By: Don Meyer, Manager
For a non-profit organization to go into debt is a mistake!
How is that for the start of a message about Mid-Continent’s debt situation? This is the last topic in the series suggested by Stan Searing in his guest blog several weeks ago. We have now dabbled in such issues as the master site plan, flood plain restrictions, the ideal board member, and steam power. Debt service, being the least attractive topic of this series, was saved for last.
Mid-Continent carries four loans. The first is a mortgage, the second our line of credit, third is the amount due the owner of the Saginaw Timber Company No. 2, and fourth is the loan from the SBA to fund our flood recovery efforts. All reflect a financial need which we were ill prepared to meet using any other funding source. I say funding because a loan is not revenue. It is a liability, which is why I began this message by calling it a mistake.
A for-profit business would see no problem with these loans. They routinely finance their operations, particularly their capital improvements, through the use of debt. The rationale is that the money will be invested in a project that will generate revenue at a higher rate than the expense of repaying the loan. Therefore the net result is a gain for them.
For-profit businesses have the added advantage of tax incentives designed to encourage them to invest by borrowing. The interest on their payment is a deductible expense as is the depreciation on any capital asset created as part of this investment. All of this can be used to reduce their income, which results in a lower tax liability.
A non-profit organization is exempt from paying tax so the incentives intended to benefit a for-profit business do not apply to us. In fact the monthly payments on any loan become what economists might call an opportunity cost, meaning that these payments rob us of the opportunity to use the money for other purposes.
We have our own funding advantage, however. It is in our ability to generate revenue through donations, making debt the funding source of last resort. Non-profits use this strategy all the time when it comes to new construction. And Mid-Continent has used it effectively with its restoration projects.
Despite our recent successes, however, the reason we are in debt is directly related to prior decisions or omissions about how to finance capital projects. We chose to construct new buildings with debt, hence we have a mortgage. Financing a capital project this way was no doubt the fastest way to raise the funds needed for a major project but it was also a concession that 1) operations could not generate enough revenue to cover capital costs, and 2) the museum’s leadership was not willing to engage in fund raising activities in order to avoid the consequences of incurring long-term debt.
This second point is the most disappointing admission to make since capital campaigns are generally one of the easiest causes for which you can solicit donations. People are more easily motivated to fund something with a tangible result, especially if their names can be attached to it in some way as a legacy of their involvement with the organization and its mission. By comparison, seeking donations to pay off a loan is next to impossible.
Our predicament with the Saginaw Timber Company No. 2 is comparable with our need for having a mortgage on our buildings. A locomotive is essentially a building on wheels when it comes to the high cost of making capital improvements; the overhaul or rebuild that keeps it in active service. The desired strategy for financing the repair of an existing asset is to follow the discipline of setting aside a portion of the revenue the asset (in this case our locomotive) generates each year while it is running. The money is then held in reserve in order to make those future repairs that will significantly extend its useful life.
We can estimate the amount we should deposit into this reserve account through an accounting technique called depreciation. But the enticement to spend on something of a more immediate purpose often defeats the best of intentions. At Mid-Continent we find ourselves in a situation where our steam program lacks such a cash reserve. So in the case of the STCO No. 2 we must now abide by a court-ordered stipulation that we payback the owner for his expenditures in returning the locomotive to operating condition. And this in turn means recognizing a debt equal to the cost of the repairs.
The line of credit is simply a financing tool to get us through the lean times, such as the winter and early spring months, when we are not generating any revenue. In our business cycle these months do see significant costs being incurred as we make repairs to our track and equipment in preparation for the new season. To cover these costs we draw on the line in anticipation that ticket and gift shop sales during the summer will be sufficient to repay the loan before the end of the fiscal year. Again this requires some discipline to ensure that the loan gets repaid on a timely basis. But at least it is a short-term process with less chance of money being diverted for a more immediate need.
The loan from the Small Business Administration is a case apart from our other loans. It would not exist had it not been for the 2008 flood. The extent of the damage was beyond our means to finance the magnitude of the repairs in any other way. For although our goal was to gain the support of FEMA to fund the repairs, they required us to apply for a SBA loan first, then they would consider funding any shortfall that existed after all of our other sources of revenue (the loan, donations and insurance proceeds) were expended on making those repairs.
I do not believe that we could have avoided incurring this debt. The extent of the damage was simply too great. But I do believe we could have taken prior steps that would have allowed us to cover more of these costs ourselves and minimized our dependence on an outside agency for support. Using depreciation to create a cash reserve to fund repairs to our buildings and equipment would have helped. Increasing the amount of our insurance coverage would have been another act of wisdom, but such a step would also have increased our short-term expenses, which is why we avoided this option. And finally having developed a larger donor base would have prompted more support in the way of charitable donations made in response to the catastrophe. As it was we did benefit from peoples’ care of our museum with gifts to our flood recovery efforts that exceeded our expectations during the challenges of a troubled economy. A broader base could have produced an even better result.
The impact of all of this on our cash flow is substantial. The mortgage and the SBA loan are paid back in monthly installments with a combined draw on our general fund of about $3,500 per month. When there is an outstanding balance on the line of credit, we pay back the principal based on our ability to pay. Otherwise interest is due on a monthly basis. And the amount due the owner of the STCO No. 2 has no payment schedule, but simple interest is accruing annually, increasing the size of the debt the longer it remains unpaid.
Our debt load right now is about $821,000. This is not a cause for alarm among the folks who issued our loans. They know from our financial records and history of performance that we have the ability to pay even if we are only able to generate revenue at our usual pace. The obvious challenge to Mid-Continent’s current leadership is to do better than usual, which takes us back to the urgent need to create a board of directors capable of generating revenue sufficient to retire our debt load while addressing the competing demands on our funds for such things as the steam program, tapping into municipal water and sewer, restoring our collection, constructing new buildings to house the collection and upgrading the existing infrastructure.
Financial management is not for the faint of heart. It does require a disciplined approach by a leadership team that can work in unison in achieving a costly, long-term solution. Patience becomes a necessary virtue if we are to fully eliminate our debts. And the good fortune of avoiding any further disasters would be an added blessing. Donations will have to carry the load of funding our capital projects while the general fund continues to bear the burden of making those loan payments.
A debt free existence is a possibility and one that should remain a guiding principal for anyone who is tasked with leading this organization forward.
