Communications

There is certainly a variety of debt service coverage (DSC) ratios in the financial services industry. Even so, they all have a common objective, which is to measure whether a commercial business generated sufficient profit to pay its interest-bearing debt service...or is projected to do so.

The numerator in a DSC ratio defines profit available to pay interest expense and repay long-term debt as scheduled. The denominator defines interest-bearing debt service as the sum of interest expense and scheduled long-term debt repayment. The differences in DSC ratios are confined generally to a) the definition of profit available to pay debt service and b) a highly subjective risk factor requiring profit available to pay debt service be, for example, 1.25 times as great as actual or projected debt service.

Distributions are a case in point in defining profit available to pay debt service. If they are included as operating expenses, regardless of their GAAP classification, it drives down the DSC ratio. Further, the greater the risk factor, which should theoretically vary by individual borrower, the greater the required profit available to pay debt service.

Assuming a borrower meets the required DSC ratio, however defined, what does it really tell us? Since the focus is on profit, it tells us that the borrower generated sufficient profit - or will do so - to pay its interest-bearing debt service. Profit, however, refers to accrual profit since virtually all credit worthy borrowers keep their books on an accrual, and not on a cash, basis. In effect, a DSC ratio honored by a borrower tells us that the borrower has the capacity to pay its debt service if and when all revenue included in the ratio's numerator is collected in cash and all expenses in the ratio's numerator are paid for in cash. And keep in mind that cash collection and cash payment may span multiple time periods.

In effect, a DSC ratio is a debt capacity ratio. It does not measure whether a borrower actually paid for its debt service. It measures whether it has, or will have, the capacity to do so. Rather, it is the FASB 95 statement of cash flows or the Uniform Credit Analysis (UCA) cash flow statement that identify actual payment from operating cash flow and not from accrual profit.

The moral of the story, however, is that DSC ratios and actual operating cash flow statements work in tandem. Every lender wants to assure its borrowers have the capacity to service their interest-bearing debt, the task of the DSC ratio. And every lender needs to know why or why not its borrowers generated sufficient operating cash flow to pay their debt service, which is the task of an actual operating cash flow statement.

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Today's accounting software invariably assures that all accounting entries balance and that the accounting equation is honored before the company bookkeeper may exit the system. Consequently, the reliability of company-prepared financial statements increases in step with the increased use and application of checks and balances in accounting software. There is certainly some comfort in this positive trend since a properly prepared set of accrual financial statements is the best source document for thorough and comprehensive credit analysis.

In general, there are a few accounts that call for close attention in reviewing a set of company-prepared financial statements. It is always prudent to check the following:

• Allowance for Doubtful Accounts. It should change from year to year as the company records bad debt expense as well as adjusts the balance for accounts receivable it writes off in the period.
• Inventory. A big jump in inventory may reflect planned buying decisions on the part of the company or it may reflect a failure to transfer some inventory to cost of goods sold in applying the matching principle.
• Prepaid Expenses. A stable or increasing balance may reflect prepayment for services to be used later or it may reflect failure to account for prepaid expenses used up in the operating period.
• Accumulated Depreciation. Since depreciation expense is a non-cash charge, it is easy to overlook and fail to record properly in closing the books for the year.
• Accumulated Amortization. Same issue. Amortization is a non-cash charge and it, too, is easy to overlook at year end.

Note that all these accounts have an impact on reported profitability. A failure to report a bad debt expense results in an understatement of operating expenses and an overstatement of net profit. A failure to transfer inventory to cost of goods sold results in an understatement of cost of goods sold and an overstatement of net profit. A failure to account for prepaid expenses used up in the operating period results in an understatement of operating expenses and an overstatement of net profit. A failure to account for all depreciation expense results in an understatement of cost of goods sold or operating expenses - depending on how the fixed assets are used - and an overstatement of net profit. Finally, a failure to account for all amortization expense results in an understatement of operating expenses and an overstatement of net profit.

It is always wise to know your borrower. It is also wise to know your borrower's bookkeeper and understand how he or she closes the books for the year.

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On Thursday, December 7th, Shockproof! Training conducts a webinar on Analytical Focus in the Credit Write-Up, which is recorded and available for use for a limited time in lieu of the live presentation on December 7th.

Over the recent past, two trends in commercial credit training have emerged. One is the use of recordings in place of live presentations. The other is segmentation of recordings into smaller bites that roll up into a completed presentation at the conclusion of the multiple micro leaning sessions.

For example, the recording of Analytical Focus in the Credit Write-Up runs about 90 minutes in addressing the four steps in the exercise. The recording can be divided into four parts.

Part 1 / Step 1 runs about 25 minutes, includes two poll questions that participants answer as they arise, and identifies the four essential analytical issues that must be examined and resolved for every credit request. In a "grab and go" world, a busy analyst or lender learns about the four essential issues and their importance in less than half an hour.

Part 2 / Step 2 picks up where Part 1 left off in the recording. It runs roughly 25 minutes, includes one poll question, and identifies the four essential issues for the commercial borrower used as the webinar's case study. It does so by reference to analytical reports attached to the exercise. Busy analysts and lenders now learn how to read and interpret projected financial results, including a projected Uniform Credit Analysis (UCA) cash flow statement.

And so on for Part 3 / Step 3 and for Part 4 / Step 4. The Part 3 / Step 3 micro learning session runs roughly 15 minutes, includes one poll question, and addresses the importance of the Business Drivers in explaining the accrual and cash flow performance of a borrower. The final Part 4 / Step 4 micro learning session also runs about 15 minutes, includes two poll questions, and identifies whether cash flow proxies, such as traditional "cash flow" or an actual cash flow statement, such as the UCA cash flow statement, is the better metric to identify the four essential issues.

In effect, four micro learning sessions roll up into one complete webinar on the proper analytical focus - what, why, and how - required for every credit write-up. The sum does indeed equal the whole of its parts using a recorded live webinar and all the course materials routinely provided with live presentations...and at times and dates decided by the financial institution.

If you would like more information about Analytical Focus in the Credit Write-Up, about any of our other 26 single-topic Webinars, or about any of our six Credit College Courses, please call us at 1-866-237-7228 or send us an email at inquiry@shockproof.com. If you wish, you may review the description of all single-topic Webinars and Credit College Courses on our Products page.

Please note that all single topic Webinars and each session in the Credit College Courses are recorded and available for use and review, should participants prefer the flexibility of on-demand sessions and webinars.

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