Retooling Your Financial Reserves

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©2012 CliftonLarsonAllen LLP1

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© 2 0 1 2 C l i f t o n L a r s o n A l l e n L L P

Retooling Your Financ ial Reserves

Catholic Cha rities USA Annua l Gathering

Oc tober 1, 2012

Ben Aa se and Bruc e Braunewell

CliftonLarsonAllen LLP

http://www.catholiccharitiesusa.org/page.aspx?pid=1174




Learning Objec tives

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 policythat will build confidence with your organization’s 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.




Why Nonprofits Need Reserves

To bridge cash flow needs

To maintain financial solvency

To weather economic cycles

To fund expected opportunities

To fund unexpected opportunities

To protect yourselves against unpredictable political behavior

To purchase and maintain productive assets

To drive capacity for new debt to fund major capital needs




Who Cares About Our Reserves?

Organizational leaders

Board members

Creditors

Regulators

Rating agencies

Contributors

Service recipients

A lot more people than you’d

think when you don’t have them…




What We’re Seeing and Hearing

http://www.timeshighereducation.co.uk/

http://www.dailycal.org/




Context

Reserves (by themselves) ≠ Capital

Reserves are (just) one important

part of an organization’s overall

capital structure.




Capita lization: One Definition

The accumulation and application of resources—operating andworking capital, operating reserve, risk capital, endowment and

building reserve—to support achievement of an organization’s

mission over time.

Excerp ted from http :// ww w.kresge .org/ co ntent/ files/We bina r%20PPT%201-25-11.pptx




Understanding Risks of Undercapitalization

Excerp ted from http :// ww w.kresge .org/ co ntent/ files/We bina r%20PPT%201-25-11.pptx

The theory being that without adequate capitalization – or theappropriate capital mix – your mission is at risk.




July 2009 Urban Institute Study

AGE DOESN’T MATTER

“Sixty-five percent of young organizations—defined as no more

than five years old—had operating reserves that would cover

less than three months of operating expenses, and nearly one-

third of these young organizations have no operating reserves.

Older organizations tend to be somewhat stronger, but even

among those that are more than 30 years old, nearly 50 percent

had low operating reserves.”

SIZE DOESN’T MATTER

“More than half of

organizations in every range of

expenses reported operating

reserves of less than three

months.”

REVENUE BASE MAY MATTER

“Two categories had significantly more

organizations with less than the suggested

minimum reserves—those with revenue

primarily from government grants orprogram services.”

MISSION DOESN’T MATTER

“More than half of all organizations across

all missions, except for environment and

animals, had operating reserves of less

than three months.”

HOW DID THESE ORGANIZATIONS FARE THE LAST RECESSION?

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.

Available a t http :// ww w.urban.org/uploa ded pd f/411913_dc _nonprofit_reserves.pdf




Nonprofit Operating Reserves Initia tive

Ad hoc group of nonprofit

finance professionals.

Center on Nonprofits and Philanthropy

at the Urban Institute serves as secretariat.

Objectives:

Define an “Operating Reserve Ratio”

Use the ratio to focus attention on

the importance of nonprofit financialstability

Available at http:// ww w.ncc s2.org/w iki/imag es/3/ 3c/O peratingReservesWhitePaper2009.pdf




Nonprofit Operating Reserves Initia tive

White paper recommendations:

Set a minimum operating reserves ratio.

Tailor your policy to your organization’s needs and funding structures.

Recommendation = no less than three months of operating expenses.

Define how the operating reserves will be invested as part of your

organization’s overall investment policy.

Decide how often to measure and report.

Discuss how your operating reserves will be replenished if you need todip into your reserves or they fall below the minimum threshold.

Available at http:// ww w.ncc s2.org/w iki/imag es/3/ 3c/O peratingReservesWhitePaper2009.pdf




Why You Need Them Today More Than Ever

In conclusion, both intuition AND evidence suggest that…

Many nonprofit organizations have inadequate reserves and have

suffered over the past several years because of it…

…and while many organizations are understandably focused on a

relatively short time horizon…

…there is an emerging interest in addressing the question of financial

reserves more prudently…

…to help you emerge from this current economic crisis wellpositioned to withstand the next challenge that arises.

Adapted from “Maintaining Nonprofit Operating Reserves,” The Nonprofit Operating Reserves Initiative Working Group, December 2008




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?

HOW ARE RESERVES

IMPACTING YOU?




CASE STUDY:

NATIONAL COUNCIL ONFINANCIAL RESERVES




NCFR’s Reserves

Does this trend look

familiar?




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.




Why 50%?

Because it felt good.

Responsible.

And it’s what their peer

organizations were doing.




Ask Yourself…

Q: Best practice or popular practice?

