Ratio analysis for church loan

The posts on what ratios are important for evaluating a church loan have been combined into this page.  Why?  Posts appear in reverse chronological order.  So when an idea develops over many posts, you read them backwards on the blog.  The posts on ratio analysis are pulled together here in chronological order.  Should be easier to read.  I’ll make a few minor editing changes.  Here they are:

Numbers a lender looks at when considering a church loan – introduction

A loan officer from your bank or credit union looks carefully at your financial statements when deciding whether to give your church a loan for construction or to refinance your existing loan.  A variety of numbers will be pulled from the financial statements and compared to other numbers.  What does the loan officer look at?

I will discuss this in a series of posts.  All of the posts are combined into this one page so they are easier to read. 

I’ll describe the ratios, how they are calculated, and give an illustration.

My comments are based on talking to lenders over many years.  Every time I go to the Christian Leadership Alliance conference, I make a point to stop by and visit all of the lenders in the exhibit hall.  I usually ask about their lending criteria.

At the 2011 CLA conference, I visited with three of the big lenders to the church community.  Here is my composite description of what they consider.

There are typically three ratios a lender will look at:  debt coverage ratio, loan-to-value, debt to income. 

Here is the shorthand version for any finance readers in the audience: 

  • DCR from 1.0 to 1.25,
  • LTV 70%,
  • debt:income 3x.

Here is the description in English instead of in the foreign language spoken in the far-off land of Finance and adjacent republic of Accounting:

Debt coverage ratio – this is the amount of income that is available to make the loan payments compared to the amount of those payments.  Lenders want to make sure that churches will be able to afford the loan payments on a cash flow basis.  Will there be enough cash to cover the loan?  A perfectly reasonable concern.

The range of ratios that I heard this year ranged from 1.0 up to 1.25.  Over past years I’ve usually heard numbers in that range as well.

Loan-to-value – this is the amount of cushion the lender has if they have to take the property back.  In other words, if they get the property, will they be able to sell it for more than the loan balance?

This is usually expressed as the amount of the loan divided by the market value of the property.  Complicating this calculation is figuring out the market value.  In the last three or four years market values of all buildings have dropped dramatically.  This is where the appraisal comes into play.

The calculation:  you take the amount of the loan and divide by the appraised value of the property.  Lenders want to see a ratio of 70%.  This means that in order to get a $1,400,000 loan, the property needs to be worth $2,000,000.  That gives you a 70% ratio.  That gives them some cushion – they could take back property worth 2 million, discounted it a bit, pay for a commission and closing costs, and still have cushion to recover their loan and past due interest.

Debt to income – this is the amount of debt compared to the amount of total revenue.  Typically lenders will want to see debt no higher than three times revenue.  This means if you have $1,500,000 of total revenue, consisting of contributions and program revenue (things like retreats, special events, high school camps, and stuff) then the maximum loan would be $4,500,000.  That’s a ratio of 3 to 1.

Next post: audit or reviewed financial statements?

Numbers a lender looks at when considering a church loan – audit or review of the financial statements

Where will the loan officer get the numbers for calculating those ratios when deciding whether to give your church a loan?

That’s where those financial statements from your CPA come into play.  The loan officer will go to those financial statements for last year and pull out the numbers.

This is where the question of having an audit or review comes into the discussion.  Several years ago banks required audited financial statements for just about all loans.  That is slowing changing.

Some banks are allowing reviews for loans below a certain amount.  Some are even allowing compilations for smaller loans.

You’ll have to check with your lender for their policy.

What I am hearing is that audits are typically required for loan balances over 5 million.  Below that cut off a review of the financial statements may be sufficient.  Some lenders are even allowing a compilation report if the loan balance is below 1 million.

Ask your bank if reviewed financial statements are acceptable.  Ask your CPA to look at this question as well.  Might be worth pushing the question.  You would realize substantial savings in hard cost and staff time if you can shift from an audit to a review.

