A significant cash reserve might be indicative of prudent management at a nonprofit, or it could reveal a lack of investment expertise.
We have already discussed the proper usage of stocks and bonds by charitable organizations.
This is the ninth piece in a series inspired by our soon-to-be-released book Good Practices for Handling Money for Non-Profit Organizations, and it deals with the usage of cash.
When a charity does not have a budget or has a poorly prepared budget, the tendency is to maintain the majority of its assets in cash to satisfy short-term financial demands.
Donors should be wary of any organization whose yearly reports reveal a sizable financial reserve.
Is the high amount of cash these organizations hold due to a lack of smart investment strategy on their part, or is it a deliberate attempt to stave off inevitable expenditures?
Having a big amount of cash on hand is detrimental to financial success since interest earned on cash is the lowest of any investment option.
The many forms of debt and the need of maintaining a healthy cash balance
Charities have two types of obligations, and both require consistent funding.
The first is money spent on things directly linked to philanthropic purposes, such as grants to artists or other worthy individuals, scholarship and award money, and supplies and materials for education. Such costs are quite particular and vary widely depending on the charity’s mission.
The second type of obligations that nonprofits must meet are administrative expenses. Trustees’ fees, travel, rent, payroll, yearly audit, and fundraising charges all fall under this category of obligations.
Nonetheless, there are three situations in which a strong cash position on the balance sheet is preferable for nonprofits.
One possibility is that they are putting aside funds for the purchase of investment assets that are difficult to quickly convert into cash. A good example is a charity that is very close to closing on the purchase of a piece of real estate. The charity may gradually grow its financial reserves in the lead up to the acquisition in order to cover the payment.
It’s possible that nonprofits are boosting their financial reserves in preparation for a large withdrawal demand from a private equity fund in which they’ve already committed.
Maintaining a sizable financial reserve is essential for charities to finance anticipated expenditures.
To add to this, nonprofits have the ability to save up money for future investment opportunities. They keep an eye out for prospective and major market occurrences, which will help them to capitalize on investment opportunities when they arise. For example, nonprofits may capitalize on falling bond prices after an interest rate increase or on falling share prices of target companies after a failed or aborted corporate acquisition.
Thirdly, charities can utilize their cash reserves as an investing instrument if they are large enough. Short-term deposits with high interest rates, which pay more than long-term bonds, might help them maximize rewards while minimizing risks. These deposits might last for a single day, a week, or even three months.
Currency carry trading is a high-stakes gamble
While it is normal practice for investors to have funds in foreign currencies, charities with sizable foreign currency cash positions on their balance sheets should be questioned by authorities and potential contributors. Do the nonprofits’ overseas currency holdings serve to pay down debts denominated in that currency or to purchase investment assets in that currency?
It’s unfortunate but common that investors may try to gain from rising interest rates in a foreign currency, a risky bet that might go horribly wrong.
Donors should stay away from organizations that store funds in foreign currencies in order to earn more interest since this demonstrates an inexperienced approach to investing.
Think about it. As compared to the return on a domestic cash deposit with the same length, which is just 1% per year, an investor may be enticed to maintain a portion of his cash holdings in a foreign currency cash deposit that carries an annual interest rate of 10%.
They believe they may earn a profit using a strategy known as the carry trade, which takes advantage of the disparity in interest rates. Whenever the deposit matures in foreign currency, they would be able to withdraw the interest earned as well as the original amount and convert it to their own currency.
More attractive interest rates can be found in currencies issued by rising economies as opposed to those of more industrialized nations.
Yet as the 2008 financial crisis demonstrated, carry trades are not risk-free. Many people who had money invested in the currencies of Iceland, Southeast Asia, and Africa had a large portion of their wealth evaporate as a result of the sharp declines in value of those currencies during periods of market volatility.
Read more: Who Wins the Market: The Swift or the Smart?
For instance, many businesses, banks, and investors looked to the carry trade between the high-yielding Indonesian rupiah and the low-yielding US dollar as a means of reducing costs or increasing profits before the onset of the Asian Financial Crisis in 1997 and 1998. They did this because they believed the two currencies’ exchange rate to be steady.
When the global financial crisis worsened, the value of the rupiah plummeted against the dollar, resulting in huge losses for investors engaging in carry trades.
Given the precarious nature of the carry trade, potential benefactors and charity authorities should assess the charity’s approach to managing currency risk.
A budget that spans many years is helpful for running things smoothly
When it comes to risk management, a charity’s investment committee should create a long-term financial plan to ensure the organization can pay for both anticipated and unforeseen costs.
The goal is to account for as many potential costs as possible so that investment money may be managed effectively. This will allow the charity’s investment arm to save up enough money to meet unexpected costs. Secondly, the investment managers will be able to better organize investments to match assets and obligations if they have an understanding of the charity’s future cash flow needs.
If the charity’s investment department understands that it will need to pay for its annual report and audit in May, for instance, it may prepare accordingly. Similarly, if the organization is aware that every five years it must pay for an expensive refurbishment of an orphanage, it will purchase bonds with a maturity that corresponds to this expense.
The board of directors, rather than the investment committee, should be in charge of creating and approving the charity’s multi-year financial budget.
The investment committee’s responsibility is to ensure that the charity always has access to sufficient funds by keeping a close eye on the correctness of this budget.
Certainly, regular communication between the investment division and the division responsible for costs will aid the performance of both units.