The rainy day - did the pandemic change views on reserves?

01 Dec 2021 In-depth

The pandemic has heightened the focus on charity reserves. Charity Finance convened a panel of experts, and Ian Allsop dipped into their observations.

Charities and their reserves is not a new topic. However, the shock of the pandemic meant that for a large number of organisations, now was suddenly the rainy day they had been saving for. The Charity Commission’s Trustee Research 2021 report, published in July, found that a quarter of charities had to draw on their reserves to keep operating during the Covid-19 crisis, while the regulator’s submission to a House of Lords committee in September 2021 revealed that the number of registered charities with an income over £500,000 which had no or negative free reserves increased from 9% in April 2020 to 28% in July 2021.

This has prompted a discussion about how charities should approach reserves, especially those who find they need to rebuild them. What lessons have come out of the pandemic? What is the best way of assessing reserves? And how do charities communicate a real picture of what their objectives are when considering reserves, both internally and externally?

Daniel Chan is a director in PwC’s charities audit team, and is interested in reserves from that perspective, as well as because of his role on the Charities SORP committee and as a trustee. “I am also interested in longer-term considerations around how reserves policies are set, for example using risk-based approaches. There are also considerations over liquidity and commitments which have already been made. It is important to look at free reserves and managed cash and investments measures.”

So, what was the position that the panellists found themselves in at the outset of the pandemic?

Ashley Wang has been finance director at the Overseas Development Institute (ODI) for just over two years, and recently its chief financial officer. “When I joined, one of the first policies I reviewed was our general reserves policy, and so it was already revised, and we were already taking a risk-based approach, pre-pandemic. We had revisited our working capital definition. A lot of our activities take place outside the UK, so we carefully looked at our expenditure priorities, as well as our currency exposure.

“As a result, we didn’t change our general reserves policy when the pandemic struck as it was already established and we could follow our spending priorities. Most of the work we do is research and technical advice funded by governments and foundations. For this, we could change our delivery model in a reasonably flexible way without suffering a major loss of income. But repatriating people from overseas was our top priority, which could have affected our reserves due to the additional expenditure. We also looked into business interruption insurance claims to recover some costs.”

Yvonne Smithers was offered the job as director of finance at St John Ambulance in February 2020. By the time she started in July that year, the focus of the role had dramatically changed. Smithers explains: “There was a point where we were losing £1.5m a week. We had to take swift and decisive action, including reducing expenditure through property sales and, sadly, 180 redundancies.”

The charity had historically taken a risk-based approach to reserves, allowing for up to six weeks’ operating costs. But the pandemic’s impact was such that this would not be enough. To secure ongoing support to the NHS through sending specially trained volunteers into hospitals and communities, St John appealed for government funding and received a £6.8m grant.

Martin Miles has been chief financial officer at the British Heart Foundation (BHF) for almost seven years. “One of the first things I did when I joined,” he recalls, “was to look at the reserves policy. As a medical research charity, we have significant levels of grant commitments – our reserves are there to provide the liquidity protection to ensure we can settle grants as they fall due, even when income is disrupted. The policy in place then required us to cover one to two years of grant cash flows, but assumed all sources of cash income stopped immediately – an unrealistic assumption in respect of legacies, given we will have already received notification of significant future income. With an adjustment to income assumptions, the policy moved from targeting maximum reserves of some £250m, to only half of that.

“However, as the first lockdown approached in early 2020, we were in the fortunate position of having cash and investments significantly above the required level – something we became ever more grateful for as the scale of the challenge we faced became apparent.”

He says that BHF’s latest set of accounts, published in September, highlight how it was more affected than many others in numbers terms. “With the BHF operating a £200m turnover retailer, the impact of the shops being unable to trade for eight months of the year is massive – even after government support, we had a net £40m loss. But it can be very black and white. Since the doors reopened, we have had record months. It is very strange how you go from nothing to doing great business. The experience of that period has resulted in a further adjustment to our reserves policy; we now allow for a net cash loss from short-term disruption to retail trade.”

Kris Murali left Sense to take over from Smithers as finance director at the Scout Association. He says that the Scouts started the pandemic in a positive way. “Membership fees are paid at the beginning of the year so 50% of our income was available up front. But commercial income and events dried up. Activity centres closed. Trading operations had cash flow issues, so there was a lag between subsidiaries receiving income and meeting their Gift Aid commitments to the main charity. Our reserves policy was to hold between three- and six-month’s expenditure but it became very clear, very soon, that this was not going to help us.

“We had to secure cash flow, and look at our business model. We started looking at the balance sheet and our asset base. We took the decision to sell one of our prime properties in London, which was mainly an investment property. This caused considerable difficulty with the movement as it was historic and symbolic. But we had pragmatic discussions and a decision was taken. The sale realised £46m, which we are now utilising to build reserves, invest in strategy, and invest to generate income going forward.”

Designation

How charities communicate their reserves policy is another area of interest for Chan. He mentions the range of approaches he sees in his work for PwC’s Building Public Trust Awards, which assesses the reporting by the 100 largest charities by income, and includes analysis of how charities communicate their reserves policies and how this impacts strategy.

