For-profit businesses aren’t the only organizations that can find themselves in need of a loan. Nonprofits also may land in situations that call for relatively quick cash. If your organization is in such a spot, 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’s generally not a concern with donations or grants, assuming you meet the performance obligations.
Other hurdles include having to pay interest. And rates for nonprofits tend to be higher than those for businesses, as the loans are considered riskier since nonprofits often don’t have comparable financial resources. The fees associated with certain loans — for example, appraisals, closing costs and attorneys’ fees — pile up quickly, and you may be required to make a significant down payment.
On the other hand, once you’re approved for a loan from a reputable lender, you know you’ll get the funds. And applying for a loan generally requires less time and effort than applying for grants, holding fundraising events or wooing major donors. You’ll usually get the money sooner, too.
Right — and wrong — times to borrow
Many nonprofits operate in environments where revenues peak and dip throughout the year. Many bills and expenses don’t match up to this cycle, though, which can lead to cash flow crunches. For example, nonprofits often see a big jump in donations around year end 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 less predictably. A previously reliable funding source might dry up with little to no notice. Or a natural disaster could hit at a time when cash reserves are low. 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 new building. You may intend to finance the project with a capital campaign. However, campaigns can take longer than anticipated, and pledges might not materialize. 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’ve 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 aren’t the answer to every cash gap. If you’ve been running a budget deficit for several periods, adding debt usually isn’t advisable. Even if you can obtain a loan, the interest rate likely will be quite high. You’re generally better off trimming expenses and raising revenues.
To increase your odds of securing a loan, collect necessary information before reaching out to lenders. This also will expedite the 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 on hand information 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.
The types of information required to obtain a loan demonstrate how important it is for nonprofits to maintain accurate records and prudently manage financial resources. These practices are critical for every organization, but you’ll be glad to have followed them consistently if your nonprofit ever needs to borrow.
3 financial ratios lenders evaluate
Credible lenders will review at least three financial ratios when determining whether to make your organization a loan. Following 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’s the collateral for the loan with the loan amount. Because loans to nonprofits 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. Nonprofits 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’re requesting compared with your total revenue. Lenders generally frown on nonprofit DTI ratios showing the new loan greater than 3.0 to 3.5 times annual revenues.