I continue to see and hear about issues that our clients and others in the nonprofit industry are having with their lenders with respect to financial statements. It is becoming more evident that many lenders do not understand nonprofit financial statements due to their unique financial reporting requirements. Below are the top 5 issues that nonprofits have with their lenders.
- Understanding the business
- Determining appropriate financial covenants
- Understanding expenses
- Endowments and net asset restrictions
- Changes to nonprofit accounting standards
Understanding the business
Not all nonprofits operate in the same manner. In fact, I would argue that there is more variety in the nonprofit industry than in any other industry. There are nonprofits that have manufacturing operations, others that rely solely on grants, private foundations, hospitals, homeless shelters, churches, etc. The list is extensive, as are the programs and nature of every nonprofit’s operations. If a nonprofit is donor-driven to fund operations, a banker should not treat them the same as an organization that relies on fees-for-service, or as one that relies on sales. As a result of understanding what keeps a nonprofit’s lights on, a lender can then better understand the lending risk, and better design financial covenants.
Determining appropriate financial covenants
Many nonprofit organizations have the same financial covenants on their debt as for-profit entities. This is not necessarily a bad thing in the proper circumstances, but should be evaluated. Take for example a nonprofit that has significant assets including a large endowment and a liquid investment portfolio. They are extremely reliant on market performance and donations to cover operating costs, but they have significant reserves for down market years. If a lender was to assign any cash flow (based on net profit) driven covenant to this nonprofit, they would almost certainly be in default if there was a down-year in the investment market (investment losses and substandard contributions). Even with a sufficient surplus of liquid assets to cover debt service obligations, this organization could unnecessarily be in default. A better option for a nonprofit such as this would be a liquidity-based financial covenant.
Another common issue when discussing nonprofit financial statements with lenders is the simple lack of understanding of how to read nonprofit financial statements. For example, if there is a covenant calculation that uses the change in net assets (bottom line) before depreciation, amortization and interest, I have seen instances where those expenses were not added back to the calculation. Often on nonprofit financial statements, if there is a statement of functional expenses, many expense line items are not itemized on the statement of activities (profit and loss equivalent). Instead they are either presented in a separate schedule of functional expenses or disclosed in a footnote. Lenders should go through training to understand where all of the relevant information is documented to evaluate the financial standing of a nonprofit.
Endowments and net asset restrictions
Another piece of financial information that untrained lenders may not understand is restrictions on assets. There are currently 3 classifications of net assets: permanently, temporarily, and unrestricted net assets. Obviously, unrestricted net assets can be used to meet debt obligations, but donor designated endowment funds (permanently restricted) must be managed prudently to last in perpetuity, which most likely means they cannot be used to meet debt obligations. Temporarily restricted net assets most likely cannot be used to meet debt obligations unless the donor has designated that they be used for that purpose. Footnote disclosures provide lenders and other users of the financial statements with details regarding the restrictions of an organization’s funds.
Changes to accounting standards
There are numerous accounting standards that must be adopted over the next 3 years that will have a significant impact on covenant calculations and nonprofit financial reporting. First, there are new nonprofit reporting standards (Accounting Standards Update (ASU) 2014-16) that will change how net assets are reported, how expenses are reported and allocated, how investment income is disclosed, and require certain liquidity disclosures that may be informative to lenders. Next, leases greater than twelve months will have to go on the balance sheet with ASU 2016-02. This will put a capital lease asset and liability on the statement of financial position (balance sheet). This could significantly impact financial covenants. There are also significant changes coming to revenue recognition (Topic 606). Lastly, all entities should have adopted ASU 2015-03 which simplifies the presentation of debt issuance costs. With this adoption, debt issuance cost is no longer presented as an asset, but is now netted with the debt liability. Also, amortization of these costs is now required to be included in interest expense.
It would be helpful for more nonprofits to have joint meetings with their lenders and CPAs to discuss their financial situation as well as debt structure and related financial covenants to ensure all parties are in the best situation to help each other.