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Operating Reserves

Erratic cash flows, loss of a key employee, litigation—all of these events have the potential to adversely affect an association's operations. When these types of events occur, an association can be caught off-guard and unprepared to manage the financial impact on operations. Associations can manage the adverse effects of these kinds of events by establishing an operating reserve (also known as a long-term reserve).

Benefits of an Operating Reserve

An operating reserve is established by the board of directors to accumulate and maintain a specific balance of unrestricted net assets for operating purposes. The primary benefit is financial protection from unexpected revenue shortfalls or increased expenses. Added potential benefits include:

• Improved strategic decision making
• Flexibility to invest in new opportunities
• Improved management of potential risks

Determining an Appropriate Operating Reserve Amount

Operating reserves typically range from three to six months of budgeted operating expenses. However, there is no one formula that works for every association. To best determine an appropriate operating reserve amount, management should:

• Identify significant potential risks to the association's financial health;
• Estimate how long it might take to successfully manage each risk; and
• Quantify the total potential revenue lost or expense incurred

Of course, depending on the circumstances, an association's reserve needs can change from year to year. For example, an association with steady cash flows, a solid membership base and a growing investment portfolio might initially determine that a three-month reserve is appropriate. However, if that same association plans to construct a new building and obtain a loan to finance the project, an appropriate reserve might be six months or more.

Therefore, management should also consider the factors below when determining an appropriate operating reserve amount:

Sources of revenue—Revenue derived from a small membership base can be more susceptible to variances in membership levels and the economic factors.

Existing financing—An available line of credit gives an association the ability to weather short-term fluctuations in cash flows. However, a line of credit that is in use for an extended period of time might be an indication of other cash flow difficulties. Principal and interest payments on long-term debt require cash for the life of loan, reducing operating flexibility.

Planned events—Future plans that involve significant financial commitments would limit an association's operating flexibility. Even if the plans were to commence after a number of years, an association would need time to build up an appropriate reserve.

Summary

Associations that take the time to analyze their financial risks and establish and maintain an operating reserve will benefit greatly when times are tough. They will have evaluated what could go wrong and will be better prepared to manage an organizational crisis. If your association has not yet considered the need for an operating reserve, now is the time.

If you would like more information on how operating reserves can benefit your association, please call Jim Hagestad, Senior Audit Manager – Not-for-Profit Practice, at 312-980-3245.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.