The rates on cash instruments have soared, with government money market funds now yielding over 5%. Yet checking and savings accounts have lagged far behind. That’s a dilemma for decision-makers trying to decide how much a nonprofit should have in reserves.
As they fine-tune their capital reserves, some nonprofit decision-makers may turn to fixed income. After all, history favors bond investors over those sitting in cash. With the economy likely to slow, intermediate-duration fixed income provides an attractive entry point—particularly after the third quarter’s run-up in rates. Long-term investors stand to collect decades-high yields plus capital appreciation if and when rates reverse course.
Many organizations holding excessive levels of cash are struggling to redeploy their capital. How much should be set aside for immediate operating expenses versus their long-term pool? While this may seem intuitive, there are nuances. Perhaps there’s a building acquisition that will likely occur in the next three years, though the timing and dollar amount remain unknown. It doesn’t make sense to let cash languish but would reallocating to longer-term bonds be too risky? Cash seems safe now, but is it the right answer for the next several years?
Solving for this middle ground tends to be a weak spot for many organizations. Rather than vague rules of thumb for how much a nonprofit should have in reserves, Bernstein has developed a thoughtful framework designed to meet the needs of tomorrow and years to come.
Ruminate on Your Risks
While each organization is unique, in our experience, all grapple with four common risk categories:
- Revenue risk
- Spending risk
- Timing differences
- Borrowing capacity
Revenue risk captures the challenges that organizations face around incoming cash flows. Does the organization generate more revenue than expenses—or do they run a deficit? Our model measures the stability, reliability, and concentration of various income sources (e.g., annual donations, major gifts, foundation grants, government contracts, service fees, tickets, etc.) alongside any income constraints. All these factors shape an organization’s revenue risk profile.
Spending risk gauges the inherent flexibility of an organization’s budget, alongside any restrictions on expenditures. Can the organization quickly downsize if revenue is interrupted? Are they vulnerable to demand spikes in economic downturns, disasters, or other unforeseen events? We focus on restrictions and constraints that last more than one year, and consider what proportion of costs are fixed, such as long-term leases. By answering these questions, we can better understand both the composition and elasticity of expenses, and how those limitations factor into our overall risk picture.
Significant timing differences between revenue and expenses could put the organization at greater risk, as they may need extra reserves to cover temporary shortfalls. Think of organizations that receive the bulk of revenue through an annual fundraiser yet dole out funding for programs and operations throughout the year. Or perhaps a capital project looms on the horizon. Either way, significant timing differences require careful consideration when it comes to striking a balance between cash versus short/intermediate reserves.
Finally, we consider the ability to borrow. Is there an existing credit line, borrowing source, or the wherewithal to create one? In an emergency, another option could be to margin your investment portfolio—after consulting with your CPA on the potential tax implications. These strategies are often overlooked despite their ability to create a cushion during times of need.
Translating into Time and Money
After evaluating the various risks, we quantify a reserve amount starting with the most immediate needs. The number of months in reserve that should be held in cash is driven by the organization’s level of risk. As a baseline for how much a nonprofit should have in reserves, we typically recommend that most organizations hold between 3–6 months in cash, with a median of 4–5 months. However, higher risk translates to more months of reserves, while organizations with lower risk can justify shorter time frames. We recommend a floor no lower than three months for all but the most financially secure organizations. Conversely, we would need to see significant risks to go beyond seven months.
To determine the optimal dollar value, we suggest comparing it against the organization’s expected annual expenses. Longer timeframe items follow a similar approach, identifying likely needs for funds and over what period of time.
Aligning the Allocation
After determining the time frame and dollar values for the reserves, we align the allocation to the time horizon and associated need for liquidity. Reserves earmarked for immediate cash flow and expenses would be allocated to cash instruments or short-duration income-producing bonds. For periods longer than a year, we would incorporate increasing amounts of bond exposure as the timeframe lengthens. Going forward, these risks and reserve levels should be closely monitored and adjusted as the organization grows and its risk exposure evolves.
Excessive Cash Can Hurt
In today’s environment, sizing how much a nonprofit should have in reserves is not as simple as you’d think. If the Fed has finished its hiking cycle—or if rates fall due to economic weakness—cash equivalents are likely to underperform short and intermediate duration bonds. The potential return from price appreciation in bonds over the next 12 months is double that of remaining in instruments like money markets. Investors who wait until after rates have declined are likely to miss an opportunity. Seeking thoughtful advice today can help you determine the best way to size and invest your operating reserves.
- Pavan W. Auman, CFA
- Director, Tax & Transition Strategies—Wealth Strategies Group