The Importance of Cash Reserves

Don’t Sideline Your Future to Make Ends Meet Today

Private companies and larger city governments have long maintained cash reserves as part of sound fiscal management. But small- and medium-sized towns and municipalities have often relied too heavily on a general reserve fund intended to cover any contingency, across departments, rather than establishing specific reserve funds for specific purposes. Such an approach can be more than a little short-sighted, particularly when it comes to the infrastructure deficit currently facing most water systems in North America — the difference between the amount a community should invest in asset renewal and what it actually spends, leading to deterioration over the long term.  

Cash reserves are funds that are set aside for varying purposes. They can be restricted by legal covenant for a specific purpose, unrestricted for general operating use, or set up in a way that falls somewhere in between. Setting aside funds for specific uses is a time-tested risk mitigation strategy and demonstrates an intent to be a prudent steward of a community’s water system and supply.

Yet there are few commonly accepted guidelines and best practices to help municipal water utilities establish cash reserve policies. If you, like so many of your peers, don’t already have established reserves, you’re probably wondering where you should start. What kind of cash reserves should you consider? What are communities similar to yours doing and how do their systems compare to yours?

Those are all good questions but there are no simple answers. All systems are different and each faces unique challenges, so they must be analyzed on a case-by-case basis. The cash reserves that will serve your organization best will depend a great deal on your organizational goals and priorities, so defining those should be your first step. The next step is to review some of the most common reserve types and ways to maximize the advantages of each to best address those priorities.

But first it’s a good idea to explore the purpose of cash reserves in general, as well as some of the challenges around setting them up. If your water utility has not established sound, formal reserve policies, what follows may help you understand why that is – and why changing it should be a priority.  


Why Cash Reserves Are Important

There are several types of cash reserves that serve a variety of purposes. We’ll cover those in more detail in a future white paper but generally speaking, reserves are important because they serve to meet a utility’s need for the financial management of a certain level of assets, help with cash flow issues and allow the utility to prepare for a number of contingencies. These include operating reserves that address:

  •  revenue losses due to fluctuations in demand or lower than normal sales;
  • cash shortfalls resulting from payables due before receivables arrive; and,
  • unplanned or emergency operating expenses.

In addition, capital reserves address contingencies specific to capital projects, such as funding;

  • a specific project (either all or a portion), such as replacing a treatment plant;
  • long-term infrastructure rehabilitation and replacement; or,
  • emergency infrastructure repairs.

Debt service reserves, designated by a borrower to ensure full and timely payments to creditors, are also important. Debt service reserves support the costs associated with borrowing and help maintain a good credit rating.

There are multiple benefits from establishing and maintaining healthy cash reserves but the following are probably the top four.

     1. Reserves help the utility move toward financial self-sufficiency and sustainability, making them less dependent on the community’s general reserves for unplanned and emergency expenses.

     2. They can help prevent the need for rate hikes in response to those unplanned or emergency expenses, providing customers with rate stability.

     3. Cash reserves can positively impact the utility’s credit rating, which in turn will help make it easier to secure debt financing while reducing the associated costs.

     4. And finally, cash reserves can reduce, and sometimes even eliminate, the need to borrow in the first place, allowing the utility to use debt more strategically – and more affordably.


Why Are Cash Reserves So Challenging?

Water utilities are expected to provide reliable, uninterrupted service with virtually no margin for error, and this in spite of aging infrastructure and volatile revenue streams. 

As infrastructure ages, unplanned and expensive emergency repairs become almost inevitable. In addition to these unexpected costs, water utility revenues are impacted by climate and usage variations. As a result, most water utilities struggle with insufficient funding, resulting in budget shortfalls when unexpected costs or cost overruns occur, which in turn leads to the postponement of important – and necessary – infrastructure renewal. The clearest evidence of this is the huge infrastructure deficit facing a large number of communities across North America – a deficit that is approaching crisis-level for many communities.

With all this uncertainty, the strategic use of cash reserves can play an important role in providing financial resilience and in moving communities toward sustainable management of their water systems.

But the reality is that many communities continue to struggle year after year without any established cash reserve policy. There are several obstacles that contribute to the difficulty these communities face when it comes to instituting cash reserves, including:

  • Organizational Silos: Multiple departments – i.e. planning, engineering, public works, and finance – need to break out of their silos and work together in addressing complex topics such as cash reserve policies.  

  • Ad-Hoc Practices: Scrambling to implement an ad-hoc funding plan when an emergency happens will address that single expense but will leave the future uncertain.

  • Short Sightedness: Elected officials focused on the next election can be hard to convince when it comes to improving the long-term financial sustainability of water services, especially if those efforts involve rate increases.

  • Informal, Status-Quo Practices: Even when a status-quo practice for establishing reserves does exist, it’s often based simply on the transfer of surplus revenue into a general reserve fund – when and if there is any – after operational and maintenance costs are covered. This kind of status quo practice often leads to an inadequately funded and overtaxed general reserve.

  • Political Interference: Raiding reserves for unrelated projects is far too common – and rarely a good idea. 


Reprioritizing Cash Reserves

The ability to pay for both improving aging infrastructure and unplanned repairs, as well as to react to volatile revenues, are critical issues for the modern water system manager. An adequately funded cash reserve policy will improve the utility’s ability to better respond to revenue fluctuations (see: Wanting To Increase Your Fixed Revenue Does Not Make You A Bad Person), respond to emergencies and natural disasters, schedule long-term infrastructure replacement and capital projects, and schedule manageable, incremental rate increases. 

Reserve requirements and policies will vary greatly across the industry based on many factors, including whether a utility will be best served by a single reserve policy, intended to account for every contingency, or multiple reserves and reserve policies for separate and specific purposes.

These are questions only you, your staff, and your council, commission, or board can answer – and we’ll help with that in a future white paper. But if you’re scrambling so hard to make ends meet today that your future plans are being sidelined, establishing healthy cash reserves will help put you on the path to financial sustainability.

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