Kate Sayer: What are reserves really for?

30 May 2017 Voices

The failure of the charity Lifeline Project has renewed talk of whether charities need to keep more money aside. Kate Sayer says that discussions on this subject often miss the point of reserves.

Whenever a charity fails, there are comments that the reserves were inadequate. Measures often relate the level of reserves to the income of the charity. But this is based on the false premise that reserve levels should be based on a formula, whereas the reserves policy should be based on the risks facing the charity.

We need to remember that reserves are unspent unrestricted income. Charity income is meant to be spent on the charity’s objects to benefit the charity’s beneficiaries. It is not intended that charities should hoard reserves in order for the charity to continue in perpetuity or to allow trustees to sleep better. In fact, there is a strong argument that high levels of reserves can lead to complacency and poor financial practices, such as allowing long credit terms to those who owe the charity money. Organisations that are short of cash are more likely to steward those funds carefully. That is not to say that charities should not hold reserves; charities should hold appropriate levels of reserves.

Risks that should not be managed by reserves

I often see charities using reserves to help them manage problems that actually have their root cause in the charity’s failure to manage some other aspect of risk.

Closure

If a charity has to close then it has not successfully managed its risks. While it has opportunities to improve the position, it should seek to do so. If the trustees see early warning signs of problems, then they should consider merger at an early stage, rather than hope that ‘something will turn up’. So this is not a signal to trustees that they should not consider financial sustainability – it is an existential risk that should be on every charity’s strategic risk register. But it should be framed in positive terms – ‘what can the charity do to improve financial sustainability?’

Bad business models

By the term ‘business model’ I mean the structure underpinning financial flows in and out. Simply put, what makes income go up, or fall; what makes expenditure increase or decrease; and what is the link between the two. An enterprise has a bad business model if the managers do not have control over the drivers for activity and therefore income and expenditure. Kids Company is a well-known example of an organisation that had a poor business model. This was identified in the PACAC report as an operating model driven by demand such that expenditure increased whether there was income to cover it or not.

Underpricing

Many charities feel they have to bid low in order to win funding, but this leaves them with a requirement to subsidise the costs of a service in order to maintain quality. Subsidising a service from reserves is not sustainable, and it may add pressure to reduce central costs such as evaluation and impact measurement.

Risks that cannot be managed by reserves

For some situations, no amount of reserves would be enough and these are risks that should be managed in other ways.

Concentration risk

If you are dependent on one major funder, then you face the risk that your organisation will have to close if that funder withdraws funding. Commonly in such scenarios, the funder does not allow the accumulation of reserves, but even if it were permitted, you would need very large reserves to replace the funding.

Reputational damage

Certain incidents are classified as ‘killer risks’ because all stakeholders lose all faith in the organisation and continuation is impossible. For example, a childcare charity where significant and repeated safeguarding issues are discovered would likely not be able to recover from the reputational damage. In the corporate world, Enron is an example.

External events

There are all manners of events that are outside a charity’s control, from natural hazards to the collapse of partner organisations. Some are less dramatic, such as a situation where a social enterprise set up to provide school meals finds it has no further business because the government introduces free school meals for all.

Risks that should be managed by reserves

Charities should have reserves for the right reasons. Charities may have additional designated reserves for specific liabilities, but these are the reasons why it is legitimate to hold general reserves.

Bridge funding

Charities may find that they have a gap between one funding agreement and the next. The service is good, the team are in place, but the timing has not allowed for continuity of funding. If the prospects of new funding are good or the new funding is already secured, then it would be appropriate to keep the service going from reserves. You should expect to replace the reserves from the new funding.

Unexpected drop in income

Income is unpredictable, particularly if your charity raise funds from donations, events and other forms of fundraising. For example, you may have an annual appeal which takes place at the same time each year. If another event eclipses your appeal, such as an international disaster or other major news item, then the appeal may underperform.

Unforeseen termination of funding

If a funding source ends, the charity may need time to seek alternative sources of funding. This will apply to charities with diverse funding sources.

Cash flow

Reserves are held by all charities to help them manage cash flow appropriately. With regular forecasts updated for estimated receipts and payments, charities can see the level of reserves needed to provide sufficient working capital.

Conclusion

When we hear of charity failures we need to stop jumping to the conclusion that the charity did not have enough reserves and starting asking questions about how that charity was managing its risks in other ways. Reserves are a financial response, but I would argue it is the last resort. A well run charity does not need to build up large reserves – it needs to manage its strategic risks well.

[email protected]

@KateSayer1

 

 

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