What have you got in reserve?

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Roath Park Lake — a lovely little reserve near my home (my photo)

An exploration of surpluses, reserves and risk in a not for profit context.

I have wanted to write about this for some time. The relationship with surpluses, levels of reserves and risk is a common issue. It happens in all sorts of not-for-profit contexts, so it is surprising there isn’t too much written on it.

My definition of not for profits is pretty broad, I should add. I’m including charities, the social housing sector, social enterprises and similar. I suspect it will be of relevance in for-profit organisations too. They need to make similar decisions about dividends and what to leave in a business. So please do share if you know of some good stuff out there though on this topic — I’d love to hear it.

So, in the spirit of sharing, here goes. What is the optimum operating margin and surplus? What is the ideal level of reserves you want to hit in setting a reserve policy?

Here are five guiding principles to help you. Let’s get started.

Principle 1 — Set an intentional operating margin, not an accidental one

Your organisation should have a strong goal for its ideal operating margin and final surplus. Sounds obvious, putting it like that. But it is surprising how often it gets neglected. Consider the annual budgeting process. Typically this will involve identifying the likely income and then likely expenditure. The usual suspects such as staffing requirements, essential costs relating to activities and overheads get added together. The level of surplus is simply what’s leftover. Unlike in the private sector, where the point is to make a margin, it can get overlooked in the NFP. This, I would argue is a mistake. It is important to understand what is an appropriate level of surplus. Grants may create some constraints, but a healthy organisation will have strategies to address that. The level of target surplus will be different, depending on your circumstances. Understanding your ideal is critical.

Principle 2 — There is a trade-off between financial and reputational risk

There is a sweet spot to be found in the trade-off between financial risk and reputational risk. find this and you should be close to the ideal surplus. As the surplus increases the level of financial risk decreases. If an organisation keeps making deficits year on year eventually it will become insolvent. The smaller the surplus the closer you move towards that risk.

The reputational risk generally runs in the opposite direction. Once an organisation has too high surplus its reputation could be challenged. It is accruing income it doesn’t need, or not undertaking as much charitable activity as it could be. The perception runs that way anyway, even if that’s not actually the case in reality!

For some organisations, there is a reputational risk of running a loss too, although this is less often well understood. It may represent a breach of covenants if you have borrowed money from a bank. Any covenants you have will create “hard lines” on your surplus levels.

I have represented this in the following graph:

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Note I haven’t scored either axis — it depends on your organisation. The art of this is to find the sweet spot where the two intersect.

To some extent, it is possible to map the financial risk curve. Lender covenants, or your reserve policies, will help.

The reputational risk curve is more complex. It relies on understanding the perceptions of your key stakeholders. And your key stakeholders may not be a single easy to understand group, and may not be particularly open about their expectations. So the art of this is understanding what your groups of stakeholders may be saying. These could be

  • service users,
  • lenders,
  • regulators,
  • the Board,
  • third parties
  • interested social media warriors

and they will all have their own version of the curve. In my experience though, not for profits are often very cautious about what level of surplus is too much. They often believe the reputational curve goes up before it actually does.

You have set a reserves policy or business plan which has set out operating margin targets. If your performance wildly deviates from that then you may also hit reputational problems. So the reputational curve becomes a kind of U shape in that sort of situation. More on reserves policies later.

If you are in receipt of grant, you may have a different view of your target depending on the grant giver. That grant giver is motivated to get the greatest buck out of their money. They want X spent on the direct charitable works and not a penny less. Grant-led organisations will face pressures to have slimmer and slimmer margins as a result. Which is why it is wise to negotiate a management contribution as part of their grants if you can. 10% is the oft used percentage — which may not always be right — but hey its a start. After all the grant will take time to win, time to administer and time for your Board to oversee. Just make sure that’s negotiated upfront — its a losing battle to add it on afterwards!

Its also thinking about the shape of the reputational curve at the very low / breakeven/loss situation. Sometimes, this can be a powerful motivational tool to attract stakeholders to give you more funding. The urgency can be compelling. But beware overdoing this kind of fundraising tactic. Don’t overplay it Kids Company, I gather, used this fundraising ploy many times. And one day their luck ran out. (See the link at the end).

If you are a not for profit who borrows significant money from a bank, then it is critical to understand their viewpoint. They will be looking for the opposite of the grant giver. Don’t forget banks and financial institutions need to consider what their credit committees will say, and the profit is a strong driver of what gets the green light in that situation.

So, it is worth spending some time thinking about what your reputational curve looks like in more detail and the nature of that curve will depend on your circumstances.

