Many new trustees ask me what level of reserves a charity should hold. They expect a regulated sector to have a formula for this amount. But charities are not like banks - that is, there are many different business models. And you have to determine the purpose of holding reserves. In banks, the reasoning behind liquidity ratios is clear. But who do charities hold reserves for? Creditors? Beneficiaries? Staff? When I ask, trustees give me various different reasons for holding reserves.
One is that they need to have enough money to pay redundancy costs and wind up the charity. This sounds reasonable enough, but is that your plan? Do you intend to close the charity, and is that a real possibility? If your charity is not financially sustainable, you might need to look at all the options, and closure is one of them. But if there is anything worth salvaging, it would be better to work on a plan to save the services, which would be in the best interests of beneficiaries.
If the charity is in troubled waters, it's not a bad idea to have a stake in the ground so that you know how much the closure costs would be, and you could set that level as your minimum reserves.
Another reason I've heard is that the Charity Commission says you have to have at least one year of running costs in reserve. The commission has never specified a particular formula, although some charities do calculate their reserves policies in this way. In order to use this approach, you need to decide how long the reserves would need to last. For some charities, they would need at least a year in order make alternative provision for their beneficiaries. Other charities consider their reserves as a buffer for a shortfall in income.
If a particular funding stream comes to an end, how long do you need to find an alternative? This is a reasonable approach, but you have to decide which costs to include in "running costs". You cannot necessarily assume that all activities will continue forever, so some charities exclude some project activities. Each charity needs to consider what is right for them.
Some charities say they need reserves to manage risks. Yes, this is precisely why charities need to hold reserves, but reserves are just one way of managing risk, and financial resources might be the last resort. For example, you might hold an element of your reserves for legal cases brought against you by employees. Or you could invest in good employee relations. Which strategy is likely to be the more successful, and which will enhance your charity's reputation?
I say to trustees that they need to understand the risks their charity faces and need to have plans in place to manage and mitigate those risks as far as possible. For some of those risks, you might need money - to buy in extra help, get legal advice, deal with extra costs or just to buy yourself some time. Your priority as a trustee is to act in the best interests of beneficiaries.
Kate Sayer is a partner at specialist auditors Sayer Vincent