Structural balance & apportioning reserves for organisations

From a financial standpoint, the key objective of institutional organisations must be to fulfil their mission and achieve their strategic objectives in a sustainable manner. 

Their goal should be to ensure that the delivery of their mission is in balance with the financial resources available to them, thus preserving their ability to fulfil this mission into the future or indeed in perpetuity. Long term sustainability or Structural Balance requires surpluses during economic expansion that are set aside to finance deficits during economic contractions.  This is particularly important in the context of those organisations that are counter-cyclical, whereby their services are often needed most during periods of economic weakness.

The organisation needs to continuously remind itself of its fiduciary duty. Therefore, when investment  markets and in turn their finances are their strongest, that duty may require that they build up reserves rather than increasing activities and expenditure. Setting aside more and not less during expansions provides the best chance of an organisation sustaining their mission.

As institutional leaders, the quality of the decisions made in this regard depends on the collective ability to assess, plan for and communicate the financial condition of the organisation.  The availability of timely and accurate financial information, adherence to budgets and an understanding of their future mission or strategy are crucial as is the development and implementation of comprehensive reserve policy.

Reserve policy should state the level of reserves held and provide an explanation as to why they are held.  Where designated funds are set aside for future expenditure, the amount, purpose and likely timing of that expenditure should be stated. 

In many ways, reserves are reputational balancing act. Too little and stakeholders will question the sustainability of an organisation, too much and questions may be asked about why such amounts are not being more fully utilised. Therefore, clear reserve policy is vital in the following aspects:

• Gives confidence to funders
• Demonstrates resilience
• Gives an understanding of why funding is needed
• Assures lenders and creditors
• Manages reputational risk of holding substantial unspent funds

Defining reserve policy is both a retrospective and prospective exercise.  It requires a firm understanding of the nature and level of assets held, accurate budgeting and analysis of future needs, opportunities, commitments of risks. As your organisations strategic objectives, circumstances and finances change, reserve policy should be revisited to ensure that it remains appropriate. 

There is no one size fits all solution and reserve policy is specific and unique to each organisation.  For organisations with volatile income, recurring budget deficits or plans for significant capital expenditure, reserves may need to be greater.  For those with stable and recurring income, budget surpluses and limited future capital expenditure, low levels of reserves may be appropriate.  Whatever the circumstances, how you communicate your position is of utmost importance.

At Davy, we work with organisations to apportion their reserves in an appropriate fashion that they can stand over with confidence.  Reserves are segmented into tranches and rules are put in place around how these tranches may be invested. A simple visualisation may look something like the below.

Source: Davy

The first tranche we identify are Operating Reserves.  This incorporates cash at bank, which should be sufficient to meet day-to-day expenses and should allow for fluctuations in the timing of cash flows. It also includes Contingency Reserves, which relate specifically to Structural Balance.  Contingency Reserves should be sufficient to enable an organisation to maintain its services during a period of economic weakness when other sources of income are temporarily diminished or when the public need for their services are greater and, therefore, operational expenditure is increased for a period of time. These reserves must be both liquid and safe. Generating investment returns is of secondary importance.

Next, we allocate to Designated Reserves.  Such reserves are set aside to meet specific future needs and objectives such as capital projects.  Designated Reserves should be invested with the expected timing of their use in mind.  In some instances, diversified investments in risk assets such as equities may be considered.

Finally, some organisations may find themselves in a position where they have surplus liquid assets over and above those above.  These Core Reserves can in many ways act as an endowment. They provide vital income to the organisation, replenishing Contingency Reserves, providing capital for Designated Reserves and increasing the likelihood of them being able to sustain their mission.

Creating and adhering to a reserve policy is a challenging task for organisations that are driven first and foremost by their mission but failure to do so can jeapordise your long-term viability.  Effective reserve policy will aid you in maintaing structural balance.  Married with a strategic vision, it can support the growth of your mission into the future.