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Monday, September 22, 2014

Financing Nonprofit Growth, Part 4: The Balance Sheet

This is part 4 of our series on financing nonprofit growth. You can see the first three articles below:
We last left off with Fun Finance struggling to find a way to convince its Board of Directors to approve a plan for borrowing $1.5 million to finance costs associated with building the infrastructure to scale.  In order to discuss next steps, we need to take a moment to briefly review what a balance sheet is.

The Balance Sheet
A balance sheet is a financial statement that summarizes a company's assets and liabilities: what it owns and what it owes.  On one side of the balance sheet are the company's assets, and on the other side are its liabilites.  For a for profit, the balance sheet follows a simple formula: Assets = Liabilities + Shareholders' Equity.  Because a nonprofit doesn't have equity, the formula is even simpler: Assets = Liabilities

Types of Assets
There are two asset types or classes (information from Investopedia):
  1. Current assets, which include cash, inventory and accounts receivable (e.g., services for which you are waiting to get paid.  The primary feature of current assets are that they "may be converted into cash, sold or consumed within a year or less."
  2. Long-term assets, which include buildings and land, patents and investments "that management does not expect to sell within the year."
Liabilities are also broken out into current liabilities--those that are due within one year--and long term liabilities--those that are due in more than a year.  Liabilities can include a variety of monies owed, including debt, contracts to be paid, wages owed, taxes and even lawsuits.

Great!  Let's examine Fun Finance's balance sheet and start to identify the issues.

On the asset side, the value of their loan portfolio is $500,000, and they have another $250,000 in assets in the form of accounts receivable and cash.

On the liabilities side, they have borrowed $450,000 for lending and another $50,000 to support heir operations, for a total of $500,000.  Remember, for nonprofits Assets = Liabilities, so for now everything is copacetic; the balance sheet balances out.

Now watch what happens when Fun Finance goes out to raise $2 million. As we saw before, they are going to raise $500K of that in the form of grants, which increases their Assets to $1 million.  But once they assume $1.5 million in debt for operating, their liabilities soar to $2 million!  Of course, the idea is that with the investment they're going to make in people and systems they'll be able to significantly ramp up their lending, and therefore the value of their loan pool; still, that loan capital has to come from somewhere.  If Fun Finance borrowers another $5 million for lending and turns that into $5.35 million in terms of the value of the loan portfolio (given a margin of 7% on the loans), the new balance sheet still looks bad:

Total Assets [Loan portfolio ($500,000 + $5.35 million) + Cash ($250,000 + $500,000)] = $6,500,000

Liabilities [($450,000 + $50,000 + $1.5 million + $5 million)] = $7 million

Notice that the net assets are now negative $500,000!  Granted, it is expected that high growth companies will have negative burn rates (spend more than they earn) for several years while they ramp up and make investments, so long as those investments lead to positive cash flow and returns for the investors in the future.

In the next post we'll talk about how a high-volume, low-margin business can become profitable!

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