As federal and state governments face tighter budgets, some are reducing the amount of money they allocate to nonprofits.

This presents both opportunities and threats for community banks. In the face of declining government support, cash-strapped nonprofits are turning to local banks for commercial loans and lines of credit. However, banks that don’t recognize the fundamental differences between the nonprofit and for-profit worlds could end up suffering losses due to delinquent loans to nonprofits.

Nonprofit accounting

Most nonprofits operate under tight cash flow conditions and with very little operating surplus to withstand severe drops in funding. This can make nonprofits ideal candidates for small business financing.

There are some key differences to understand between nonprofit and for-profit accounting before lending to nonprofits:

  1. Accounting – Nonprofits use fund accounting financial statements to show how money is spent to carry out their mission, instead of how much money was earned. These are self-balancing accounts created for specific purposes, which are broken into three broad categories:
    1. Permanently restricted — Assets on which usage restrictions have been permanently imposed by the donor or by state law.
    2. Temporarily restricted — Assets on which there are donor-imposed time or purpose restrictions on the usage of the funds.
    3. Unrestricted — Assets for which there are no donor-imposed restrictions or time frames on the usage of funds.
  2. Generally accepted accounting principles (GAAP) require nonprofits to use accrual accounting when preparing financial statements. However, most small nonprofits use simpler cash-basis accounting to reflect transactions throughout the year. They can then use accrual accounting to prepare their year-end financial statements, or choose not to conform and keep statements on a cash basis.

Lending mistakes to avoid

One of the biggest mistakes many community bankers make when lending to nonprofits is not differentiating between permanently restricted, temporarily restricted and unrestricted funds. Bankers must remember that permanently and temporarily restricted funds are already earmarked for specific uses by donors or law. Therefore repayment analysis needs to be based on unrestricted funds.

Another common mistake made by bankers when lending to nonprofits is not holding them to the same high standards of financial management and reporting that for-profit companies are held to. The charitable mission of the nonprofit must be separated from the underwriting process. Financial capability of the nonprofit must be viewed on its own to make sure that the entity can repay their obligation. Also, nonprofits need to provide regular financial statements and meet loan covenants, just like a commercial enterprise would be required to do.

Either of these mistakes can lead to delinquent nonprofit loans and losses for the bank.

Proceed With Caution

Nonprofit organizations could represent a rewarding lending niche for your community bank, but make sure you understand the nuances involved before committing to nonprofit borrowers.

Please contact us at 417-881-0145 if you have more questions about lending to nonprofits. We can help you devise the right strategy for your community bank.