Many charities have been hit hard by the pandemic. Overall charity income appears to have fallen sharply and the distribution of emergency funding looks to have been somewhat uneven. Costs for many charities have increased and demand even more so.

The result is that a high proportion of charities have had to dip into their reserves to get through the crisis. But isn’t that precisely what reserves are for - to provide a cushion against financial shock and buy time to adjust strategy and rebuild?

In our view yes, but we frequently come across clients who see reserves in a very different way.

For many charities, Trustees often appear to be viewing reserves as (almost personal) insurance against a complete collapse. Recognising that, in theory, they could be personally liable if the charity becomes insolvent, Trustees frequently set reserves policies based on an assessment of what it would cost to close the charity should funding dry up.

This might be a reasonable position to take for a small charity delivering a single service or even a larger charity with one dominant source of income. In those cases it is easy to envisage the circumstances in which such a catastrophic failure could occur and the only way forward would be to effect an orderly closure.

For most charities, with a reasonably diverse funding base and broader range of services, such a scenario is highly unlikely. Is such a charity really likely to lose almost all its income in a short period of time or to find demand for all its services evaporates? No sound business would operate on a financial model that requires sufficient reserves to meet all closure costs simultaneously.

So what are reserves for in a charity?

A good place to start is the Charity Commission guidance on reserves. The Commission is clear that deciding the level of reserves a charity needs is primarily about effective financial management and forward planning. The key considerations in setting a reserves policy should, therefore, be:

• Cashflow management - to cope with bank balance fluctuations during the year due to expenditure needing to be incurred before income is received (e.g. from a contract).

• Risk management - money the charity might need to respond to risks in its operating and funding environment, including contingency to meet costs should income fall below expectations or to cover unforeseen costs (such as temporary staff to cover absence).

• Known commitments or planned investment - such as debts that will fall due, liabilities that will arise (e.g. from leases) or a major asset purchase that cannot be met from future income alone. For large charities this might include pension fund deficits.

Of course, the current pandemic is an extreme situation the impacts of which do require emergency support for the sector from Government and other funders. Nonetheless, it is also undoubtedly the case that a charity holding reserves to manage risk and as a contingency against fluctuations in income or costs will have been better able to weather the Covid-19 storm than a charity holding on to reserves to pay for an unlikely complete closure.

Another common myth in the sector is about how much a charity should hold in reserves. We frequently hear talk of 3-6 months running costs being a figure the Charity Commissions expects. this is not true. It is a misperception reinforced by the eligibility criteria of many grant funders. Setting a reserves policy based on the amount of time its “buys” to adjust to changing circumstances might have merit in some smaller, less complicated charities, but it will certainly be simplistic for even medium-sized charities with more diverse financial commitments.

A more sophisticated approach would be to use the headings highlighted in bold above to make an assessment of reserves needed. For example:

• Cashflow: how much has the bank balance typically fluctuated in the past? Are there known situations in which significant expenditure will be incurred before income is received?

• Risk contingency: what would be the likely cash impact if a number of the risks identified in the risk register materialised? Are any significant elements of the fundraising plan particularly risky either in the amount that may be raised or timing?

• Known commitments/planned investments: will the charity need to meet any known or highly likely liabilities in the future that cannot be met from future income?

If you would like to explore how we can help your charity develop a reserves policy that fits better with its circumstances and risk profile, please contact us at julian@almondtreeconsulting.co.uk.