Reserves planning: Determining the appropriate level of reserves for your organization

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Reserves planningDetermining the appropriate level of reserves for your organization

Original Broadcast Date: October 2013

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© Grant Thornton LLP. All rights reserved. 2

Matt UntermanSenior ManagerNot-for-Profit and Higher Education Practices

Presenters

Joe MulliganManagerNot-for-Profit and Higher Education Practices

Mark OsterNational Managing PartnerNot-for-Profit and Higher Education Practices


• Explain the importance of reserves planning in today’s not-for-profit environment

• Describe how to use key financial modeling and risk analysis techniques to determine an appropriate reserves level for your organization

• Identify how to best implement a reserves policy

Reserves planningLearning objectives


Reserves planning Agenda

• Introduction

• Approach to determining “appropriate”

• Implementation considerations

• Questions/Comments


Reserves planning Agenda

• Introduction





IntroductionWhat are reserves?

• Rainy day fund to bridge cash flow needs• Insurance to maintain financial solvency and mitigate risk• Cash on hand to fund new activities – unbudgeted required

initiatives or unexpected opportunities• Hedge against inability for timely adjustments to operations

in response to negative events


IntroductionWhat are reserves? Our definition…

• An organization’s financial reserves are a discrete subset of its net liquid assets. They are a distinct pool of assets that an organization can access to do the following:

– Mitigate the impact of unbudgeted, undesirable financial events

– Pursue opportunities of strategic importance that may arise in the future


IntroductionWhat types of assets qualify as “reserves”?

• Factors that determine which assets can be counted toward “reserves” include the following:– Liquidity– Freedom from any corresponding liabilities– “Unrestricted” with regard to donor intent

• Specific examples of assets that would not be considered reserves would include the following:– Plant, property, and equipment– Endowments and board-designated funds– Pension plan assets


IntroductionChallenges and issues

• Addressing criticism for “hoarding funds”

• Keeping expectations in check on how and when funds may be spent

• Maintaining continuity in fiscal practices during periods of transition or turnover

• Cultivating a culture of long-term sustainability; avoiding knee-jerk responses

• Substantiating that the reserves amount is appropriate and providing rationale


IntroductionHow organizations determine their reserves levels

• Conventional wisdom and limited tools– Number of months operating expenses– Liquid net assets as a percentage of budget– Specific dollar level

• Your organization is unique and your reserves level should be, too!– Each organization has a unique business model, risk exposure

and financial circumstances– The level of assets that are set aside to mitigate risks should

vary from organization to organization


IntroductionHow organizations determine their reserves levels

• Generic rules of thumb are somewhat simplistic and could result in the following:– Underserving organizations and constituents– Higher borrowing costs associated with underfunded reserves– Forced abandonment of strategic investments

due to lack of expendable resources– Hard-to-defend position; poor optics


Reserves planningAgenda

• Introduction





Approach to determining “appropriate”Step-by-step process

1. Develop a baseline long-term financial forecast

2. Perform a detailed analysis of potential risks

3. Quantify your average annual risk exposure

4. Establish your target reserves level and funding approach


Approach to determining “appropriate”Step-by-step process – benchmarking?

Note: Our recommended approach does not include benchmarking to peers. Why not?

• Beware of the pitfalls of benchmarking:− Two wrongs don’t make a right and more/less doesn’t mean better/worse− Similarities only go so far (risks, impact to

organization, etc.)

• May be performed for change management purposes


Approach to determining “appropriate”1. Develop a baseline long-term financial forecast

• Several purposes to financial modeling– Establish a “baseline” – anticipated future performance and

financial position• Understand financial dynamics of the organization and

engage in dialog regarding drivers• See trends that are not evident in annual budgets

– Link risk model to financial model– Identify needed reserves derived from risk analysis– Validate ability to fund determined reserves level– Use as ongoing tool to “adjust” reserves level as circumstances

require



• Explore the following questions:– Given your current operations and programs, what level of

margin/reserves do you anticipate generating?– Can this be altered by modifying your underlying business plan

(revenues and expenses)?– What impacts to your financials may occur due to external

events and internal decisions?

