When to Draw the Line: A Guide to Use and Abuse of Credit

A line of credit (LOC) is a valuable resource for most nonprofits that can serve as a lifeline while awaiting contract or grant payments. At the same time, misusing a line of credit is akin to playing with fire.
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A line of credit (LOC) is a valuable resource for most nonprofits. It can serve as a lifeline that allows organizations to continue delivering vital services while awaiting contract or grant payments. In some cases, an LOC can literally keep the lights on during periods of low liquidity. The need for an LOC stems from unevenly matched inflows and outflows of cash over the course of a year. Even organizations that budget properly and achieve year-end surpluses may need to access a line of credit occasionally to fund payroll, rent, and other critical expenses.

At the same time, misusing a line of credit is akin to playing with fire. Management must understand the risks as well as the benefits of drawing on and maintaining an LOC.

What are the benefits of an LOC?

If you have ever managed the finances of any organization, or even your own personal finances, you can appreciate how difficult it is to match up cash inflows and outflows. It is not unusual for a nonprofit to incur substantial upfront expenses associated with delivering services that are ultimately funded by a third party, such as a government agency or a foundation. The challenge here is the lag in between the expense on the front-end and the promised corresponding funding that may take weeks or even months to come.

An LOC is a lender's attempt to address these challenges. When used appropriately, an LOC can help solve the timing problem by allowing an organization to borrow based on funding that is due and collectible. For example, NonprofitTheater's performance season starts in October. To fund the season's launch, NonprofitTheater hosts a gala in June, during which it often receives pledges that are not actually paid in cash until August or September. An LOC enables NonprofitTheater to draw the necessary funds to pay for certain pre-production operating expenses and repay the line with the gala proceeds.


An LOC is a loan agreement with a financial institution whereby the borrower is entitled to draw funds up to a pre-established maximum amount. Borrowings may be restricted by factors such as the size of a borrower's accounts receivable or grant commitments. For example, NonprofitHealth has a $2 million LOC and current receivables of $1 million. Its borrowings cannot exceed 75% of current accounts or grants receivable which, in this case, is $750,000. NonprofitHealth will be entitled to larger draws on the line as its receivables increase, but its total outstanding balance will be capped at $2 million. NonprofitHealth may also be required to produce monthly accounts receivable aging reports or copies of grant award letters so that its lender can ensure compliance with the terms of the line.

An LOC can be revolving, which means that a borrower can repay and re-borrow funds over time, or non-revolving, which means that once borrowed amounts are repaid, they cannot be re-borrowed. The borrower pays interest on the amounts borrowed, and may also be required to pay a non-use fee. A typical non-use fee is 0.5% of the undrawn funds, and is charged by a lender as compensation for keeping these funds available to the borrower. LOCs typically include a clean-up provision, or a requirement for a borrower to pay down the line to a zero or some other minimum balance for 30 consecutive days each year.

Is an LOC right for my organization?

To determine whether or not an LOC is the right way to meet your organization's funding needs, ask yourself (or your finance director) the following question: if we had access to a line of credit, would we use it to support temporary cash flow needs? Only if the answer is YES is an LOC right for you. This is because line of credit borrowings are NEVER the ultimate funding source - they are always a temporary source of funding, in that they are ultimately repaid with cash inflows from some future grant, contract, or other payment.

To appropriately manage an LOC, your nonprofit should prepare monthly or weekly cash flow forecasts and revise them over time. Identify not only the points at which the organization will need cash to fund vital expenses, but the points at which cash inflows will allow it to pay down outstanding balances. No draw should be made without knowing when the funds will be repaid and with which grant payment or contractual reimbursement.

