One of the biggest keys to financial stability for nonprofit organizations is budgeting. Creating and approving an annual budget is fundamental to financially managing a nonprofit.
The annual budget will serve as a blueprint for your organization’s financial activity in the coming year. Because circumstances will change throughout the year, your budget must be flexible enough to change with them. In this sense, your budget is a guide that can help you plan for the financial future, as well as assess your current financial health.
Nonprofit budgets should be built around each organization’s specific programs and activities and support the organization’s overall mission. Effective budgeting will give the board and management more control over the organization’s finances—for example, by allowing them to limit certain expenses if necessary and take steps to boost income if a cash shortfall is anticipated.
By monitoring the budget closely, the board and management can move funds around as necessary for more efficient allocation.
Seven Steps to Budgeting
The budgeting process begins at least three months before the end of the fiscal year. This allows time for it to be approved by the board of directors before the start of the new year. Following are the steps involved in creating a nonprofit organization budget.
Step #1: Set goals. These include goals for the overall organization as well as specific programs. This will give you a starting point for determining how much revenue you’ll need to generate to reach these goals.
Step #2: Assess your current financial situation. Review your current year income and expenses and compare them to last year’s budget. Analyze any variances so you understand them and can adjust going forward.
Step #3: Make forecasts. Use last year’s budget as a starting point for your financial forecasts. Determine whether you expect income and expenses to rise, fall, or remain about the same in the upcoming year and plan for seasonal fluctuations in both income and expenses. Anticipate when you expect to receive major donations and incur large expenses.
Step #4: Build in contingencies. Plan for the unexpected by building contingency amounts into your annual budget to cover unplanned events that may require funding. Also make sure you understand the true operating costs of your program services—including administrative expenses—and budget for these.
Step #5: Develop and review a draft budget. Make sure the draft meets your organizational and program goals. Review and question all assumptions and adjust as needed to bring income and expenses into alignment.
Step #6: Finalize the budget and obtain approval. The finance and audit committees should review the budget, and it should be separate from the budget committee to avoid conflicts of interest. Final budget approval should come from the board of directors.
Step #7: Implement the budget. Document your assumptions and create a consolidated budget spreadsheet and file. Incorporate the budget into your accounting system, assign management financial responsibilities, and implement a system for monitoring the budget and making adjustments as needed.
Note: Capital expenditures and fixed assets aren’t included in an annual budget. Therefore, it’s a good idea to prepare a separate capex budget to account for these large expenses so you have the capital needed when it’s time to purchase them.
Budgeting and Cash Reserves
Some reports have indicated that many nonprofit organizations have less than three months of cash on hand, and just a minority of nonprofits have more than six months of cash reserves. As you work on your annual budget, also think about how much operating reserves your organization should have set aside.
An operating or cash reserve is a portion of net assets that is unrestricted and relatively liquid. Operating reserves for nonprofits are usually built using unrestricted contributions or investment income—not endowments—temporarily restricted funds, or non-liquid fixed assets.
One rule of thumb is to maintain enough cash reserves to cover between three and six months of operating expenses. However, each organization must determine the right level of reserves based on the risks they face in terms of donor stability and unexpected large outlays. Given its fiduciary oversight role to ensure the organization’s financial sustainability, the board of directors usually determines the amount and purpose of cash reserves.
The board might establish an operating reserve to continue program services if a longtime corporate donor withdraws support. Other potential uses for cash reserves might be to develop an endowment, fund future construction projects, or simply have cash on hand in case of a “rainy day.” For example, healthy operating reserves allowed some nonprofits to stay afloat even after donations dried up during the COVID-19 pandemic.
Your board might consider the following when adopting a policy for building and using an operating reserve:
- What is the minimum balance above which the reserve should be kept?
- What specific circumstances will warrant tapping the reserve?
- What process will be followed in determining when and if the reserves will be tapped?
- How (and how quickly) will reserves be replenished after they’ve been tapped?
- What kinds of restrictions or limitations (if any) should be placed on the use of reserve funds?
Cash reserve funds should be kept in a low-risk, highly liquid account so they can be accessed quickly and easily if needed, such as a bank or credit union savings account. Make sure your institution is an FDIC-insured bank or NCUA-insured credit union. The first $250,000 on deposit at these institutions will be insured against loss.
Prepare Now
Now is a good time to think about creating a budget for next year. Gather your financial information and documents, including last year’s budget, and sit down with your executive team to begin the process. This way, you’ll be prepared when budgeting season hits full stride later in the year.
Please contact our Nonprofit Group if you have any questions about nonprofit budgeting.