• Generate a solid understanding of your future financial picture


Approach to determining “appropriate”2. Perform a detailed analysis of potential risks

Purpose:

To build consensus among management and the board on the risks that may affect the organization, the financial impact those risks could have, and their likelihood of occurrence


Approach to determining “appropriate”2. Detailed risk analysis – types of risks to consider


Approach to determining “appropriate”2. Detailed risk analysis – recommended steps

• For each line of business and the organization as a whole, work with “owners” to identify risks that have monetary impact– Analyze all key budget line items (i.e., revenues and expenses)

where variance from plan could have a material impact on the organization’s financial performance

• Define scenarios for each risk with associated likelihood of occurrence to establish a “range” of outcomes– Include recurring, multiyear, and one-time risks


Approach to determining “appropriate”2. Perform a detailed analysis of potential risks

• Shortfalls in financial performance (i.e., underperformance or undesirable deviations) can occur due to:– Factors beyond control within the organization’s operating

environment– Forward-looking predictions regarding the organization’s ability

to execute– External influences


Approach to determining “appropriate”3. Quantify your average annual risk exposure

• For each risk that you have identified, determine potential monetary impacts over a time horizon– Use financial model as input– Calculate all downstream results of identified risk

• Calculate Net Present Value (NPV) based on likelihood-adjusted impact by year

• Use NPV to calculate average annual risk exposure


Approach to determining “appropriate”3. Quantify your average annual risk exposure


Approach to determining “appropriate”3. Quantify risks – linking financial model


Approach to determining “appropriate”3. Quantify risks – revenue example


Approach to determining “appropriate”3. Quantify risks – expense example


Approach to determining “appropriate”3. Quantify risks – NPV/risk summary

Then, calculate average annual risk exposure by dividing NPV by number of years in financial model.


Approach to determining “appropriate”3. Quantify risks – challenges

• Building consensus can be challenging− Risks− Impacts− Probability

• If the underlying assumptions are sound, good approximations can be made in the aggregate


Approach to determining “appropriate”4. Establish your target reserves level and funding approach

• Once we estimate the organization’s anticipated average annual risk exposure, we must then determine how much risk funding to maintain on hand

• Such a decision should consider the following:• Likelihood of a higher-than-average risk year• Timeline required to identify the manifestation of a “one-time” risk

versus the establishment of a new normal• Organization’s ability to identify drivers and make decisions to

respond to change in a timely manner• Anticipated time horizon to implement operational changes and

“open and close the spigot”



• In addition to understanding average annual risk exposure, the organization may also wish to consider the means by which it can move the reserves target “goalposts” – Explore strategic alternatives for reducing risk– More aggressive budgets typically require more dollars in

reserves– Obtain insurance coverage to offset the exposure resulting from

potential risk events



• Speed with which full funding of reserves occurs may vary based on the following:– Financial stability – assets and ability to generate– Ability to “catch up” if circumstances require (generate additional

margin if needed) – Other funding requirements (e.g., annual

operational investment)– Organizational appetite and interest



• Reserves can be funded via income statement or balance sheet– Designate existing unrestricted net assets– Set aside annual amount from operations/assets– Explore strategic alternatives to generate margin (“hard

choices”): reduce costs, increase fees, etc.– Hybrid


Reserves planningAgenda

• Introduction





Implementation considerationsDocumenting your reserves policy

Every reserves policy should have the following elements:• Clearly articulated purpose for the reserves• Process for monitoring and reviewing the annual reserves

requirements• Responsibilities for establishing and funding reserves level• Processes to respond to risk events (escalation, notification,

approval, etc.)


Implementation considerations Communication, culture, and process

• Publicize to internal and external constituencies– The plan can help development functions and board members

more clearly articulate why their institutions are “not rich” and why these funds have been set aside

• Address the culture– It’s OK to spend this money; just because a risk occurred doesn’t

mean you need to prune/alter offerings

• Update the plan (and risk analysis) annually!


Implementation considerations When to draw upon reserves

• Our methodology recommends organizations draw upon reserves to address deviations from budget

• Drawing upon reserves should be expected


Implementation considerations Reserves are a subset of your overall liquidity

• In addition to “risk reserves,” management must also ensure that it’s maintaining adequate cash on hand/liquidity to fund day-to-day operations

• Organizations should also consider what additional discretionary funds should be set aside to pursue key strategic priorities or capital improvement projects


ConclusionDetermining appropriate reserves level for your organization

• Maintaining balance sheet health via reserves enables you to be prepared for the future, while providing stability in your operations

• No two organizations’ business operations and risks are alike

• Every organization should adopt a unique reserves plan to meet its specific needs and circumstances


Comments?Questions?


Grant ThorntonNot-for-profit and higher education resources

Publications for not-for-profit and higher education organizations:

www.grantthornton.com/nfp


Joe MulliganManagerNot-for-Profit and Higher Education [email protected]

Matt UntermanSenior ManagerNot-for-Profit and Higher Education [email protected]

Presenters

Mark OsterNational Managing PartnerNot-for-Profit and Higher Education [email protected]


Disclaimer

This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered.

For additional information on matters covered in this presentation, contact your Grant Thornton LLP adviser.

Reserves planning: Determining the appropriate level of reserves for your organization

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