When not to use a line: operating deficit

Let's examine the all-too-common scenario of a nonprofit who struggles to achieve surpluses. NonprofitShelter achieves excellent results from its programs, has a small but adequate staff, and maintains good cost control. However, the organization has incurred deficits in four of the past five years. Now, there is no easy solution to NonprofitShelter's problems. In order to repair the financial health of the organization, management will need to make adjustments that may include staffing, programmatic, or other changes, to bring expenses in-line with revenue.
Is an LOC the right solution for NonprofitShelter's troubles? As you may have guessed, the answer is no. Obtaining a new LOC or drawing down on an existing one would shoulder NonprofitShelter with an administrative burden, not to mention added interest expense, all of which is a distraction from the real and vital need for management to correct the root cause of its deficit. The cardinal rule for borrowing on an LOC is that the organization's need for capital must be a temporary one. Until management changes the way it manages its limited resources, NonprofitShelter's need for capital is a permanent one.

We should note that a nonprofit may intentionally incur an operating deficit. If an organization is contemplating a large-scale change, such as expansion into a different program area or geography, sustaining a deficit might be a necessary step along the way. Though the organization may have to rely on some source of outside funding during this period, such as a grant or a loan, an LOC is not the appropriate solution. In fact, an LOC, even a long-term one, is only appropriate if the organization is confident that the resulting strategic change will produce sufficient income to service the debt and repay it before maturity. Given the risk and uncertainty that will accompany such a significant change, a nonprofit should seek grant funding or perhaps a loan that is forgiven if certain program benchmarks are met.

When not to use a line: capital expenditures

Let's now turn our attention to NonprofitChildcare, an organization that is taking on a construction project. NonprofitChildcare has an LOC which it utilizes to fund operating expenses. When it comes time to finance construction, NonprofitChildcare draws down on its LOC, even though it is only supposed to use its line to support operating (not capital) needs. Shortly after construction is complete, one of the agency's contract payments is delayed. Unfortunately, NonprofitChildcare drew the full amount of its line of credit to fund construction and cannot make any additional draws. Management is now in a difficult situation in which it must delay rent and payroll expenses until more cash becomes available. Furthermore, NonprofitChildcare has violated the trust of its lender by utilizing LOC proceeds to fund capital rather than operating expenses.

The crucial mistake that NonprofitChildcare made was assuming that any loan, even an LOC, would be appropriate in meeting the financing needs of its construction project. A construction loan would have been a much better fit, as these loans are typically interest-only for a preliminary period and then amortize according to a set schedule until maturity. Such a loan would have allowed NonprofitChildcare to service its debt on a schedule better aligned with its ability to realize the monetary benefits of its expanded facility. Just as an LOC is designed to meet short-term cash flow needs, a construction loan is structured in a way that enables an organization to complete a project with borrowed funds and repay with funds generated during a future period.

What is a nonprofit to do?

Here are some helpful tips that can guide you along the way to obtaining and utilizing an LOC:

Prepare a baseline monthly cash flow forecast based on reasonable, conservative assumptions. Then, prepare alternative versions of the baseline scenario, assuming that funding falls short of expectations, with regard to dollar amount, timing, or both. This will shed light on how and when you would use the line under various circumstances.

Seek advice from the board of directors to understand if they have experience managing LOCs in their own businesses, whether for-profit or not-for-profit.

Reach out to peers to understand whether their use of an LOC facilitated or hampered their success. The best lessons to be learned are ones from the field.

  • Build a relationship with a lender you can trust and maintain open communication to ensure that you are using the line appropriately.
  • Check with your lender before taking on any additional debt, as you may be required to obtain consent before doing so.
  • Look before you leap

    A nonprofit's capital needs are complex and ever-changing. Too often, an agency will take on indebtedness first and worry about repayments and reporting requirements later. This may later force management's focus away from its core mission and towards damage control. In a worse-case scenario, the nonprofit may even have to cut valuable programs and services in order to meet its loan obligations and continue as a viable going concern. Debt is a serious responsibility, and no organization should enter into a loan agreement without a deep and thorough understanding of the debt obligation.

    In summary:

    • A line of credit should only be drawn to support temporary cash flow needs.
  • A line of credit is right for organizations that would benefit from drawing on a line of credit at discrete and predictable points in time during a given year.
  • This post first appeared in the New York Nonprofit Press.

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