasing number of charities highlighting their financial challenges, in particular drops in income due to COVID-19, the Charity Commission is increasingly examining the levels of reserves held by charities, emphasising that a charity’s resources should be supporting activities that meet your objects and support your beneficiaries. “We need to build up reserves so that the charity can keep going”, “we need reserves in case something happens” and “If we’ve got healthy reserves then it is easier to recruit and keep trustees” are not strong arguments for reserves and also won’t wash with the charity commission if you are challenged by them.
Organisations that are short of cash are more likely to steward those funds carefully. In fact there is a strong argument that high levels of reserves can lead to complacency in strategic planning, less energy focused upon income generation or allowing long credit terms to those who owe the charity money.
So what are reserves for?
The recent immediate impact of COVID-19 has seen almost every charity at least review their reserves levels. Some have decided to use their reserves. However, what should reserves be used 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. Below we explore more about such risks and the use of reserves, starting with an exploration of what risks reserves shouldn’t be used for – the list is longer than you may first think.
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 as hard as this may be, 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 and as they see those early warning signs of problems then they should do something about them.
Charities debating the “should we close” conundrum often unfortunately end up closing because they’ve simply run out of money before a conclusion is reached, or the “next big something” they were trying to secure didn’t come off. The last of their reserves being used up “just keeping the charity open” and sadly often not doing much of the actual good work the charity was set up for in the first place.
When the long-term future of a charity looks uncertain, trustees should always consider seeking a merger with another charity with similar/shared objectives. Merger shouldn’t be seen as a matter of last resort but should be one of the first topics for discussion by trustees. Trustees are required to be good stewards of the charity’s resources – seeing those resources spent on “just keeping going” is not good stewardship. In fact, the Charity Commission criticises trustees who don’t consider merger as one of their first options when considering an organisations viability.
With trustees managing risks well, especially financial sustainability, then this gives the charity a strong position to negotiate a merger from and they will also be seen by others as being a good organisation to merge with. Otherwise, it could just feel like the charity closes or is rescued/taken over by the merger partner. Mergers/take overs in these circumstances are almost always surrounded by a sense of disappointment or failure amongst those involved with the charity, which is a real shame and a situation that could have been avoided through stronger risk management, rather than just using reserves.
Financial viability is of course a risk that needs to be monitored and managed and leaders/trustees should be encouraged to focus energies on thinking “how can we improve financial sustainability” as opposed to thinking “we need to keep reserves so we don’t have to close”.
Bad business models – A charity is a business, and just as in any business there are links between income and expenditure. However, 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. Using reserves to support additional service demand is not sustainable, however using reserves to fund work to secure the additional resources required to meet the unmet need is a better use of them and is better risk management.
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 (inflation, cost of living pay rises, rent/rates) increase, often accompanied with an increase in service demand – leaving the service under-priced and giving the charity a funding gap. These are risks better managed by ensuring funding agreement/contract budgets have inflationary cost increases factored in (1-2% annual costs increases is quite common). And also build in regular (usually annual) reviews with the funders/contractors where both contract value and expected service delivery levels will be discussed. If costs and/or demand rise then this needs paying for by those funding the services – not from reserves.
Subsidising any service from reserves is not sustainable, and it will add pressure to generate other income “just to stand still” and also add pressure to reduce central costs.
Concentration risk – aka all your eggs in one basket. 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 – Certain incidents are classified as ‘killer risks’ because all stakeholders lose all faith in the organisation and continuation is impossible. For example, a childcare charity where significant and repeated safeguarding issues are discovered would likely not be able to recover from the reputational damage. Where the reputational damage is so severe then the best action to take may be to close the charity and transfer reserves to another likeminded charity as opposed to using the reserves to try and recover/repair major reputational damage.
External events – No matter how carefully risks are identified and managed, events can simply happen which are outside a charity’s control, from natural disasters, major fire, to the collapse of partner organisations. More often they will be less dramatic, for example where a social enterprise set up to provide school meals finds it has no further business because the government introduces free school meals for all. 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 as explored above. Below we explore the key risks that should be managed by reserves.
Unexpected drop in income – Unsurprisingly this was a common issue in 2020/21 for charities and with many charities also expecting income to remain negatively affected in 2021/22 and beyond it remains an issue. Income is unpredictable at the best of times, particularly if your charity raises funds from fundraising activities such as donations, events etc. Circumstances entirely out of your control can happen which completely disrupt your programmes of appeals, events or activities or affect your donors capacity to give – for example a global pandemic!! It is for unprecedented times such as these that reserves are there to be used. However, do consider the longer-term impact. 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 sudden anymore. What is being done and how long might it take to recover to the income levels needed? At what point might you have to consider reducing services to match income levels to ensure you have a financially sustainable charity?
Bridging funding gaps – From time-to-time charities may find that they have a gap between one funding agreement and the next. 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. You should expect to replace the reserves used from the new funding. However, trustees should think very carefully in such situations to ensure that they avoid the trap of using reserves just to keep going in the hope other income will be secured.
Unforeseen termination of funding/income – It is rare for such a situation to happen, as funders generally honour their commitments. However, the impact of COVID-19 has seen quite a few grant making bodies revise/renegotiate their commitments as they themselves have seen their resources negatively affected. And if you are a sub-contractor to another organisation, then they may face business challenges which see a sudden loss of income for a charity. 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 – Reserves are held by all organisations, charitable or not, to help manage cash flow appropriately. This level of reserves is also often called “working capital”. 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.
As we started the article, upon hearing that a charity is facing financial difficulties or has had to close then let’s not jump to the conclusion that the charity did not have enough reserves. But rather ask questions about how that charity was managing its risks in other ways. And also ask yourself how your charity is managing its risks and how does it set its reserve levels.
Across the charity sector many charities are campaigning to raise funds, citing the negative financial impact of COVID-19. However even before COVID-19 hit there was an increasing number of charities highlighting financial concerns about drops in income and the Charity Commission was already beginning to scrutinise charities “pleading poverty” whilst holding significant levels of reserves. Some commentators 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.
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 and an experienced member of the team will contact you.
Andy Haynes – Visionary Knowledge Research and Compliance Lead