A: Popular practice




The Danger of Conventiona l Wisdom

Benchmarking may provide a good starting point…

…but beware of conventional wisdom.




SO WHAT IS ONE TO DO?

A h / 2 Ph / S




1 Approach / 2 Phases / 6 Steps

Review of Current

Policy and Practice

Data Co llec tion

(via Survey )

Quantitative

Modeling

Draft Policy

Rec omm endations

Finance Comm ittee

and Board Approval

Facilitated

Stakeholder Sessions

Phase 1: Identify risks to m ajorprog rams / business lines

Phase 2: Quantify identified risksand build appropriate polic y

IterativeFeedback Loop




STEP 1: REVIEW OF CURRENT

POLICY AND PRACTICE

R i f C t P li d P ti




Review of Current Polic y and Prac tice

Current reserve policy and historical context

Business and financial reporting structure

Historical reserve targets vs. actual performance and use

Program summaries

Related risk (e.g. SWOT) or strategic planning documents for each

program, operating unit, or entity-wide

External environmental scan

Investment allocation risk analytics




STEP 2: DATA COLLECTION

Data Collec tion (via Survey)




Data Collec tion (via Survey)

Suggest surveying internal departmental directors

− Direct service delivery at the departmental or site level

− Business and finance

− Information technology

−Physical plant

Questions revolved around…

− Identifying specific business risks

−The likelihood and timing of their occurrence

− Their anticipated financial impact

− Their categorical nature

−

Alternative mitigation strategies

Sample Survey Questions




Sample Survey Questions

True or False: NCFR’s 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, whatpotential high impact risks could result in your department’s needto access NCFR reserve dollars?

Sample Survey Questions (c ont’d)




Sample Survey Questions (c ont d)

For each of these identified risks…




TIME OUT FOR A SURVEY




STEP 3: FACILITATED

STAKEHOLDER SESSIONS

Fac ilitated Stakeholder Sessions




Fac ilitated Stakeholder Sessions

Goals:

Test departments’ response to seeing the survey data in aggregate

Fill any data gaps or clarify items that required interpretation

Move to consensus, most likely scenario for each identified risk

Test the materiality of smaller risks identified

Explore rationale in assigning likelihood, timing, and financial impact

Test risks identified by other respondents to ensure they are:

− Appropriately excluded

− Void of any overlaps and disputes

Sample Session Agenda




p g

Introduction and Perspectives of Participants

Review Committee Charge

Ground Rules

− Risks vs. Opportunities

− Insurable vs. Uninsurable Risks

−Budgeted New Initiatives vs. Reserve Contingencies

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

Open Discussion and Wrap-Up

On to Phase 2




Review of Current

Policy and Practice

Data Co llec tion

(via Survey )

Quantitative

Modeling

Draft PolicyRec omm endations

Finance Comm ittee

and Board Approval

Facilitated

Stakeholder Sessions

Phase 1: Identify risks to m ajorprog rams / business lines

Phase 2: Quantify identified risksand build appropriate polic y

IterativeFeedback Loop




STEP 4: QUANTITATIVE MODELING

Quantitative Modeling




Objective: To develop a data-driven financial reserve model that

quantifies the risks identified in surveys and stakeholder sessionsagainst NCFR’s 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.

Reserve Model Schematic







STEP 5: DRAFT POLICY

RECOMMENDATIONS

Rec ommended Reserve Categories




A reduction in members, membership dues, and/or assessment allocations due to

economic downturn.

Membership/ Assessment

Poor performance on conference and meeting activities from economic downturn,open access, political disruption, or disruptive technology.

Conference a nd Meeting Ac tivities

Poor performance on publishing activities due to a host of environmental,

competitive, and functional factors.

Publishing Ac tivities

Decreased investment returns caused by market volatility.

Market Volatility

Rec ommended Reserve Categories (cont’d)




Repair, replacement, or expansion of major physical and technological infrastructure.

Cap ital Investment

Uninsurable litigation risks.

Employment Funds

Entity-wide strategic undertakings not yet executed.

Major Initiatives

Unclassified ongoing business risks.

Other Baseline Reserve Needs

Data Summary




Projected requirement of $10 million at full risk valuation.

Recommended reserve categories are as follows.

Capital Investment $ 2,300,000 23%

Publishing Activities 2,300,000 23%

Market Volatility 1,700,000 17%

Employment Funds 1,000,000 10%

Major Initiatives 400,000 4%

Conference and Meeting Activities 400,000 4%

Membership/Assessment 400,000 4%

Other Baseline Reserve Needs 1,500,000 15%

Tota l $ 10,000,000 100%

Not All Risks Will Oc cur Simultaneously




A reserve level of approximately $7.1M would capture all risks assigned

either a medium or high likelihood and a time horizon of 5 years or less.

…accounts for 71% of all identified risks at full their valuation.