Typical cutoffs:

  • audited financial statements – loan balance over $5M
  • reviewed financial statements – loan balance under $5M
  • compiled financial statements – loan balance under $1M

Numbers a lender looks at when considering a church loan – Loan to value ratio

When considering whether to make a loan to a church, a lender will likely look at the loan to value ratio. 

In one sentence, LTV is the ratio of the balance of the loan in relation to the appraised value of the real estate that will be securing the loan.

Purpose of this ratio is to evaluate how secured the lender is in the event the loan has to be foreclosed. If the lender takes back the property, will they be able to sell it and recover their loan balance in full after paying commission and closing costs along with past due interest. 

Typically, the expected ratio is 70% or less. Go over that ratio and the lender probably won’t make the loan.

Complicating this is that some lenders are insisting that appraisers come back with a cautious or conservative appraisal number.  I’ve heard some unpleasant stories on this issue.  What this does is force a higher equity factor which essentially means you would have to have a 60% or perhaps 50% LTV if the appraisal number was closer to market.

Let’s walk through a ratio calculation. Let’s say you are on the board of directors for Example Community Church. 

In a separate post I have created some example financial statements for this series of posts.  The numbers in these posts will come from those dummy financials.  You can find the example financials here.  The numbers are added into the end of this page.

All of these examples are constructed assuming the church is trying to refinance an existing loan.

Let’s say the appraised value came in at $6,200,000.  Notice this is the appraised value, not the net book value on the financial statements.  So you will need to get an appraiser (actually I think banks are selecting the appraisers today but I’m not sure how that works), pay a bunch of money, then look at the report to see the appraised value.  The calculation goes like this:

  • 4,000,000 – loan (in this example, this is the amount being refinanced, which can be found in the financial statements)
  • 6,200,000 – appraised value (from the just-completed appraisal)
  • Divide loan by appraised value
  • 64.5% – loan to value ratio

Congratulations!  You are below the cutoff of 70%.  Your church met that ratio.  You can now look at the other ratios to see if you still qualify.

Now, let’s change the situation a bit to see where this gets messy.

Let’s say you completed your building in about 2002 or 2004 at a cost of about $5.4 or $5.6 million. Let’s say that since then the market value of property in your area has dropped by, say, 20%.  That means your church building is now worth about $4,500,000.  So let’s do that calculation again:

  • 4,000,000 – loan
  • 4,500,000 – appraised value (from the changed assumption)
  • Divide loan by appraised value
  • 88.9% – loan to value ratio

Sorry!  You are a long ways above the 70% cut off, which means the bank will not be comfortably secured if they make the loan.  They probably will not make the loan or refinance it.  Even worse, it is a very real possibility that your current lender might not renew the loan when it matures.

That is the very difficult situation that a lot of churches are in today.

Numbers a lender looks at when considering a church loan –debt to income ratio

Another thing lenders look at when evaluating whether or not to make a church loan is the ratio of debt to total income.

This calculation looks at the total long-term debt, or the loan that is being considered, and compares that to the total revenue.  This would include contributions and the various program revenue items.  If there is a school, the tuition income would probably be included. 

When I visited with lenders at the 2011 CLA conference, one of the loan officers indicated they would back out any income from a capital campaign for this calculation.  That make sense because the goal is to look at ongoing capacity to cover the loan.

The ratio mentioned by all the lenders I talked to was 3.0.  This means that total debt could not exceed three times the total revenue.  They seem to be more flexible on this ratio, with one saying this ratio isn’t as important as the others.  Several said they might be flexible and go to a ratio of 3.5:1.

Let’s see what this ratio looks like.  I will again use the made up numbers for Example Community Church.  Also assuming the church is trying to refinance an existing loan.

The numbers for this example are found here.

Here’s the calculation:

  • $4,000,000 – total loan
  • $1,500,000 – total revenue
  • Divide loan by total revenue
  • 2.67 – ratio of loan to income

Good news!  The ratios from these fictional financial statements show debt to income less than 3.0.  That would meet the test.

