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

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Maintaining adequate reserves is essential to establishing financial stability. These reserves provide a cushion to deal with operating deficits that may arise due to unexpected events, economic uncertainties, lean funding periods or opportunities for strategic investment. This presentation offers Grant Thornton’s latest thinking on how to establish appropriate reserves levels and our methodology for developing a sophisticated and robust risk-based approach to establishing a reserves policy within your organization.

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  • If attendance drops precipitously, I’m locked into a contract for a year before I can adjustNote: This presentation focuses on “risk reserves” – the amount of net assets that a nonprofit should have on hand to adequately protect itself against risks that may adversely impact its bottom-line.
  • Historically 1 year, then down to 6 then 3; many at 6-9 months
  • Be self-sufficientBe prepared for market-related risksAvoid unplanned cost-reduction measuresReduce the impact of industry-specific risksBut… this only works if you determine the right level of reserves for your specific organization, not if you rely on general rules of thumb!
  • Two purposes model – Establish a baseline and have conversation about it to understand… Goal is ‘we’re pretty confident in this model’5 years
  • What would 10% increase in…// base model and risk model – what if decreased 10%Mitigate short term impacts until you can adjust business modelDon’t have to pull the trigger or reduce staff
  • Physicist Enrico Fermi was known for his ability to make good approximations with little or no actual data. These are known as "Fermi Problems". While this is not provable in mathematic terms, in practice, approximations based on the aggregation of smaller elements are often remarkably accurate.
  • Explore alternatives for reducing risk:Mitigation techniquesDivestmentAdopting a "willing to let it fail" mentalityKeep the bathtub filled while it’s drainingSize (vs. speed on next page)
  • Flex – spigotWhat do you do with your first dollar of rainy day fund – to this or something else
  • Annuity; growing perpetuity
  • For example: A nonprofit expecting to generate a surplus (with the intent of using it in subsequent year activities) would effectively achieve budgeted results regardless of actual performance by tapping its risk reserves pool Regarding reserves as a means to backfill occasional operating deficits is a less reliable approach to reserves planning
  • Reserves planning: Determining the appropriate level of reserves for your organization

