Balancing the Mission Checkbook

The cash reserves myth

Following up on questions raised during some training workshops I presented last week, I’ve decided to start an occasional series called Mythbusters – Nonprofit Finance Edition. There are a number of pieces of “common wisdom” that I hear over and over again, and some of them are just not helpful. So starting with this post I’ll be adding my own spin to the Discovery Channel show Mythbusters (is it true that a penny thrown from the top of the Empire State Building will kill a person on the ground?).

Nonprofit Finance Mythbuster #1 – “Every nonprofit should have a cash reserve equal to three months of expenses.” There’s some truth and some myth to this “best practice.” It is absolutely true that every nonprofit needs to have adequate cash balances available to support the timing of payroll and other expenses, as well as to pay for unanticipated costs or increases. It’s a myth, however, that a single standard applies for all nonprofits. I have two issues with the “three month reserve” standard. One is that different organizations need different amounts of cash on hand. The second is that building a reserve of three months of expenses is not a practical, or even desirable, goal for all nonprofits.

First, how much should nonprofits have in cash reserves? A single standard doesn’t factor in some important variables, starting with the stability of the nonprofit’s cash receipts. Organizations that have contracts or fees with regular and reliable payments don’t need as much in cash as organizations that rely on a few big grants, fundraising events or campaigns, or seasonal activities. I’ve reviewed financial reports from large nonprofits with pretty low cash balances. They wouldn’t meet a standard requiring three months of expenses, but they also have regular cash receipts from program fees, contracts, and year-round fundraising. They also have high quality receivables and other short-term assets (which create “working capital”).

The other myth is that nonprofits can go from step one, the board adopts a policy requiring a three month reserve, directly to step two, open the savings account. Somewhere in there, voila, the cash is generated to deposit the required amount. Where do cash reserves come from? Consider a hypothetical agency that provides mental health services with a $2 million annual budget. A three month reserve is $500,000. Starting from zero, they need to generate a 25% surplus of income over expenses to build these minimum reserves. This is unattainable in the near future, and it may be far more cash than this agency needs. If the mental health services are paid for by third party insurance payments and contracts with the county government, cash flow may be stable enough that about one month in operating cash, or $165,000 – $200,000, will be enough.

Bust this myth. Rather than falling back on an easy standard, each nonprofit needs to understand their revenue sources, project month by month cash flow, anticipate any shortfalls, build in some cushion for snags or surprises, and create a workable and customized policy.

My interest in financial mythbusting is inspired in part by a series I’ve enjoyed by Paul Shoemaker at his SVP Blog at Social Venture Partners Seattle. Over the past few months Paul posted a series called “10 Things We’d Like to Tell Every New Philanthropist.” For example, Lesson #3 – “I need to be careful to not let the non-profit get too dependent on my contributions.” Each of the questions that he poses seem to make sense, but he warns that these common misperceptions and mistakes need scrutiny and discussion to avoid the problems they can cause. He’s finished the list of ten lessons for philanthropists and said he would follow this series with “10 Things We’d Like to Tell Every Nonprofit.” I look forward to seeing his new top ten list.

Kate Barr believes that every nonprofit financial question relates to strategy, structure and mission impact. She enjoys interpreting financial information to find stories numbers can tell. She loves writing, teaching, and talking with interesting people.