Principle 3 — Not all expenditure is the same

In a for-profit organisation, the meaning of a large surplus is clear — activity has been successful for one reason or another in creating profit. Completely obvious of course, but it is not so clear when reading a set of not-for-profits. There is no obvious relationship. I have set this out in a simple list — feel free to add in your own thoughts

Low surplus

  • An organisation working as hard as it can to max
  • An organisation facing real external challenges
  • An organisation under pressure from stakeholders
  • Spending cash just to get it out of the door
  • Poor cost control
  • Over-runs masked by delays in other projects
  • An organisation which takes on too much
  • An organisation which doesn’t negotiate well or doesn’t do its due diligence

High surplus

  • A prudent, efficient well run organisation (understands its cashflows, properly diversified, closely managed risks)
  • Lender aware
  • Delays to projects
  • Insufficient investment in the back office or scrimping on projects
  • Not achieving as much as it could be — complacency
  • Lax stakeholders

Its hard isn’t it. Boards, in particular, have to navigate these complex waters. If that’s you, or you are in any kind of leadership role, do get underneath the operational issues. Don’t just rely on a surface reading of the management accounts. And it is a personal bugbear of mine when charities rush expenditure to get money out of the door before the year-end. That can be better handled via accruals or a reserves policy. Don’t waste a precious resource! (Rant ends here).

There is a distinction between back-office and front line expenditure. The homeless benefit more directly from food than from the organisation incurring audit costs say. When I say you need to get underneath things this split is what you need to be able to understand. I would argue that the not for profit sector as a whole could increase its transparency on this. They shouldn’t hide the auditor costs by the way, to extend this example. In that case, it is showing that this is an organisation which takes its governance and compliance seriously. The smoke and mirrors of cost allocation is a game which can backfire on a charity, even if well-meant.

Principle 4 — Cash is King

You may have heard the old adage — profit and loss is vanity, cash flow is sanity. Cash is king is another version. Whichever you prefer it’s as important to understand your cash position as it is your surplus. They may not be the same thing. Settling on a target surplus also implies understanding your cash flow, and working capital requirements. Get a clear handle on with your debt collection and payments management. Organisations which drain cash year on year are eventually going to hit the buffers.

To start, get a handle on any non-cash adjustments / amounts going through your accounts. Pension adjustments, if you have or ever had a final salary scheme, can cause some exotic volatility. A whole article in itself. Adjusting accruals wildly can have the same effect, although auditors are cracking down on their misuse. But one of the key non-cash adjustments is your level of capitalisation.

As the accounting nerds will tell you — by capitalising a significant purchase we spread the cost of that item over its useful economic life. Its a really valuable accounting technique, and subject to some complex rules. But it can have untoward effects. If capitalisation levels are high or increasing rapidly, then you really do need to fully consider and explore the effects in more detail. If not understood then you could be storing up trouble for tomorrow.

In my experience, less attention is paid to cash flow management in a formal sense. But the CEO and leadership team will have an acute nose for trends. On a more practical, day to day basis I mean, as the paycheques depends on it! Explore and document these trends. Take a look at likely scenarios, the impacts of delays, or potential bad debt to understand any potential vulnerabilities. Addressing liquidity issues can take time, but can often be planned and managed in advance.

Principle 5 — Reserve for Risk

My final principle is after working through these points the not for profit should be in a position to set its reserves policy. The reserves a not for profit holds are the total surpluses it has built up since start. So the lever to changes reserves is the annual surplus level achieved. It is good practice to have an ideal range of reserves — a floor and ceiling if you like.

The floor is the basics. At very least it must be enough for you to be a going concern — ie trade for the next 12m — 18m. A lot of charities will look at the net redundancy costs it has built up to date in setting this floor. Its also worth setting aside an allowance for property costs, e.g. dilapidations on your office, or winding up costs too.

On top of this skeleton, it’s worth making an allowance for risks. If there is a chance your core funding could be cut by 10% then a charity could build up a buffer in addition. The previous principles should help you flesh that out. This is a valid and helpful approach which not for profits could make more of I would argue. Volatile actuarial movements (on pensions and investments) could go to their own designated reserve. This would help reflect and contain their exotic nature. A decent auditor should advise on the nuances involved.

At some point, there is a natural ceiling — ie too much in reserves relative to the organisation. It probably is something like many years worth of income or trading surpluses for example. In Covid-19 world, it seems like this is a problem many would kill to have! But it is worth having a plan for what you would do if you hit this ceiling — and make it transparent in the accounts. You might deliberately spend it on a project, or tactically run lower surpluses until equilibrium has been reached. It does matter though how those decisions are reached and how those decisions.

Summary

I hope by these five principles I will have set you on the way.

  • Set an intentional surplus for your organisation.
  • Understand the trade-off between risks.
  • Not all expenditure is equal.
  • Cash is king when it comes to planning.
  • Finally, build a reserve policy based on your risks.

Kids Company — interesting link is below — worth a google

https://theconversation.com/kids-company-why-the-insolvency-watchdog-wants-former-childrens-charity-directors-disqualified

Experienced Chief Finance Officer -track record in Welsh social housing and third sector. Chartered Accountant (FCA BFP). Views my own - my space for blogging.

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