…represents 52% of forecasted fiscal year 2012 operating expenses.

…offers a subjectively reasonable bottom range.

LIKELIHOOD TIMEHORIZON

Rec ommenda tion




Based on current risks and forecasted fiscal year 2012 operating

expenses of $13.7 million, NCFR should maintain reserve levelsbetween $7.1 million and $10 million.

Reserve Leve l% of

ForecastedFY12 Expenses

% of CurrentRisks at Full

Value

Amount Over / (Under) CurrentReserve Leve l

Ceiling $10 Million 73% 100%$1 Million

Over

Current $9 Million 66% 90% –

Baseline $7.1 Million 52% 71%$1.9 Million

Under

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




STEP 6: FINANCE COMMITTEE

AND BOARD APPROVAL

Committee and Board Approval




Proposal: Change the NCFR Reserves Policy

From the present…

− The minimum recommended goal is to have NCFR reserves at least equal to

one half of the total budgeted yearly expenditures.

To a policy based on a data-driven approach…

− Total Reserves Risks / Exposure of the NCFR

Proposal




The Total Reserves Risks (TRR) shall be the sum of all reasonablepotential draws on the NCFR reserves.

− NCFR will use a bottom-up method to determine TRR.

The NCFR FinCom will annually determine TRR update process.

− FinCom will conduct reviews at least once every three years.

The lower and upper reserve targets shall be determined by theNCFR FinCom as follows:

−

Lower: $7.1 million (Today = 71% of current TRR)

− Upper: $10 million (Today = 100% of current TRR)

Proposal (cont’d )




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

Treasurer’s monthly financial reporting package.

− Actual reserves are defined as the reserves market value minus

forecasted reserves spending plus forecasted operations surplus

If reserves fall below the lower reserves target…

– NCFR Treasurer will notify President and FinCom and hold a FinCom

discussion within two weeks.

– FinCom will any suggested actions to BoD.

Risk is…well, risky…what to watch out for




Segregate current risks from hypothetical ones.

− Conversely, changes in strategic direction

warrant reassessment.

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.

© 2 0 1 2 C l i f t o n L a r s o n A l l e n L

L P

Thank you





Thank you.

And come see us at booth #3!

For further information, please c ontac t:

Ben Aa se Bruc e Braunewell

Princ ipa l, Nonprofit Partner, Nonprofit

220 South Sixth Street, Suite 300 610 West Germa ntown Pike, Suite 400

Minneapolis, Minnesota 55402 Plymouth Meeting, PA 19462

612-397-3069 267-419-1137

ben.aa se@c liftonlarsona llen.com bruc e.braunewe ll@c liftonlarsona llen.com




Retooling Your Financial Reserves

by Ben Aase

It’s an age-old question that many leaders are revisiting during these di-cult economic times: “How much money should my organization havein reserves?”

There are plenty o arbitrary rules o thumb—or example, holding a

minimum o three months’ cash or setting aside 25 percent o your projected annual operating budget. Unortunately, these “best practices” arenot supported by thoughtul reasoning, nor do they refect the businessrealities acing your unique organization.

Look to your industry

Being aware o nancial trends in your industry can be a good way tostart thinking about reserves. For example, governmental entities acrossthe country are acing delayed payments due to projected ederal and

state budget decits. As states delay or hold back payments to reducetheir scal year appropriations, individual entities that rely on thoserevenue streams need to position themselves to shoulder these aid shits.Governmental entities should also consider statutory requirements andthe limitations that can be placed on nancial reserves. And they shouldknow what types o activities the unds can be reserved or, the appropri-ate mechanism or designating reserves, and any dollar amount limits.

Most industries’ membership associations or trade publications alsooer standards or benchmarks as guidance

percent o the operating budget. And while the “bottomup” method did not provide right or wrong “answers” per

(continued rom page 15)



up method did not provide right or wrong answers per

se, it did provide an objective and data-driven ramework and process. In the end, the organization’s trustees eltcondent that their reserves policy was supported by a disciplined and reasoned approach that was predictableand consistent. Too oten, reserve policies are treated asa one-time exercise, refective o your organization at a snapshot in time but then let to sit idle. Your organiza-tion’s reserve policy should not be static. It should grow with your organization.

In today’s tight credit markets, you can’t aord tocome up short on reserve unds when they are needed. And while organizations with reserves are oten applaud-ed or their conscientious behavior, a short-sighted and

insucient reserves policy can actually turn an organiza-tion’s rainy day und into a risk. So ask yoursel: what areour key risk areas at this stage, in this economy, in oureld? And then evaluate your reserves.

Ben Aase is a nonproit and government consultant withLarsonAllen. Contact Ben at [email protected] or 612-397-3069.

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Retooling Your Financial Reserves