In this example, a loan up to $4.5 million would be acceptable for this specific test.  If the lender were willing to go to a 3.5 ratio, then a loan up to $5.25 million might be allowed.

Let’s change the details a bit in the other direction.  Let’s say that a year ago your income was $1.5 million but because of the recession, the flock at your church got hit hard and had to reduce their giving.  As a result, income dropped by 25% from last year’s amount of $1.5 million, so the current year giving is 1.12 million.  What does the ratio look like now?

  • $4,000,000 – total loan
  • $1,120,000 – total revenue
  • divide loan by total revenue
  • 3.57 – ratio of loan to income

Oops!  That is way above the 3.0 ratio and is even above the 3.5 amount.  Depending on how flexible your lender is, this could either prohibit you from getting the loan or perhaps you could still continue the conversation.

Numbers a lender looks at when considering a church loan – debt coverage ratio

This is the most technically complex ratio we will discuss.  This is one of three calculations that lenders typically use when considering whether to make a loan to a local church. 

The concept of this ratio is to look at how much income the church had last year to apply towards the loan payments.  This would take the change in net assets (okay, okay, you can call that net income if you want) then add back interest and depreciation.  This represents the income that could be applied to loan payments after all the other expenses were paid. 

This number is then divided by the total P&I payments, not just the interest expense. 

So you see it is an interesting arithmetic calculation.  The goal is to provide an indication how easily the church will be able to continue making loan payments.

So what does this calculation look like?  Let’s use our hypothetical Example Community Church financial statements, which you have seen before.  You can find them here. Numbers also included at the end of this page.

Here is information for your assumed loan:

  • 5.0% – interest rate on loan
  • 20 years – term of loan
  • $26,398 – monthly payment  
  • $316,776 – annual payments

I would calculate the debt coverage ratio this way:

  • (50,000) – change in net assets  
  • 200,000 – add back interest  
  • 150,000 – add back depreciation  
  • 300,000 – available to cover debt payments  
  • Divided by:
  • 316,776 – loan payments  
  • 0.947 – debt coverage ratio, or DCR

That means last year you did not have enough money before interest and depreciation to pay 100% of your P&I.  The built-in assumption is that this year will be the same.  That scenario makes lenders nervous.

By the way, each lender has their own way to calculate DCR.  I used the calculation that makes most sense to me as a CPA.

Each lender also has their own requirement for the debt coverage ratio.  Of the three lenders I spoke with at the CLA conference in April, one required 1.0, another required 1.1 or 1.15, and another required 1.25.  Check your loan document for the exact requirement.

So anyway, with the made-up financial statements you have seen, the debt coverage ratio is only 0.947 when a requirement would be 1.0 or higher.  Since that is barely below the requirement, it would be iffy whether you get the loan.  If the lender required 1.1 or 1.2 and preferred something even higher, then I would guess you will not get the loan.

This is a very interesting calculation.  I won’t go into the dynamics of the calculation, but will just say that it is very difficult to increase this ratio by a big factor if you fall short.  To have a big impact on this ratio, giving has to increase a lot without any increase in spending.  Sort of difficult for a church to do that after a few years of cutting back on expenses.

Numbers a lender looks at when considering a church loan – other factors

A few additional comments on stress test and cash on hand –

Stress test

One of the lenders I spoke to said they are performing a “stress test” on the debt coverage ratio with an interest rate of 7.5%.  This shows how difficult it will be for the church to handle an increase in the interest rate, if rates were to rise in the future.  This will probably make it more difficult for churches to qualify.

