Instructor Blog

Q: How would the UCA snapshot calculation be different if they use cash basis accounting? Would it simply not include the changes to the ARs and APs? 

A: The UCA basically changes the income statement from accrual to cash accounting, thus you do not need to convert each operating account to cash using their counterpart accounts if you already have a 100% cash-based P & L to complete a full UCA cash flow. Thus, in a cash based scenario, a UCA snapshot is of little use. Note if you wanted to use a snapshot, then all of the operating accounts, not merely A/R and A/P should already be reflected on a cash basis on the financial statements; however, depreciation (which can often be lacking or misrepresented since cash-based financial statement are not GAAP compliant) on a cash based statement, would need to be added back on UCA snapshot. 

The full UCA cash flow statement identifies the cash amount for all revenue and expenses reported on the accrual income statement, thus a cash-based income statement will provide those amounts. On a full UCA, begin with the Cash based income number, then make the adjustments for Distributions and Loans to Owners to arrive at Net Cash after Operations.  Business Cash Income is the cash counterpart to accrual net income after adjustments for Loans and Distributions. On a long form UCA an adjustment for Interest Expense is needed to arrive at Business Cash Income. 

The full long form UCA goes further than the snapshot adding value to your cash flow analysis.  It determines if there is sufficient cash flow to pay down long-term debt as scheduled. It identifies the amount of cash spent on fixed assets and other long- term investments. It identifies a financing requirement for the year. It identifies the sources of cash to meet the financing requirement. If the statement is properly constructed, the calculated change in cash - the financing requirement less the financing - will equal the change in cash from the company's accrual balance sheet.

Notes: Most borrowers are not pure cash businesses. Cash based financials are not GAAP compliant. Beware, sometimes you may see depreciation included and sometimes it may be excluded. Depreciation would be an add back if using a UCA snapshot. 

If the business is not a 100% cash business or if you only have a cash-basis federal tax return and no financial statements, a critical first step is to get the underlying accrual financial statements from the borrower. If they are showing A/Rs and A/Ps, then you know they are not a pure cash business.  The accrual financials exist, since every borrower will keep track of receivables (unless it’s a pure cash business), inventory levels (if the borrower has inventory), and payables and accruals (unless, again, it’s a purely cash business).

Course overview: Cash Flow Analysis and Borrowing Causes

Q: What is the best way to determine the line of credit need for a growing C&I business?

A: In a two-part webinar that we offer, we address the issue of projections - Projections and Repayment Sources: Parts I and II - which comes down to projecting the performance ratios for the Business Drivers. The Business Drivers set both the cash and accrual position of a borrower. They are as follows:

1. Sales Growth
2. The Gross Margin
3. SG&A% or Operating Expenses as % of Sales
4. The Owner Payout Rate
5. Accounts Receivable Days
6. Inventory Days
7. Accounts Payable Days
8. Fixed Asset Spending as % of Sales

The eight Business Drivers apply to some borrowers, such as a distributor or manufacturer, while far fewer would apply to a real estate investment company, e.g., Sales Growth in the form of a change in the Occupancy Rate, Operating Expenses as % of Sales or Effective Gross Income, and Rents and Deposits Due relative to Effective Gross Income.

The attached Credit Refresher on Forecast Assumptions and Cash Flow provides more detail. Note that the starting point for projections is always the last actual values for the Business Driver Performance Ratios. We change them only if there is a compelling reason to do so.

Looking for compelling reasons brings management into the picture to provide its input on likely changes. In addition, we assess the competitive forces at work in the borrower's market and determine if they are sufficiently strong to force change in one of more of the Performance Ratios. That issue is addressed in the other attached Credit Refresher on Competitive Forces and Cash Flow.

The projected credit line is then the existing line plus the cumulative cash impact of the changes in a) the Gross Margin, b) Operating Expenses as % of Sales, c) the Owner Payout Rate, d) Accounts Receivable Days, e) Inventory Days, and e) Accounts Payable Days. If this cumulative change is a cash outflow, the line increases by the amount of the change - and vice versa.

We emphasize, too, that this whole projection process is a very rough guess at best. But the process of thinking through all these issues can be very helpful to both the lender and the borrower.

All sessions, including these two, are available via 30-day recording.

Course overview: Projections and Repayment Sources

Q: At our institution, the way we do our Global Cash Flow is to use Fritz Schumacher’s Cash after Personal Debt service of $1.77MM (on slide 27) and add that Business Cash Flow to get $3.13MM as it was on slide 33. However, it was recommended to use the “Ready cash total” from personal assets of $272.7M on slide 36 rather than personal cash flow of $1.77MM. We feel that this may be flawed because we view cash flow and cash on hand separately. Cash flow is typically recurring and the cash on hand could be gone at any point. Can you please explain more why we would use the “Ready cash total” from the PFS rather than cash flow?