He poses the question as to whether designated reserves, as a way of allocating the intended use of funds, is helpful. “It is useful to communicate plans,” argues Smithers.

Murali is aware of the sensitivities about the asset base, where seemingly large reserves can make fundraising a problem. “Our challenge is that the balance sheet looks rich, so even though we are clear about what we are doing, at first glance people will question it. We need to be realistic and make the case to stakeholders and the public.”

Miles considers what he calls a double-edged sword. “Over the last year, we worked hard on the clarity of our external communication, given the need to balance providing confidence to the research community, whilst still emphasising the urgency of our fundraising ask.”

Murali argues that funders need to understand the business model. “Astute ones look at the balance sheet then come and ask the questions. But for the Scouts, it isn’t just about communicating to the funding audience but our wider movement. We have a federated structure which creates particular challenges in terms of perception about the main organisation and the connected charities.”

Internal communication

Wang weighs how best to communicate internally about expenditures in the short term when finances are tight. She reckons it helps to have clear priorities. “During the pandemic, I made it clear to the team that the priorities were employees, infrastructure, and then suppliers. This helped manage expectations.”

Murali says that it is hard to keep everyone in the loop, especially when there are quick changes and varied audiences. “In the Scouts we have a lot of communication initiatives both externally and internally. Even when people were on furlough, they were fully informed. Our stakeholder engagement level is high and they question everything, so it is not easy. But Scouts are good at communication with members. We did a deal with Zoom, and we had 18,000 people on one of the all-member calls.”

Chan talks of charities who were reforecasting and monitoring on a much more regular basis – in some cases daily. He says: “From a governance perspective, it was about involving trustees in that process. WhatsApp groups were created and everyone was chipping in.”

The pandemic led to speedier decision-making, and Wang feels that the situation created a sense of urgency. “More frequent dialogue and open conversations with the finance committee and board helped build trust and improved the quality of inevitably difficult decisions at a critical time, also facilitating buy-in and feedback.”

Setting reserves policies

At the Scouts, setting the reserves policy is a joint partnership between the senior management team and the finance committee. “We need to make the case, and build proper structures,” says Murali, “but the chair of the finance committee has a big say in selling it to the wider board.” Smithers identifies a debate between finance and non-finance trustees on a board and Chan describes this tension as a healthy dynamic on the board.

“Generally, there are trustees who would want to spend more and use the resources to achieve greater direct impact, while there are others who would be more prudent,” says Chan. “On balance, I think there are trustees who have become more supportive of holding higher levels of reserves.”

Murali says: “We had a new finance committee chair, and a fresh pair of eyes that questions everything can be positive. I was also new which helped. It gave us the platform to make changes.”

So, does all this mean reserves policies need to change? Miles adds: “For us, the reserves policy stays, but our downside is now more extreme. Even though retail suffered, fundraising was more resilient than people expected. What we all know now is that a pandemic can have an incredibly significant short-term financial impact if you are unable to trade, such that we need to allow for a loss in assessing our cash requirements.

“The other learning has been to reassess aspects of our cash and investment portfolio, to ensure we retain maximum liquidity even through the sudden disruption of a national lockdown.”

Wang ponders how organisations should approach general reserves in relation to investments, striking the balance of risk and return. “Our finance committee is now thinking about asset allocation for the reserves and excess working capital. How do you maintain liquidity and generate a reasonable return?”

A risk-based approach

For Smithers, taking a risk-based approach to reserves is about keeping it simple. “It depends on your income streams and cost-drivers; what business you are in, what services you deliver. How quickly can they be turned off? Focus on the risks specific to those areas.”

Murali thinks that risks inherent to your main business are important. “For us, any threat to membership numbers affects long-term viability. Most costs are fixed so we need that regular income stream to provide the same level of services. Our offering is unique, as no one will come and start a new Scouts movement, but that isn’t the same for all charities.”

For Wang, the answer lies in the robustness of the risk register and how well it is kept up to date and monitored.

Looking ahead

Chan points out that charities also have to consider future strategy. He said: “It is about looking ahead, including the investments that need to be made for the charity to be fit for the future. The charity’s ambitions, and the associated funding requirements, are key to this.”

Smithers says that ensuring sustainability through the business model is key. “Distinguish between what you have to do, and what is nice to do. Investing in digital transformation is vital. We made tough decisions about what to stop at the outset of the pandemic but didn’t stop digital transformation work as it is essential. You have to talk about investing in the business now to build reserves back up. Spend more now with a longer-term strategic view.”

Wang thinks that a three- or five-year strategic plan ties charities into these decisions and how they rebuild reserves, “so that you build them up or spend to invest in line with strategic objectives”.

Miles firmly believes that measures of liquidity are the most useful. “When the BHF implemented the last SORP, changes to the recognition of legacy income and research grants fundamentally changed the way the balance sheet looked, but obviously had no impact on the cash position. There can be smoke and mirrors around accounting techniques, and hence access to cash and investments is the most important consideration for reserves and therefore the ability of the organisation to survive.”

Chan concludes by asking whether there should be a change in how reserves are presented in trustees’ reports and accounts. But that, like other important questions on reserves, is a debate that will continue to go on.

With thanks to PwC for its support with this feature  

 

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