A model recession
May 2009
Charles Nall’s mathematical model on the relationship between development spending and reserves requirements
Mr Micawber famously (and pre-decimally) observed ‘Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.’ For charities the equivalent stricture is that happiness is a sufficient structural surplus on general funds. This article explains why and sets out a mathematical model to explore this in today’s economic climate.
The view expressed in this article is deliberately simplistic and is only a starting point. The principles and the model can be endlessly refined.
The initial premise
Surpluses of income over expenditure are necessary and cumulate into reserves. However, it is general funds surpluses that are crucial because they can be used as the charity sees fit to advance its objectives, providing a degree of autonomy.
When risks and opportunities crystallise, general funds are unrestricted in their ability to meet the costs of an effective response. In what follows, therefore, surpluses refer to surpluses on the general fund and reserves are general fund reserves. Specifically, the term reserves refers to general fund net liquid assets since, as many have recently re-discovered, it is dangerous to depend either on the liquidity of property or on the availability of debt.
The generally understood point is that surpluses provide both a short-term financial cushion and flexibility, and an important source of long term financial security for a charity. When setting an appropriate reserves target for a charity the trustees assess risks – both those we know of and can quantify and those that we can’t.
Modelling reserve requirements for year on year variations in income and expenditure is generally well understood and is not explored further here – see www.cfdg.org.uk for CFDG’s presentations on reserves policy.
Charities also face Donald Rumsfeld’s ‘unknown unknowns’ – the tsunami event that can wipe organisations out. These are often systemic – affecting all organisations or large sub-sectors – and usually predictable to some degree (with hindsight). Crucially, they also effect all or very large amounts of an organisation’s activities. At The Children’s Society, rabid inflation of the late 1970s and early 1980s affected all our activities’ costs. Plus, changing attitudes to illegitimacy and single parenthood since the 1950’s along with the scientific advance of the contraceptive pill eliminated much of the need to provide children’s homes, our original core activity.
The longer a charity’s time horizon, for instance endowments and long term work with beneficiaries, the more likely it is that a systemic event will endanger the beneficiaries. The Children’s Society’s past trustees, staff and volunteers carry in their heads a substantial slice of our organisation’s 128 year history. As a rule of thumb, we assume such events occur every twenty years and that they require the equivalent of six months gross expenditure to support children and adjust our operations to the new environment.
Though it is unfashionable to do so, expressing required reserves as a proportion of annual spend, as in ‘six months expenditure’, is entirely appropriate to a systemic risk that is difficult to quantify. The Children’s Society’s reserves target of six to nine months general fund net liquid assets should allow us to adjust to systemic events on a timescale that is appropriate to traumatised children.
Because of the long-term nature of these systemic ‘tsunami’ risks, reserves to cover these events should be earning a capital (as well as an income) return to maintain their value relative to inflation.
Given that charities are rarely large enough to tackle all the beneficiary need that they are focused on, charities generally aim to grow so as to meet more of that need. Charities seek more future development spending. Growth also means that a charity’s reserves must grow in line with activity if the activities’ risk profile and the trustees’ risk appetite (on behalf of their beneficiaries) stay the same. Though this is often under- appreciated, it is obviously expensive to grow reserves in line with rapid activity growth where reserves’ levels need to be relatively high. Although investment growth can mitigate these costs, reserving needs are a potentially heavy constraint on development spending.
So, a surplus has three purposes. The first is to fund short-term opportunity and risk, the second is to fund development spending and the third is to augment reserves where the investment returns are insufficient.
The model
The model set out in figure 1 below might look a little daunting, but is a useful tool for finance professionals.
The model assumes that restricted income and expenditure are perfectly matched in the year, so the surplus is always a surplus on general funds. Development spending is assumed to create income in a later year than those considered here. In creating your own model, you will need to think carefully about assumptions implicit in the model – e.g. the consistency of risk and growth characteristics within components of aggregates for your charity.
The model can be refined to suit the individual organisation. For instance, if your charity runs contract services that are not critical to beneficiary welfare, then a transition period to soften closure is not necessary – there should be little effect on the charity’s reputation. Accordingly, part of the reserves requirement for shutting that activity might be based on the redundancy bill and lease obligations. Part of the reserves requirement for growing the activity might be its working capital needs and some annual provision for accumulating redundancy liabilities. The overall model can be built up from distinct business subsidiary calculations.
Insights from the model
Though you didn’t need a model to tell you this, the first lesson is that charities must avoid consistent general fund deficits. These are disastrous as they trigger a vicious cycle. Development spending is unfunded and reserves’ investment returns are unlikely to meet the need for reserves growth, so reserves shrink relative to expenditure and often in absolute terms too. As reserves shrink, so does the opportunity to invest in income generation as an alternative to steep cuts in activity. Ultimately, this path means development spending must be reversed and core activity is endangered.
If your charity is fortunate enough to still have supposedly excessive general fund liquid reserves, the key need is to control expenditure whilst searching for opportunities to boost the charity’s rate of general fund income growth because only general fund income gives you the flexibility to eliminate the deficit and return to surplus and thus to put new development activity on a sustainable footing. Given the consolidating fundraising market, also consider the option of combining your reserves with a more successful fundraising brand charity as outlined below.