    1. 1. CPE Credit is not available for viewing archived programs. Please visit http://www.grantthornton.com/events for upcoming programs. Reserves planning Determining the appropriate level of reserves for your organization Original Broadcast Date: October 2013 © Grant Thornton LLP. All rights reserved.
    2. 2. Presenters Mark Oster Matt Unterman National Managing Partner Not-for-Profit and Higher Education Practices Senior Manager Not-for-Profit and Higher Education Practices Joe Mulligan Manager Not-for-Profit and Higher Education Practices © Grant Thornton LLP. All rights reserved. 2
    3. 3. Reserves planning Learning objectives • 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 © Grant Thornton LLP. All rights reserved. 3
    4. 4. Reserves planning Agenda • Introduction • Approach to determining “appropriate” • Implementation considerations • Questions/Comments © Grant Thornton LLP. All rights reserved. 4
    5. 5. Reserves planning Agenda • Introduction • Approach to determining “appropriate” • Implementation considerations • Questions/Comments © Grant Thornton LLP. All rights reserved. 5
    6. 6. Introduction What 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 © Grant Thornton LLP. All rights reserved. 6
    7. 7. Introduction What 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 © Grant Thornton LLP. All rights reserved. 7
    8. 8. Introduction What 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 © Grant Thornton LLP. All rights reserved. 8
    9. 9. Introduction Challenges 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 © Grant Thornton LLP. All rights reserved. 9
    10. 10. Introduction How 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 © Grant Thornton LLP. All rights reserved. 10
    11. 11. Introduction How 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 © Grant Thornton LLP. All rights reserved. 11
    12. 12. Reserves planning Agenda • Introduction • Approach to determining “appropriate” • Implementation considerations • Questions/Comments © Grant Thornton LLP. All rights reserved. 12
    13. 13. 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 © Grant Thornton LLP. All rights reserved. 13
    14. 14. 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 © Grant Thornton LLP. All rights reserved. 14
    15. 15. 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 © Grant Thornton LLP. All rights reserved. 15
    16. 16. Approach to determining “appropriate” 1. Develop a baseline long-term financial forecast © Grant Thornton LLP. All rights reserved. 16
    17. 17. Approach to determining “appropriate” 1. Develop a baseline long-term financial forecast • 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 © Grant Thornton LLP. All rights reserved. 17
    18. 18. 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 © Grant Thornton LLP. All rights reserved. 18
    19. 19. Approach to determining “appropriate” 2. Detailed risk analysis – types of risks to consider © Grant Thornton LLP. All rights reserved. 19
    20. 20. 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 © Grant Thornton LLP. All rights reserved. 20
    21. 21. 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 © Grant Thornton LLP. All rights reserved. 21
    22. 22. 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 likelihoodadjusted impact by year • Use NPV to calculate average annual risk exposure © Grant Thornton LLP. All rights reserved. 22
    23. 23. Approach to determining “appropriate” 3. Quantify your average annual risk exposure © Grant Thornton LLP. All rights reserved. 23
    24. 24. Approach to determining “appropriate” 3. Quantify risks – linking financial model © Grant Thornton LLP. All rights reserved. 24
    25. 25. Approach to determining “appropriate” 3. Quantify risks – revenue example © Grant Thornton LLP. All rights reserved. 25
    26. 26. Approach to determining “appropriate” 3. Quantify risks – expense example © Grant Thornton LLP. All rights reserved. 26
    27. 27. 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. © Grant Thornton LLP. All rights reserved. 27
    28. 28. 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 © Grant Thornton LLP. All rights reserved. 28
    29. 29. 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” © Grant Thornton LLP. All rights reserved. 29
    30. 30. Approach to determining “appropriate” 4. Establish your target reserves level and funding approach • 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 © Grant Thornton LLP. All rights reserved. 30
    31. 31. Approach to determining “appropriate” 4. Establish your target reserves level and funding approach • 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 © Grant Thornton LLP. All rights reserved. 31
    32. 32. Approach to determining “appropriate” 4. Establish your target reserves level and funding approach • 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 © Grant Thornton LLP. All rights reserved. 32
    33. 33. Reserves planning Agenda • Introduction • Approach to determining “appropriate” • Implementation considerations • Questions/Comments © Grant Thornton LLP. All rights reserved. 33
    34. 34. Implementation considerations Documenting 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.) © Grant Thornton LLP. All rights reserved. 34
    35. 35. 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! © Grant Thornton LLP. All rights reserved. 35
    36. 36. 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 © Grant Thornton LLP. All rights reserved. 36
    37. 37. 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 © Grant Thornton LLP. All rights reserved. 37
    38. 38. Conclusion Determining 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 © Grant Thornton LLP. All rights reserved. 38
    39. 39. Comments? Questions? © Grant Thornton LLP. All rights reserved. 39
    40. 40. Grant Thornton Not-for-profit and higher education resources Publications for not-for-profit and higher education organizations: www.grantthornton.com/nfp © Grant Thornton LLP. All rights reserved. 40
    41. 41. Presenters Mark Oster Matt Unterman National Managing Partner Not-for-Profit and Higher Education Practices 212.542.9770 mark.oster@us.gt.com Senior Manager Not-for-Profit and Higher Education Practices 212.542.9834 matt.unterman@us.gt.com Joe Mulligan Manager Not-for-Profit and Higher Education Practices 212.542.9513 joseph.mulligan@us.gt.com © Grant Thornton LLP. All rights reserved. 41
    42. 42. 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. © Grant Thornton LLP. All rights reserved. 42
    43. 43. Thank you for viewing this presentation. Visit us online at: www.GrantThornton.com twitter.com/GrantThorntonUS linkd.in/GrantThorntonUS © Grant Thornton LLP. All rights reserved.

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