For example, we are working on a deal that does not cover using the borrower and guarantors global cash flow. However, we have $15MM in verified liquid assets. If we were to use your logic and include the “Ready cash total,” this would cover over 50 times. Do you think this is the appropriate way to assess the cash flow coverage? If so, why?

A: Our recommendation that lenders use ready cash support to identify a guarantor’s contribution to global cash flow is intended to cause us to consider a guarantor’s likely financial status at the time of a potential borrower default. The scenario at that time becomes one of significant financial strain that will likely reduce or eliminate borrower cash flows to the guarantor. The consequence of the borrower’s deteriorating financial condition erodes, if not eliminates, guarantor cash flow and in effect makes liquid assets held by the guarantor the new primary source of repayment.

An important lender responsibility is to identify debt service capacity at all three levels: borrower, guarantor, and collateral liquidation. Our job is to then create a loan structure that mitigates risk at all three levels. Our Session Three focus is on guarantor assessment, and we recommend using guarantor cash flow and ready cash or other liquid assets as measures of a guarantor’s financial strength. Guarantor cash flow is often fleeting in that it can be invested in illiquid assets, consumed, used to support other guarantees, or given away. The impact is especially profound if that cash flow is heavily or totally dependent on the borrower because it can end abruptly and stress both borrower and guarantor ready cash support.

We fully agree that whether cash flow or ready cash assets drive our guarantor assessment, more is always better.

Course overview: Guarantor Analysis, Global Cash Flow, and the Second Way Out
 

Q: When calculating business cash flow, it states to deduct distributions but not add contributions?  Why would we subtract distributions but not add back contributions?

A: Distributions and capital contributions are two different sets of activities. Distributions are operating activities that pay income taxes and owner compensation. As such, they directly reduce business cash flow.

Capital contributions, on the other hand, are financing activities. They provide cash to help meet the cash flow shortfall from business cash flow. Therefore, they are classified as financing activities that do not impact business cash flow.

Q: What benefit does the UCA cash flow give us over a traditional Statement of Cash Flow that starts with net income?  Are there specific areas on the UCA cash flow statement that a lender should focus on?  What are they?

A: The Uniform Credit Analysis (UCA) Cash Flow Statement is the most comprehensive statement of cash flows generated by a business. The Statement and its underlying process of combining income statement and balance sheet cash flows was assembled by the lending industry for the sole purpose of measuring the ability of a company to meet all its cash flow demands with cash from operating the company during the period. The Statement is also deliberately sequenced in a way to specifically determine the ability of the company to service debt with cash from operations.

No other cash flow format is capable of readily determining if operations-generated cash flow is adequate to service debt. The FASB 95 Statement of Cash Flows identifies all of the same company-generated cash flows for the period and simply groups them into Operating, Investing, and Financing Activities without comparing them to required debt service during the period. That is, Net Cash Provided by Operating Activities – or cash flow from Operating Activities – is not matched against current maturities of long-term debt to determine if operating cash flow was sufficient to meet all debt service obligations.

Further, the FASB 95 statement suffers from certain classification issues. For example, FASB 95 classifies distributions as a Financing Activity while the UCA Statement classifies distributions as an Operating Activity since distributions serve to pay income taxes and owner compensation. As a result, FASB 95 fails to identify the dollar amount of operating cash flow available to pay down long-term debt – as well as fails to identify the amount of long-term debt that is scheduled for repayment as we noted above.

Note also that cash flow proxies frequently used in the lending industry fall well short of comprehensively measuring cash flows available to service debt. Both Traditional Cash Flow (Net Income + Depreciation / Other non-cash expenses) and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization or other non-cash expenses) fail to acknowledge in any way the impact of cash flows triggered by movement in the company’s balance sheet accounts. Although these two cash flow proxies may offer a reasonable measure of how well profits cover required debt service, neither is a suitable measure of true cash flow.

Please note that we offer a 4-part series that addresses this question comprehensively.

Using Cash Flow Statements and Proxies for Risk Assessment

Course overview: Ratios, Borrower Cash Flow, and the First Way Out
 

Q: I am going over the solutions for the first session. Can you tell me where the number highlighted ($83,527, on page 5) is coming from?

A: 1. Exhibits II and III show that the company needs $621,082 of either inside or outside financing to meet its debt service. Inside refers to loans or capital contributions from owners and / or related parties. Outside refers to loans or capital contribution from financial institutions or investors. Another possible source of cash would be existing cash balances on the balance sheet at the beginning of 2021, but that cash balance was only $51,422 - too small to be of much help as it turns out.

