When should a not-for-profit consider borrowing?
Because of the uncertainty of contributions and limited collateral, many commercial lenders are reluctant to provide loans to not-for-profit organizations. As a result, many never consider borrowing as a part of their financial strategy. But there are a number of cases in which a not-for-profit would benefit greatly from borrowing. The following lists a few scenarios in which not-for-profits should consider borrowing:
- To finance the purchase of equipment (e.g., a new computer system, office furniture and equipment or a vehicle), especially if the new asset will help to generate future cash flows.
- To finance the remodeling, construction, or purchase of a new building. Commercial banks will often make short-term loans to organizations to help finance such purchases during the construction phase or while waiting to collect on pledges made to a capital campaign.
- To cover operating costs during a brief gap while the organization is waiting to receive funding or during a “valley” in the cash flow projection for the year. Not-for-profits often use revolving lines of credit established at local banks for this kind of funding.
How do not-for-profits obtain loans?
In order for a not-for-profit to obtain a loan, it is important for management to understand what it takes to qualify. Lending institutions have the same lending criteria for not-for-profit organizations as for any other commercial borrower. They require that repayment is assured through a reliable source of funding. Lending institutions often look for the following criteria when considering loan applications:
- A track record of borrowing
- Significant, predictable, recurring funding from federal, state, or foundation grants
- A predictable earned revenue stream
- Major pledges from reputable donors
- Board members who are willing to guarantee (co-sign) a loan
- The consistent ability to meet accounts payable and payroll obligations on a timely basis
- Professional management and record keeping, including reviewed or audited financial statements
- A good cash flow model
Be sure to understand the debt covenants
Many lending institutions ask you to provide quarterly or annual income statements, balance sheets, and tax returns. Some loans will require covenants—promises that your organization will meet certain tests in the future. They may require a certain positive cash flow, a certain debt-to-cash-flow ratio, or other financial criteria. During a downturn in your industry or the economy, your organization may face temporary cash flow or profit shortages.
Prior to signing on the dotted line, it is very important there is a clear understanding of the terms and conditions contained in the loan documents. Otherwise, if the organization falls short, your bank may say the organization is in default. Default triggers numerous penalties, and it may require repayment of the loan immediately. Different lenders require different conditions, so ask the lender up front what conditions or covenants apply.
Financial reports offer lender clues
Consider the impact a sudden downturn in the economy or another crisis would have. Will you still be able to comply with those covenants? As you read through the financial reports, is there anything that would concern you as a prospective lender? Do your financial statements paint a true picture of strong fiscal management? If not, it is management’s duty to ensure these weaknesses are addressed.
If your organization has a lending relationship, periodically review compliance with loan and other legal covenants. Lack of compliance can cause a lender to withdraw future credit, leading to a significant cash crisis. For auditing purposes, the organization must require a waiver letter from the bank as evidence that the bank will not call back the loan immediately. Otherwise, the non-current portion of term loan has to be classified as a term loan if a waiver letter was not obtained after the organization has breached its debt covenant.
When there is a legitimate need for it, the use of debt can allow not-for-profit organizations to function more smoothly and not be as reliant upon the timing of its cash flows.
Maxine G. Romano can be reached at Email or 215.441.4600.