While there is no one right answer for all organizations, generally we believe that having six months of budgeted expenses in reserve is a good place to start. However, each organization is unique and may experience distinct and unexpected circumstances that could affect long-term financial health. That which may be too little for one organization could be more than enough for another, even within the same budget size.
A variety of factors can drive what’s needed to be held in reserve. If your organization’s revenue streams are diversified, income is relatively reliable, or costs can be cut quickly, then it’s likely you will not need to hold as much in reserve. However, if your organization has few revenue sources, income that fluctuates significantly year to year, or it will take time to cut costs, it’s likely more will be needed to be held in reserve. In addition, if there are strategic initiatives that your organization wants to pursue and they are not budgeted for, your organization will need even more in reserve.
To quantify the dollars needed in reserve we recommend going through a risk and opportunity assessment. After identifying all potential risks and opportunities, discount them based on the likelihood or time frame over which they may occur. A dollar value, or range of potential values, can then be assigned to each item to determine the total dollar amount or range to hold in reserve.
The process and its outcome should be outlined in a reserve policy with a risk/opportunity assessment included as documentation. With the new reserve target or range it’s important to outline which actions to take to either add to the reserve, or whether to consider a spending plan. This assessment should be revisited every few years to determine if there have been any changes to your organization’s risks or opportunities.