Let me recalculate Example Community Church’s debt coverage ratio going from 5% to 7.5%:

Here is information for repricing the loan to 7.5% for the stress test:

  • 7.5% – interest rate on loan
  • 20 years – term of loan
  • 32,224 – monthly payment  
  • 386,688 – annual payments

Debt coverage ratio

  • 300,000 – available to cover debt payments as calculated in previous post 
  • Divided by:
  • 386,688 – loan payments with repricing at 7.5%
  • 0.776 – debt coverage ratio, or DCR

The debt coverage ratio drops from 0.947 to 0.776, which is a big change.  Even if the church qualified under the initial calculation by being substantially above a 1.0 cut off, the stress test of 7.5% would drop it down a long ways.

I do not know how the particular lender incorporates the stress test into their evaluation.  But here you have a picture of what that calculation looks like.

Cash on hand

Another lender mentioned that they have added an additional calculation.  This is the amount of cash on hand.  They want to see either cash equal to three months of salary plus debt payments or cash equal to 20% of total expenses.  Ouch. 

Let’s see what this would look like using the made up financial statements of Example Community Church that you have seen here.

Cash equal to three months salary and debt:

  • 500,000 – annual salary  
  • 316,776 – annual P&I (total payments from previous post)  
  • 816,776 – total for year  
  • 245,032 – 3 months worth of salary and debt  
  • 200,000 – cash from above  
  •  (45,032) – shortfall  

Cash equal to 20% of total expenses

  • 1,550,000 – total expense  
  •    310,000 – 20% of total expenses  
  •    200,000 – cash
  •  (110,000) – shortfall  

Again, ouch. 

I would make a very wild guess that there are not many churches that would have enough cash to meet either of those calculations.  Why? Running down cash balances would likely be the very first thing to do when giving drops.  Would you rather use up your cash reserves or lay off staff?

Numbers a lender looks at when considering a church loan – final observations

This wraps up a series of posts on ratios a lender looks at when considering whether to make a loan to a church. 

Just a few more thoughts.

The recession has hurt giving levels at most churches.  The financial health of the balance sheet has suffered as well.

Meeting the debt coverage, loan-to-value, and debt to income ratios is difficult for a lot of churches.  The numbers I made up for an illustration put the church in the gray area on most of the calculations.  The made-up numbers probably reflect a church that is healthier than where most churches are today.

How your church stacks up in comparison to the ratios required by lenders is going to be a major factor in whether you can qualify for a loan.

A comment I heard from several lenders was that their institution was making loans…..to churches that qualify.  Ouch.  If you clear those three hurdles (LTV, debt:income, DCR) then they will talk.

If you know how to calculate those ratios, you can figure out for yourself what your lender will see when they look at your financial statements.

I hope that this series of posts has provided background on ratios that lenders are using and what those calculations look like.  If you need help interpreting your own financial information before you talk to a lender, call your CPA or any CPA listed at the CLA or ECFA website.

Example financial statements to illustrate financial ratios in a local church

I have started a series of posts about ratios used by lenders when considering a church loan.  Here are the financial statements I made up to illustrate the series.

A loan officer would extract data from these financial statements to evaluate whether the church is healthy enough to afford the loan.  The overall health of this fictitious example is probably slightly better than the typical church today, but that is just my guess.

Example Community Church – financial statements

Statement of financial position (a.k.a. balance sheet)

  • Assets
  •    200,000 – cash  
  •    300,000 – other assets  
  • 5,500,000 – land, building, and equipment  
  • 6,000,000 – total assets  
  • Liabilities
  •    200,000 – current liabilities  
  • 4,000,000 – long-term debt  
  • 4,200,000 – total liabilities
  • 1,800,000 – net assets
  • 6,000,000 – total liabilities and net assets 

Statement of activity (a.k.a. income statement):

  • Income
  • 1,400,000 – contributions  
  •    100,000 – other revenue  
  • 1,500,000 – total revenue  
  • Expenses
  •    500,000 – salary  
  •    200,000 – interest  
  •    300,000 – utilities and other occupancy costs  
  •    400,000 – other expenses  
  •    150,000 – depreciation  
  • 1,550,000 – total expenses
  •     (50,000) – change in net assets 

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