Keeping cash in reserve is vital but can be shockingly expensive, writes Charles Nall.
How much should a charity put aside in reserves? When making provision for the future, there are things that can be reasonably estimated. For example, opportunities can be quantified, random, year-to-year movements in income can be analysed and risks can be rated and valued. That's the easy bit.
The tough bit is that, every so often, unforeseen financial events engulf the charitable world. Looking at The Children's Society's 123-year history, one can determine that roughly once every 20 years an event occurs that costs half of gross turnover. Changes since the Second World War have included state provision of care homes, the pill and inflation and investment booms.
The implications of this are significant. First, this type of event is going to happen again. Second, it will be largely unexpected, so it's not enough to be proud of low reserves. Third, no restricted-funds contract makes provision for such risks, so either government underwrites the sector or a risk margin is needed in contracts. Fourth, banks don't like distressed companies, including charities, so you need to accumulate free reserves.
Fifth, you will spend those free reserves at some time.
Take that 20-year cycle as a model, with a six-month reserves requirement and inflation of 5 per cent. If you're a new charity, you've got to earn a free funds surplus of 2.5 per cent of turnover a year. To match cost growth of 5 per cent you need a further 2.5 per cent of turnover as a minimum to match that growth (how many new charities earn a free surplus of 5 per cent?). All the other reasons for a surplus, such as investing in services and meeting quantifiable risks, come on top.
If you're an established charity with that level of reserves in place, a surplus of 2.5 per cent is still a large amount of money. To avoid this surplus requirement, you're going to need a total return held in your investment fund that at least matches growth or inflation of 5 per cent.
And you need to be fairly sure about maintaining the capital value of the fund at consistent levels until needed - a real role for derivatives?
Most charities understand that the right level of reserves is fundamental to looking after their beneficiaries, both now and in the future. The shock is how expensive this might be. Action to address this affects many aspects of a charity's financial life.
Ultimately, the justification for core liquid reserves is that although future shocks are uncertain, their financial impact can be estimated, however untidily, and provision made.
- Charles Nall is corporate services director at the Children's Society.
- Free reserves are vital to deal with the unforeseen
- A new charity needs a free funds surplus of 2.5 per cent of turnover a year
- To avoid this surplus requirement, a charity needs a total return held in an investment fund that matches growth or inflation of 5 per cent.