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Learning Objectives
At the end of this session, you will be able to: Speak with confidence about the importance of financial reserves to the long-term viability of your organization. Prepare, communicate, and update a data-driven reserves policy that will build confidence with your organizations key stakeholders. Understand how this policy integrates with your financial planning and reporting processes. Create an interactive process to develop and adjust reserve targets that will engage your staff and board.
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Context
Reserves (by themselves) Capital Reserves are (just) one important part of an organizations overall capital structure.
REVENUE BASE MAY MATTER Two categories had significantly more organizations with less than the suggested minimum reservesthose with revenue primarily from government grants or program services.
Those that filed an IRS Form 990 in 2000 but did not file in 2006 because of organizational closure or contraction reported reserves ONE-THIRD THE LEVEL of those organizations that survived.
9 Available at http://www.urban.org/uploadedpdf/411913_dc_nonprofit_reserves.pdf 2012 CliftonLarsonAllen LLP
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Adapted from Maintaining Nonprofit Operating Reserves, The Nonprofit Operating Reserves Initiative Working Group, December 2008
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Common Questions
How can we build some? How do we defend them? How much is enough? Too much? How do I build a culture that values them? What sources can fund reserves? What should our policy include? How can I respond to clawbacks?
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NCFRs Reserves
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Old Target
November 2003: NCFR Board of Directors approved recommendation from NCFR Finance Committee Resolved that the following motion shall be approved: To establish a reserve goal of at least 50% of operating expenses and that NCFR work to achieve this goal within 10 years.
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Why 50%?
Because it felt good. Responsible. And its what their peer organizations were doing.
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Ask Yourself
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True or False: NCFRs current reserves policy works well. What are the most critical cost drivers in your department? Keeping both your cost drivers and income sources in mind, what potential high impact risks could result in your departments need to access NCFR reserve dollars?
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Review of Survey
Agree on nature, likelihood, impact timing, and dollar exposure Review proposed financial model conventions Consider overlap with other operating units or departments Identify additional reserve requirements Agree on adjustments to survey results
On to Phase 2
Review of Current Policy and Practice Data Collection (via Survey) Facilitated Stakeholder Sessions Quantitative
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Quantitative Modeling
Objective: To develop a data-driven financial reserve model that quantifies the risks identified in surveys and stakeholder sessions against NCFRs current reserve levels, and that provides NCFR with a reasonably comprehensive yet practical tool to carry forward.
Result: A compilation of total financial risk that can be analyzed by various characteristics reserve type, time horizon, likelihood, etc.
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Data Summary
Projected requirement of $10 million at full risk valuation. Recommended reserve categories are as follows.
Capital Investment Publishing Activities Market Volatility Employment Funds Major Initiatives Conference and Meeting Activities Membership/Assessment Other Baseline Reserve Needs Total
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10,000,000 100%
LIKELIHOOD
TIME HORIZON
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Recommendation
Based on current risks and forecasted fiscal year 2012 operating expenses of $13.7 million, NCFR should maintain reserve levels between $7.1 million and $10 million.
Reserve Level % of Forecasted FY12 Expenses % of Current Risks at Full Value Amount Over / (Under) Current Reserve Level
Ceiling
$10 Million
73%
100%
Current
$9 Million
66%
90%
Baseline
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$7.1 Million
52%
2012 CliftonLarsonAllen LLP
71%
Other Considerations
The nature of these risks will continue changing Our recommendation is not a static range NCFR will need to update the data model for significant budget growth or reduction and changing risk profile based on activities Possible methodologies for further refinement
Subjective Scenario Modeling: Interactive, more variability Regression Analysis Expected Value: Simplistic, would likely undervalue reserve needs Normal (Gaussian) Distribution 1 Standard Deviation = 68% of fully valued risks 2 Standard Deviations = 95% of fully valued risks Monte Carlo Analysis: Computational algorithms, random sampling
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Proposal
The Total Reserves Risks (TRR) shall be the sum of all reasonable potential draws on the NCFR reserves.
NCFR will use a bottom-up method to determine TRR.
The lower and upper reserve targets shall be determined by the NCFR FinCom as follows:
Lower: $7.1 million (Today = 71% of current TRR) Upper: $10 million (Today = 100% of current TRR)
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Proposal (contd)
NCFR FinCom will annually set target points as dollar amounts.
FinCom will review and recommend to BoD annually or upon major changes for approval. Treasurer can call for a review as needed.
The state of the actual reserves will be tracked and reported in Treasurers monthly financial reporting package.
Actual reserves are defined as the reserves market value minus forecasted reserves spending plus forecasted operations surplus
Know which risks should be mitigated through insurance and/or litigation rather than reserves. Separate reasonable, ongoing risks to your organization from singular catastrophic events that could jeopardize entity-wide solvency. Beware of duplicative risks. Address the nuances of precedent relationships between risks when analyzing for aggregate financial impact.
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Being aware of financial trends in your industry can be a good way to start thinking about reserves. For example, governmental entities across the country are facing delayed payments due to projected federal and state budget deficits. As states delay or hold back payments to reduce their fiscal year appropriations, individual entities that rely on those revenue streams need to position themselves to shoulder these aid shifts. Governmental entities should also consider statutory requirements and the limitations that can be placed on financial reserves. And they should know what types of activities the funds can be reserved for, the appropriate mechanism for designating reserves, and any dollar amount limits. Most industries membership associations or trade publications also offer standards or benchmarks as guidance.
The bottom up method
If you want to move to an objectively informed reserve policy, a more nuanced approach is to use a bottom up method. This technique dissects your organizations business model and identifies the risks to your revenue and expense drivers (and assets and liabilities where appropriate). It then assigns dollar amounts and probabilities to those risks. The result gives an organization a range of acceptable reserve levels based on real scenarios that your organization could face, given your line of business and competitive environment. In practical and general terms, this type of analysis addresses risks and associated reserve needs that are likely to fall under the following groupings: General operating: for ongoing operational expenses during interim periods of economic disruption (less than 12 months) Capital investment or improvement: for the repair, replacement, or expansion of major technological infrastructure and facility needs Business model: for operations over a three-year period during which your organization must make a significant change in its business model Uninsurable legal: for uninsurable costs associated with litigation Market volatility: for unanticipated investment losses caused by market volatility Initiative or opportunity: for business initiatives that require significant development or start-up costs
Putting the idea into practice
To illustrate the idea, take the instance of a large international association with a $350 million operating budget. It used the bottom up method to move away from its previous best practice reserves policy requiring 50 (continued on page 16)
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(continued from page 15) percent of the operating budget. And while the bottom up method did not provide right or wrong answers per se, it did provide an objective and data-driven framework and process. In the end, the organizations trustees felt confident that their reserves policy was supported by a disciplined and reasoned approach that was predictable and consistent. Too often, reserve policies are treated as a one-time exercise, reflective of your organization at a snapshot in time but then left to sit idle. Your organizations reserve policy should not be static. It should grow with your organization. In todays tight credit markets, you cant afford to come up short on reserve funds when they are needed. And while organizations with reserves are often applauded for their conscientious behavior, a short-sighted and insufficient reserves policy can actually turn an organizations rainy day fund into a risk. So ask yourself: what are our key risk areas at this stage, in this economy, in our field? And then evaluate your reserves. Ben Aase is a nonprofit and government consultant with LarsonAllen. Contact Ben at baase@larsonallen.com or 612-397-3069.