Currently and prospectively, many charities face tightening funding on their contract activity, pushing many into restricted funds deficit and so into overall deficit on general funds, wiping out scope for service enhancement and new developments. It is vital that such charities’ reserves policies and income strategies take this likelihood into account. Ensuring reserves are invested securely to be available when needed is vital. Avoid Icelandic banks.
Charities at breakeven have the same imperative to grow income since, unless income growth is greater than expenditure growth, they slip into riskier territory on their required reserving level and development spending eventually becomes unsustainable. Expenditure needs to be reined back for a year or two to allow a healthy general fund surplus to arise.
In this case, where general fund reserves are very low against the required level, an unpalatable choice is forced upon the trustees between tolerating the risks of running unsustainable activities and the undesirable option of cutting beneficiary provision.
For charities with low reserves and little general fund income, cutting expenditure is not going to create a useful general fund surplus. This is an unsustainable basis. Service quality and/or volume must react very rapidly to changes in the funding environment. Ultimately, the future of the charity needs to be considered carefully by its trustees.
These latter two groups of charities are going to be at risk in this recession as local authorities’ trading income dries up, squeezing discretionary grants and service contracts.
As mentioned above, having general fund fixed assets, perhaps owning your land and buildings, will be a crucial advantage as this would provide the funding to facilitate a merger with an established charity with an effective fundraising brand. The combined charity then releases cash from the fixed assets into reserves and maximises the chances of earning a general fund income (fundraising) return in the consolidating fundraising market, so protecting future development spending. Be careful – if the supposedly branded charity has a high proportion of contract income and relatively low fundraising margins (for example a large retail operation), your property may only postpone the inevitable as the same pressures come to bear on the combined charity.
Charities with a large structural surplus are in a virtuous circle. They can add to their reserves and develop their work and income streams. They can run a riskier but potentially higher return investment policy that, in the longer term, may free up the use of their surplus for development funds and/or even higher income growth rates and yet more development spend. This needs to be accompanied by a strong investment committee so that boom does not turn to bust on all fronts in a recession.
The economic outlook – deflation, then inflation?
Nearly everyone is agreed on the basic problem in the UK economy: it is excessively indebted and that is exacerbated by its dependence on financial services. Government measures will have only a palliative effect, vital though that it is, unless debt is reduced. This is likely to be painful, so the immediate outlook may well be deflation. Cost inflation will ebb away to very little for charities and income may fall. This recession is likely to be deep enough to warrant the description of an exceptional systemic event. Trustees will face a difficult judgement about how much of their finite reserves operations can consume in any particular year given that the recession may be lengthy.
The problem with deflation and weak economic growth is that it favours nominal assets that bear little interest (bonds) whilst real assets tend to perform poorly (equities, property). This scenario also means weak wider income growth. In this scenario cost control is the absolute essential discipline (along with cash management) to generate development funds. The goal of reserves management is to not lose money, rather than make money (there is unlikely to be a ‘rising tide that lifts all boats’).
There is an economic upturn scenario where debt ebbs away and savings are not encouraged so that increased earnings are directed to spending. This is economic growth with inflation. Given the current damage to the economy’s production base, the titanic monetary and fiscal easing occurring is likely to mean a hefty dose of moderate inflation in the medium term.
The problem for charities with inflation is that income tends to lag economic growth, so cost pressures mount distressingly quickly. However, after the initial shock of inflation, the economy adapts and the prices of real assets take off sharply (many older readers will remember the boom in house prices in the 1970s) as nominal incomes rise rapidly. The trick is to catch this wave of asset price growth and use excess reserves to boost income growth rates to match or exceed inflation and so boost sustainable activity and available development funds. Simply spending finite reserves on direct activity is a road to ruin in these circumstances.
On a longer-term view, the governor of the Bank of England famously marked that the UK had seen a ‘nice’ decade. The nice decade (and a half) finally ended in September 2008. The next decade is probably going to be far bumpier with shorter periods of growth of perhaps two or three years. Structural surpluses will have to be larger whilst reserves are rebuilt and to cushion operations from unexceptional deficits arising in historically unexceptional recessions. This will reduce future development funds.
Conclusion: a model – so what?
The insights and comments above do not need a model to arrive at them. A good dose of common sense and patience to go through individual worked examples with ‘real’ number
scenarios can do this.
What is the benefit of a model then? A model is simply a faster way of working through those examples. It requires a set of explicit inter-relationships between a set of key factors. It therefore requires more rigorous thought and explanation to allow these to be identified and formulated. Even if those relationships cannot be modelled, understanding should be improved to better inform a ‘common sense and intuition’ approach.
A model can be extended into multiple years, and changes in variables can be tested within a run of years. The latter is particularly important given the possibility of a deep recession followed by a bout of relatively high inflation.
A vital lesson from the credit crunch is to test scenarios where everything goes wrong at once and to test for where, either individually or collectively, some things go very wrong indeed. Similarly, stating the assumptions clearly allows risks within the model’s methodology to be identified.
The particular benefit of this model is that it helps link the current environment to activity, risk (reserves) and that ever so valuable commodity, resources for future development.
Author: Charles Nall
Charles Nall is corporate services director at The Children’s Society and chair of the Charity Finance Directors’ Group.
There are no comments on this article. Be the first to comment.