2. Exhibit III shows the company needs a further $269,953 to fund its fixed asset spending. The Exhibit also shows that it needs an additional $86,863 to pay for the subordinated debt repayment to the owner. Related Party cash flow drained that amount from the company.

3. $621,082 + $269,953 +$86,863 = $977,898 which is the Financing Required reported in Exhibit III.

Now assumptions come into play about how the company used the additional short and outside long term debt it arranged.

4. The company applied the amount of additional short term debt it did not need to pay for its debt service - $273,289 - to pay $86,863 of subordinated debt to the owner. Once this payment was made from additional short term debt, the company had $186,426 of remaining short term debt to apply to fixed asset spending. Since fixed asset spending was $269,953, the $186,426 payment needs to be supplemented by $83,527 of the $183,267 of new long term, outside debt arranged by the company to meet the full amount of fixed asset spending. The unused new long term debt of $183,267 - $83,527 = $99,740 goes into the company's cash account on its balance sheet and increases it by $99,740.

Why the company arranged more new long-term debt than it needed is unclear, but it could indicate the it had no clear idea of its cash position or cash needs at the time it made the term loan request. In addition, it may have acquired more fixed assets than it had initially planned as the year unfolded.
 
Long story, but I hope it helps. The assumption here that the company first took care of its owner and used the excess short term debt to pay down $86,863 of subordinated debt due to the owner is open to challenge, but I think it seems logical.

Course overview: UCA Cash Flow Statement, Traditional "Cash Flow," and EBITDA

Q: On prior Poll Question, (Poll #2), please go over how depreciation on Schedule M1 goes up. Thanks.

A: Depreciation expense reported on the company’s accrual income statement would remain unchanged, but now it would exceed depreciation expense reported on Schedule 1120S by an additional $20,476, since this latter amount would be removed from the original $111,303 reported on Form 1125-A and result in a Form 1125-A depreciation expense of $90,827. Thus, the Schedule M1 adjustment for depreciation would increase.

Q. “Fixed Asset spending per instructions “is that just based on Form 4562?

A: This refers to the Fixed Asset computation instructions in the Exercise.

Ccourse overview: Business Income Tax Returns and Ratio Analysis

Q: Should the Section 179 Deduction be adjusted back into personal income if it’s reported on the personal tax return since it’s not a true cash expense?

A: For a Subchapter S corporation., Partnership, or LLC where the tax obligation passes through to the owner(s), the Section 179 Deduction is also passed to the owner(s) of the business. The Section 179 Deduction does not reduce the individual’s personal cash flow. It only reduces taxable income of the individual. For a Subchapter S corporation., Partnership, or LLC, the Section 179 Deduction passes through to the owner on the Schedule K-1, then flows to the Schedule E where it is used to offset any Ordinary (Taxable) Business Income that is passed to the owner from that business entity for tax purposes.

Recall that Ordinary (Taxable) Business Income that flows from the business via the Schedule K-1 to the owner’s Form 1040 taxable income is all non-cash. It is not included in the individual’s cash flow calculation. The Section 179 Deduction is also non-cash, and it does not impact the cash flow calculation for the individual because it is only used to reduce the Ordinary (Taxable) Business Income that is passed through to the owner. Neither of these numbers would be included in the personal income cash flow calculation for an owner in any way.

When you are completing a business cash flow calculation, it is GAAP depreciation amount that needs to be added back, along with any GAAP amortization, as those are included in expenses in the calculation of Net Income for the business. The Section 179 Deduction is not recognized under GAAP. Therefore, unlike depreciation and amortization, it is a) never used in the calculation of accrual Net Income and b) never added back to Net Income in computing traditional cash flow. In effect, the Section 179 Deduction has no impact on cash flow for the business or for the owner.

Q: What is a distribution with a built-in gain?

A: This is a property contributed to a partnership that has a built-in gain. This property would be reported on the tax return at the time the property is distributed to an owner. The partner contributing the property may be liable for tax on the built-in gain.

Course overview: Understanding Schedules K-1

Q: Why would Larry Crevin agree to a Covenant if he does not need a renewal?

A: Until he fully pays down the line and has no further obligation to the lender, and he is subject to covenants and conditions imposed by the lender and agreed to by Larry Crevin. If he refused to honor an existing covenant required by the lender, the lender may well decide to reject the renewal and call the line as due and payable on its renewal date. This assumes, of course, that Total Coverage needs the short-term financing and does not have the cash resources necessary to liquidate the line.

When we get to projections, we'll be able to determine whether Larry Crevin needs to renew the line. Renewal (or refinancing) of the line is the most likely situation given the growth and the 2018 cash flow deficit. If Total Coverage generated a sufficient cash flow surplus to fully pay down the short-term balance of the line at the end of 2018, they would not need to renew – a daunting task.

