It's tough to build and manage a rainy day fund when it's drizzling outside. But maintaining adequate operating reserves is essential to the health of every nonprofit. As the economy improves and revenues increase, nonprofit leaders must focus on building--or rebuilding--their organizations' reserves.

If you've been forced to dip into your reserves recently, you're not alone. According to a 2011 survey conducted by the Nonprofit Finance Fund, 28 percent of respondents had less than 30 days of cash on hand and another 32 percent had less than 90 days of cash available. The Minnesota Council of Nonprofits found that almost a quarter of its survey respondents planned to tap their reserves in 2010 to meet basic operating costs.

The ideal reserve depends on an organization's unique qualities, including its operating structure, sources of funding and types of expenses. But most experts agree that a minimum of three months' cash helps mitigate the risk of budget shortfalls and unexpected events.

Some nonprofits need greater reserves--say six months' or one year's worth--and a smaller percentage may be safe with less. Generally speaking, the more predictable and steady a nonprofit's cash flow, the less that's needed in reserve. To determine the optimal amount, however, talk to a financial advisor familiar with your organization.

Accessibility Is Everything

As most executives probably learned during the recent economic crisis, reserves must be easily accessible and unrestricted if they're to be effective in emergencies. Program-specific donations and grants aren't much help when a nonprofit needs to pay the office lease or make payroll.

To increase unrestricted revenue, educate donors about the flexibility of such gifts. Although some will insist on targeting their dollars, many are likely to respond when they learn that unrestricted donations can be more valuable than those with strings attached.

Foundation and government grant makers traditionally have been reluctant to give unrestricted funds. But according to several recent studies, many are increasing the proportion of grant money available for general operating support, including relaxing restrictions on current program grants. So consider asking grant providers if they can relax restrictions on funds they're currently providing, and start looking for grants with looser restrictions.

Accessibility is just as important. Avoid any type of investment that might restrict or penalize withdrawal of funds on short notice, such as equity investments or certificates of deposit. Instead, look for the highest interest-earning checking, savings or money-market account, or possibly U.S. Treasury bills or short-term bond funds. Organizations with a significant reserve should consider hiring a professional money manager.

Define ‘Need'

One of the most difficult aspects of managing reserves is knowing when to tap them. Removing cash to address operational shortfalls, or when expenses exceed income, is usually justified. Even if a nonprofit runs efficiently and typically sticks to its budget, unplanned events such as natural disasters or economic crises can throw a wrench in the works.

But take care that such withdrawals don't become routine. If you're dipping into reserve funds every month to pay ordinary expenses, it's time to reevaluate the budget and find ways to cut costs.

Reserves aren't just a rainy day fund, though. Many organizations use them to seize opportunities, expand programs and services, and even improve access to credit. Prudence is essential when using reserves proactively. Nonprofit boards should define reasonable uses of reserves and outline the evaluation and approval process for specific proposals.

When to Stop?

Excess reserves sounds like an enviable problem to nonprofits just struggling to meet expenses, but it is possible to sock away too much for a rainy day. These funds typically earn minimal interest and can almost certainly be better "invested" elsewhere--whether that's earning returns for a long-term endowment, helping to expand services or providing greater donor or membership benefits.

Charity watchdog groups take an especially dim view of what they consider excessive reserves, which can negatively affect how they rate a nonprofit, and, in turn, how the public perceives its effectiveness. Of course, what constitutes "excessive" depends on the organization. But keeping several years' worth of expenses on hand certainly merits scrutiny.

Although the economy is only slowly recovering from the recent crisis, now is the time to think about how to rebuild reserves that have likely eroded over the past few years. This may require additional belt-tightening and a reassessment of organizational priorities. But it will all be worth the trouble when you're in a tight spot and need the cash.

Michael Borowitz is a shareholder in the not-for-profit group of accounting firm Clark Schaefer Hackett. He can be reached at (614) 885-2208 or mborowitz@cshco.com.

Reprinted from the January 2012 issue of Columbus C.E.O. Copyright © Columbus C.E.O.