Look Before You Leap: Key Considerations When Seeking Loans
For-profit businesses are not the only organizations that can find themselves in need of a loan. Not-for-profit organizations often face cash flow issues due to budgetary restraints that call for relatively quick cash. If your organization faces similar situations, consider the decision to borrow carefully.
Loans vs. other funding sources
The primary drawback to a loan is that you must pay it back. That is generally not a concern with donations or grants, assuming you meet the performance obligations.
Other hurdles include having to pay interest. Unfortunately for not-for-profits, rates tend to be higher than those for businesses, as the loans are considered riskier since not-for-profits often do not have comparable financial resources. The fees associated with certain loans — for example, appraisals, closing costs and attorneys’ fees — pile up quickly, and your organization may be required to make a significant down payment.
On the other hand, once you are approved for a loan from a reputable lender, you know you will receive the funds. Additionally, applying for a loan generally requires less time and effort than applying for grants, holding fundraising events or soliciting major donors. You will usually receive the money in a more timely manner as well.
Right — and wrong — times to borrow
Many not-for-profits operate in environments where revenue is not generated consistently throughout the year. Many bills and expenses do not match up to this cycle, however, which can lead to cash flow crunches. For example, not-for-profits often see a big jump in donations around major fundraising events or receive grants in lump sums. A revolving line of credit may be the type of loan to provide needed liquidity in these situations.
Cash flow issues also can arise in an unpredictable fashion. A previously reliable funding source might dry up with little to no notice. Or, a large unforeseen expenditure may arise that was not accounted for in the organization’s budget. In such circumstances, you may want to consider a bridge loan, typically lasting no longer than one year. Bridge loans are used to fill a funding gap until more permanent financing is secured or a financial obligation is satisfied.
Longer-term loans can be an option for capital purchases (for example, equipment or facilities upgrades) or projects such as a major renovation or purchase of a new building. You may intend to finance the project with a capital campaign. However, campaigns can take longer than anticipated, and pledges might fall through. A loan can help you avoid delays as the project progresses.
Similarly, you can come across mission- or operations-related opportunities that require prompt action. Perhaps office space you have had your eye on suddenly becomes available, or you encounter an attractive strategic opportunity. Loans may prove the only way to bring such possibilities to fruition.
Of course, loans are not the answer to every cash gap. If you have been running a budget deficit for several periods, adding debt usually is not advisable. Even if you can obtain a loan, the interest rate likely will be quite high. You are generally better off cutting expenses and soliciting more donations to raise revenues.
If your organization determines that obtaining a loan is the best option, there are several questions you should be prepared to answer, as well as several pieces of documentation you should obtain before reaching out to lenders. This also will expedite the application process.
Lenders generally want to see:
- Plans for the loan proceeds;
- Several years of tax filings and audited financial statements;
- Reports of pledges, receivables, accounts payable and outstanding debt;
- Descriptions of major funding sources; and
- A board resolution approving the loan.
Additionally, you may also need to have information on hand about your organization’s history (including articles of incorporation and bylaws), short- and long-term strategic plans, programs, funding, management and the board of directors. Finally, prepare cash flow projections showing a repayment plan.
Do not wait
Both the types of information and amount of information required to obtain a loan demonstrate how important it is for not-for-profits to maintain accurate records and prudently manage financial resources. These practices are critical for every organization, but you will be glad to have followed them consistently if your organization ever needs to borrow.
Sidebar: Three financial ratios lenders evaluate
Credible lenders will review several financial ratios when determining whether to make your organization a loan. The three ratios noted below are the most common:
- The loan-to-value (LTV) ratio is often used when financing a capital asset. It compares the value of the property that is the collateral for the loan with the loan amount. Because loans to not-for-profits are viewed as higher risk (especially in the absence of a loan guarantor), lenders usually require an LTV ratio of 70% or lower.
- The debt coverage ratio (DCR) measures the cash flow available to service the proposed debt. It compares the available operating income with the new debt, including principal and interest payments. Not-for-profits are more likely to qualify for a loan if their DCR is at least 1.20.
- The debt-to-income (DTI) ratio is an easy representation of the loan amount you are requesting compared with your total revenue. Lenders generally frown on not-for-profit DTI ratios showing the new loan greater than 3.0 to 3.5 times annual revenues.
For more information, contact Dan Omahen at firstname.lastname@example.org or 312.670.7444. Visit ORBA.com to learn more about our Not-For-Profit Group.