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The pandemic exacerbated financial sustainability issues faced by charities. Many have already had to redefine their risk profile as a result of the last two years, and remodel how they hold and utilise reserves to ensure their survival.

The importance of reserves in helping charities achieve sustainability is underlined by the fact that the Charity Commission’s guidance on reserves, CC19, is subtitled “building resilience”.

While some charities have found that their reserves levels have been depleted by necessity during the pandemic, all organisations face a number of new economic challenges. Factors like the cost-of-living crisis, inflation, continued Brexit uncertainty, and the war in Ukraine will both affect charities directly in terms of their own costs, and place additional pressure on their services as the needs of beneficiaries increase.

Forecasting therefore needs to be undertaken with the same rigour as at the height of the pandemic, and revisiting, monitoring, and constantly reviewing reserves policies is an integral part of this.

Why do you need a reserves policy?

The Charity Commission’s guidance hasn’t been updated since 2016 but its core principles remain pertinent. It says that reserves, which it simply defines as “the funds a charity keeps in reserve”, can strengthen a charity’s resilience in the event of, for example, drops in income or the demands of a new project.

It is important for charities to have a policy explaining their approach to reserves that is stated in the trustees’ annual report and accounts (TAR). The Commission stresses that there is “no single level or even a range of reserves that is right for all charities”. Any target set “for the level of reserves to be held, or decision that there is no need for reserves, should reflect the particular circumstances of the individual charity and be explained in the policy”.

Despite the importance of having reserves, Charity Commission research from earlier this year found that over a third of charities with income over £0.5m do not have an appropriate reserves policy, or if they do, it isn’t in the TAR. It also found that only 22% of charities’ accounts are correctly disclosing the actual reserves level.

Have reserves levels fallen?

The popular perception is of organisations dipping into their reserves as lockdowns hit – of now being the rainy day – and certainly this was the case for a significant number, as research has confirmed. The Charity Commission’s Trustee Research report, published in July 2021, found that a quarter of charities had to draw on their reserves to keep operating during COVID-19.

A more recent survey revealed that 40% of charities have been forced to spend from their reserves over the past two years.

The regulator’s submission to a House of Lords committee in September 2021 revealed that the number of registered charities with an income over £500,000, which had no or negative free reserves increased from 9% in April 2020 to 28% in July 2021.

For some charities, however, their reserves position actually improved over the pandemic because of a combination of factors such as the curtailment of activities due to lockdown measures, and the use of government support schemes.

In both situations, a fresh look at the reserves policy is important as each is problematic.

A low level of reserves could indicate that a charity is not viable in the medium- to long-term, whereas a high level could discourage funders who may think that the charity doesn’t need their help. Money from trusts and foundations is likely to be increasingly vital to many charities, but such funders undertake great scrutiny of an applicant’s reserves situation when making decisions.

Risk-based approach to reserves

Given the external environment, a traditional reserves policy of a certain number of months’ expenditure, typically three or six months, is increasingly insufficient. Charities should focus more on their individual circumstances and determine the level of reserves that is right for them.

The reserves policy should be linked to risks and opportunities, and an understanding of the level of reserves required to survive economic shocks without compromising service levels. Keeping a close eye on cash flow is also critical.

Reserves are there to help mitigate against and manage risks such as income reduction or unexpected cost rises, as well as to invest in new opportunities. Therefore, an analysis of the financial risks faced is needed to assess whether a higher level of reserves can be justified.

Factors such as how diversified income is, or how fixed the cost base, are determinants that can be reviewed to clarify how much certainty a charity has regarding future income and expenditure, and therefore what level of reserves is realistic and appropriate.

Not just about unrestricted funds

Reserves policies generally focus on unrestricted funds, which is understandable as money over which a charity has complete discretion on how to spend is invaluable if there are any surprises. But restricted and designated funds are also important and need to be considered with a policy.

For example, some income may be allocated to cover specific fixed costs, hence its restrictive element. But what if that suddenly ends? How will the shortfall be covered?

And what about the element of unrestricted funds that trustees may have set aside for future commitments? Such designated funds also need to be taken into account when determining a reserves policy.

Other considerations

Trustees may still be wedded to the model of expressing a reserves policy in terms of x months expenditure. There is a suspicion that some charities hit on three or six months, simply because everyone else does. Charities need to consider what they mean by expenditure in this context. Everything that is spent? Or the amount required to cover fixed costs, or key running costs such as salaries? There is no right answer and it will depend on an organisation’s operating model, but again, it is about being aware of a charity’s own specific requirements.

A more sophisticated reserves policy may consider a reserves range, which could be useful for charities with spikes in income. Or trustees could set short and longer-term reserves targets.

Communication

Whatever the current level of reserves, be it healthy or not, ensuring that the reserves position is explained clearly in the trustees’ annual report is very important. There may be a perfectly valid reason why the balance sheet seems to show a lot of spare cash, but if trustees can justify it in the narrative it may help clear up any misconceptions about a charity’s true chances of financial sustainability.

For the board, being clear about why and at what level they hold reserves is key as they look to balance operational needs with reporting to potential funders, and other external stakeholders including the wider public, as well as being clear internally about the true position the charity is in.

Not a one-off exercise

It is very important that charities regularly review their reserves policy and ensure it remains fit for purpose. It should also be revisited quarterly, or more frequently if circumstances change.

Conclusion

The economic climate means charities should make revisiting their reserves policy a priority, even if the pandemic has led them to do this already. Whether surplus reserves means trustees can invest in opportunities to help the charity increase its effectiveness and impact, or a lower level leaves them exposed to risks around sustainability, building resilience is vital. The degree to which a reserves policy addresses these issues is integral to this.