Charities reserves and strategic planning

Every charity needs to think about its future and prepare for it. This involves the creation of a strategic plan which is linked to the income of the organisation along with its resources and reserves which feed into a budget for its delivery. Ideally, the budget is arranged over a period of more than one year enabling it to support the delivery of the strategic plan. This plan will involve consideration and understanding of the income generation of the organisation and its associated risk.

The level of reserves is often not discussed or considered by the Board of Trustees in their strategic plans – the focus can often be more on the budgeted income, future income streams, surplus or deficit for the year. Reserves are usually considered once a year when the reserves policy is being looked at in the annual accounts and justified at that time without any flow through to the strategy and future plans.

Every charity needs to think about its future and prepare for it. A good strategic plan will consider various scenarios and timelines, for example looking at plans for building for the future, investment in resources and assets, as well as perhaps maintaining the current position. So there will be an element that may relate to the need for investment. Such investment could be recruiting fundraisers who will need funding until they are up to speed to cover their own costs or investment in service lines, new buildings or equipment. This investment could well come from the charity’s reserves if the reserves are understood, and if there are amounts available for spending. For instance the charity strategy could have an expansion plan that needs seed funding from its reserves to be able to grow or become more efficient/effective, and to generate future sustainable income as a result.

The board needs to take active responsibility for managing the finances of the charity that requires reacting to, and dealing with, the actual results in the management accounts and how this affects the future strategy and plans of that organisation. If income plans are not being achieved, the charity needs to consider how it will deal with this situation, whether this includes using reserves, recruiting additional resources to generate income, seeking new income sources, considering mergers and collaborations, or cutting costs.

One of the key aspects of managing the risks is building resilience in the organisation by not being overly dependent on one type of income and building an earnt income into the structure; usually from trading, or better still charitable income. Such resilience should look to cover risk appropriately, for instance in the cost of living crisis charity shops tend to perform better as the public turn to them to save costs and in turn donations/fundraising tend to fall away. So these income sources can complement each other from a risk perspective as when one falls, the other is expected to increase.

To make any informed decisions about reserve levels, the strategic plan needs to consider how the charity is financed. Are funds raised by the charity in advance before being spent – from funders, service contracts or fees? In which case the view may be that the charity operates in a lower financial risk model and the level of reserves needed may be more modest. Or is income received in areas after delivery of the activity with clawbacks or performance criteria dictating the final amounts that may be received? In this case, the working capital requirements may be higher if borrowings or social investments are not available to bridge the gap.

Reserves are about the active management of an organisation to help it survive a period of difficulty and manage its way back into sustainability. However, reserves should not be looked at as a desire to hoard funds to give the charity peace of mind. Reserves need to work as hard as income generation, achieving the budgets and delivering on the objectives of the charity.

An easy way to think about reserves is to build up a picture of why the organisation needs to hold funds and why. A simple example is perhaps fixed assets – these could be designated as a separate fund or form part of the free reserves – but are illiquid funds which represent the net book value of the fixed assets owned by the charity and used to deliver charitable services and activities.

Another reserve could be an income risk reserve. For example, legacies are unpredictable and income levels could fluctuate year-on-year. Past performance has no meaning for future receipts, so in order to help manage these peaks and troughs, a charity could use good years to put funds aside for leaner years to bring a more even and sustained level into the yearly budget managed through transfers from this reserve. The level of this reserve would need monitoring if it grows too big to release funds to free reserves or the amount being budgeted as income if the pot grows small. Each element of income could be thought through in a similar fashion to create an amount that forms a realistic income reserve. This reserve may sit within the free reserves, but could make up one element of this pot – another could be working capital.

The fact that reserves represent unspent income can often be overlooked. Most charities do not have the power to accumulate funds and should be applying their resources to charitable purposes, or be able to justify why they have not. Therefore, when charities hold reserves they are balancing the need to spend on their beneficiaries (or charitable purpose) in the current period versus spending for the future as well as against the need to hold funds to manage risk. By not spending reserves the charity is depriving itself from being able to apply money to deliver its charitable objectives – which is one of the duties of trustees.

Reserves do have an important part to play in any organisation whether it’s a commercial company or a charity to cope with liquidity and working capital needs, funds for future development and investment, risk assessments and future planning. However, they do need to be considered and assessed. Charities that have undertaken their strategic planning to encompass budgets, future plans, liquidity, working capital and reserves, have been able to determine how much funds are required to be retained in reserves and many have been able to free up reserves to use in the charity.

Income risk

Every charity will have its own unique income risk profile. Some income is more inherently risky such as legacy income and its budgeting and predictability. Other income such as residential care home fees may be less so but voids can be unpredictable, as will cash collection perhaps. Income risk is simply about asking yourself lots of questions to understand the risk around each income source, and then documenting this in a meaningful fashion.

For example, let’s consider donation income from trusts and foundations. How much has been agreed and signed for in grant agreements? How much is promised or is work in progress to finalise the agreement? And how much is purely speculative? Similarly, each other income line or category will have income risk within it to a greater or lesser degree. The budget for the year will be a mix of all these assumptions leading to a suggested prediction of income from trusts and foundations.

It is important for the board to be aware of the difference in guaranteed income against the projected pipeline and against estimated income used for budgeting purposes. It is important to understand the income risk that the budget has within it and to monitor that risk over the year. A budget provides an annual snapshot, and this information should also be clear, with speculation and assumptions used understood so that this estimated income can be managed and monitored by the Board at the year evolves. Therefore as income is realised during the year both under and over estimated income levels can be considered and appropriate action taken to mitigate against these changes in income levels.  Unless income risk is managed it can result in unplanned and unauthorised usage of unrestricted reserves. So we have seen where an organisation spent virtually all of its reserves in one year and nearly went bust because the management account forecasts just assumed income would be received at 1/12^th of the total projected income rather than pick up on the underperformance of the service team and that income was not being earnt in line with the plan. By the time the Board identified the issue and cut back on expenditure and staffing levels the funds had been spent.

Furthermore, many organisations may look at longer-term income forecasts and budgets which help plan for beyond the coming year. where income streams are not guaranteed it is crucial to have a longer term time horizon to be able to manage the income risk as otherwise if the funds fall away after the year end the organisation is not looking at and managing how it will deal with this issue and change the outcome.

Each set of management accounts needs to continue to inform the board with an update against each income stream and their risk of achievement as the year progresses. This helps the board understand the whole picture so they can make informed decisions around whether the budget can be delivered or if they need to take precautions such as reducing costs. A good reserves policy will also help the organisation in monitoring and managing its income risk in both the current year and future years, informing the strategy and decision making.