Borrowing to undertake capital projects can help an organization grow. But, if not done properly, it can kill one. Consider the true stories of two organizations.
University A’s strategic plan called for doubling its student population over 15 years. Marketing surveys indicated that it was at a competitive disadvantage because key student support facilities were either nonexistent or outdated. With a weak development office, it had no choice but to borrow. It issued tax-exempt bonds at favorable rates and it achieved its enrollment growth goal.
Human Services Agency B had no strategic plan. It wanted to buy a headquarters building to save on property taxes. It bought a building with three times more floor area than it had been renting with money borrowed from a bank at market rates. It expected to lose money until it was able to expand program activity, but it did not expand and eventually it was forced out of business through merger.
What can we learn from these examples? Have a plan based on market surveys or other credible information explicitly linking borrowed resources with specific outputs, and never borrow without adequate cash flow to support debt service (principal and interest).
Before you borrow, analyze the impact the new debt will have on your organization’s financial health. To make the discussion concrete, assume new borrowing is used to acquire a building. With no down payment, there will be a new asset on your balance sheet (the building) but also a new liability of equal size (the debt). A down payment reduces the borrowed principal, but it also reduces the cash on your balance sheet. Either way, there is no change in your net assets as a direct and immediate result of borrowing.
Things go down hill from here. Over the life of the loan, the value of the building on your financial statements will gradually melt away, and net assets will decrease unless the new building generates revenue or reduces expenses in excess of interest and depreciation – an accounting construct that describes how fast you are consuming, or using up, the building you just bought. This was Agency B’s problem: its new building did not help it to produce new revenue. Interest payments alone exceeded property tax savings.
If you are thinking about borrowing, it is important to understand your creditors. Before lending, they will look at the relationship between various numbers on your financial statements. This article will serve as an introduction to the techniques they use to size you up. You should analyze your situation as they would.
Your creditors’ first concern is getting their principal back, with interest, on an agreed-upon schedule. They have first claim on revenue, but they are mindful that financially strapped organizations occasionally succumb to the temptation to suspend debt service payments. You must convince them that your current cash flow is sufficient to service the debt you propose to undertake, and you have a sufficient financial cushion in case of an unforeseen reversal of fortune.
Creditors want assurance that (1) the borrower’s historical operating surplus is sufficient to support debt service and (2) the borrower has enough net assets to provide a cushion in the event of a sudden, unanticipated drop in revenue. The size of the cushion determines the borrower’s debt capacity, or the maximum amount it can borrow. This article draws upon the experiences that Standard & Poor’s (S&P) and Moody’s Investors Service have had rating the creditworthiness of nonprofit bond issuers, i.e. borrowers.
Consider debt capacity first. S&P wants the sum of unrestricted net assets and temporarily restricted net assets to be at least three months of average annual operating expenses (not counting depreciation), although it would prefer to see something in excess of six months. Another measure of debt capacity is the debt-to-equity ratio. S&P wants total debt, including the new borrowing, to be no greater than half of the sum of unrestricted net assets and temporarily restricted net assets minus the equity in physical assets, which are illiquid and unavailable to service debt should operating losses occur.
The next question is whether operating surplus will be sufficient to make principal and interest payments. S&P wants a borrower’s operating surplus plus depreciation to be at least twice its projected debt service. The multiple is called coverage. Three is good, and five is excellent. Operating income excludes donations that are permanently restricted or appear to be nonrecurring. Moody’s also excludes one-time items from expenses.
If the borrower has significant investment income, S&P includes interest income and realized capital gains on investment in the calculation of operating surplus, provided the total does not exceed the organization’s policy on spending investment income. Moody’s, on the other hand, simply counts 5 percent of an organization’s cash, investments and endowment as operating income. Moody’s Investors Service considers similar factors, but it is also very interested in the ratio of operating surplus to operating revenue, a concept called operating margin. It does not set a minimum for each factor. Median operating margins for Moody’s rated debt in categories of different investment quality varies between 0.4% and 4.1%. Median coverage ranges from 2 to 3. Median debt-to-equity ratios range from 1.5 to 0.12.
Creditors favor organizations with a strong source of earned income, such as admissions and ticket sales, that enjoy a secure market niche because they are in a good position to raise their prices to support debt service, if necessary.
Once you decide whether and how much to borrow, the next question is: borrow from a bank or issue bonds? All nonprofit organizations are able to borrow in the public bond market, but only 501(c)(3)s can team up with state and local governments to issue bonds that are exempt from federal income taxes. The bonds can be secured either with a physical asset, revenues generated by the project, or simply the “full faith and credit” of the issuer. In any case, 501(c)(3)s can achieve substantial savings in interest costs. Under current market conditions savings are unusually modest, but they are likely to improve as market rates rise, as most experts expect.
There are issuance costs associated with bond transactions so, if the principal is less than a few million dollars, selling bonds in the public market is not likely to be cost-effective. A private placement (when one investor buys all of the bonds) or a bank loan is likely to be more efficient, although interest payments on bank loans are not tax-exempt, and therefore bank rates are higher.
When it comes to taking on new debt, endowed 501(c)(3)s have a tremendous advantage. Not only do they have a prodigious debt capacity, they can actually make money by going into debt. To illustrate: assume a 501(c)(3) has $100 million in unrestricted net assets, $7 million in cash and short-term investments, and it wants to build a $3 million building. It could pay cash but, if it issued tax-exempt bonds, it would earn a higher market rate on its investments than it would pay on its bonded indebtedness. A difference of one percentage point over 20 years would generate a net cash flow of $167,000 a year.
This example assumes fixed rate bonds, much like a conventional mortgage. Although it is possible to issue bonds at variable interest rates, this is probably unwise under current conditions because rates are at historic lows. They are more likely to go up than down.
Allowable purposes for tax-exempt debt are: capital expenditure projects, reimbursing prior capital expenditures, refinancing of prior debt, and working capital. These purposes can be combined in one issue. Proceeds can reimburse money spent before they were issued only if the issuer adopts a resolution officially expressing its intent to reimburse such expenditures, and feasibility studies can be expensive. An “official intent” resolution does not obligate an organization to undertake the specified project, so adopting one should be the first order of business when thinking about a capital expenditure project.
The Dos and Don’ts of borrowing are simple. Do not borrow to finance budget deficits. Do not borrow unless you have a clear understanding of your growth potential and how debt will help you fulfill that potential. Never borrow to finance operating deficits. Do not borrow unless you have adequate capacity, you can service the debt, and it will strengthen your balance sheet. Do issue tax exempt bonds if you are a 501(c)(3), and if the principal is large enough.
Woods Bowman is Associate Professor of Public Service Management at DePaul University in Chicago . He is also a member of the National Center on Nonprofit Enterprise’s Research Advisory Network.