Course overview: Cash Flow Analysis and Borrowing Causes

Q: Is it possible to have too much in overbillings? Is so, how much would be considered a red flag?

A: Yes. Too much in overbillings can indeed be considered a red flag.

First of all, keep in mind that some contracts do not allow billings in excess of costs because the client does not want to provide project working capital for the contractor.

If overbillings are allowed in the contract, overbillings in excess of 15% to 20% may signal financial difficulties on the part of the contractor. There is no rule of thumb about this issue, but anything in this range of overbillings – billings in excess of cost and profits – should indeed get the lender’s attention.

Recall that excess billings over costs and profits are not profit. Rather, they are simply a positive cash flow timing difference that will change from time to time. The schedule of closed jobs and estimated costs to complete open jobs should be prepared more than once a year by the contractor and its accountants.

The liberal use of billings in excess of cost and profits may provide sufficient cash for a project, but such front-loading also means that contractors must have a clear idea of how much cash is required to complete a project. Otherwise, they may have billed and received all the cash available under the contract and exhausted cash available to pay subcontractors and building materials near the end of the project.

To use billings in excess of cost and profits under the percent of completion method of accounting demands that the contractor take the time to carefully estimate project needs. Mistakes in such estimates can harm a contractor’s financial health, especially if contracts do not provide much flexibility in adjusting for changes in materials costs.

Course overview: Understanding and Analyzing Contractor Financial Statements: Part I of II

Q: In the presentation you discussed A/R Days. However, there was no mention of retention accounts. Often times our contractors have large accounts in retention, so how should we view these accounts which would increase A/R Days and working capital? If they are removed, would this be understating the A/R Days since it is most likely retention accounts will be paid at the end of a large project?

A: The short answer is a) include the “A/R – Retention” balance in computing A/R Days and b) exclude “A/R – Retention” from Working Capital.

A retention is intended to encourage, or compel, contractors and subcontractors to complete a project on time and on budget. To that end, the client will frequently hold back – or retain – a percent of the total contract that is due and payable on completion of the project to the client’s satisfaction. Both parties agree to the retention provision in the contract.

As a contractor invoices a client for project progress payments, it classifies a percent of the invoice as a retention posted to an “A/R – Retention” account on its balance sheet. The invoice to the client does not include any reference to the percent of the invoice designated as retention. The client customarily withholds payment of invoices from the contractor until the billings equal the agreed upon retention amount. From that point on, the client is obligated to honor the periodic billings from the contractor.

Upon completion of the project, the contractor bills the client for the final time and states the amount within the invoice total necessary to fully pay the retention. The amount due could be the full amount of the retention or some portion of it, depending on the cumulative payments made by the client up to receiving the final invoice.

The are a couple of points to keep in mind:

It is common for contractors to forego use of a retention account even though the contract provides for it. In such circumstances, there is no “A/R – Retention” balance to use in computing A/R Days. It is hidden in the general “A/R – Contracts” balance, and the full balance is used in computing A/R Days for contractors.

A few contractors will set up a current asset account, such as “Retentions Held” and a current liability account, such as “Liability for Defects”, and bill the client over the life of the project for the total contract amount less the retention. Upon completion of the project, the contractor will debit the balance in the “Liability for Defects” account (eliminate the balance) and credit the “Retentions Held” account by the same amount (eliminate the balance). As part of this transaction, the contractor will also credit (increase) “Revenue” on its income statement and debit (increase) “Accounts Receivable – Contracts” by the same amounts. Retentions are now recognized as revenue and included in “Accounts Receivable – Contracts” in computing A/R Days for contractors.

To summarize, “A/R – Retention” should be included in the A/R Days computation since the amount posted to that account has been recognized by the contractor as revenue under the percentage of completion method of accounting. To exclude it would result in an underestimate of A/R Days.

With respect to “A/R – Retention” and Working Capital, it is customary to exclude “A/R – Retention” from Working Capital computations. There is little assurance the full amount of “A/R – Retention” balance will be collected in cash in the next operating period since collection depends on the progress of the projects and the ultimate satisfaction of the clients.

Course overview: Spreading Financial Statements

Q: Do banks use FASB 95 CF or only UCA?

A: It varies by financial institution. All credible software spreading systems produce the UCA cash flow report, so if a lender uses accrual financial statements as its source documents for analysis, it is likely to use the UCA cash flow report.

The FASB 95 statement of cash flows is always included in the set of accrual financial statements, but it is not designed to answer the four essential issues addressed by the UCA cash flow statement – the borrowing causes, the cash sources of debt service, the financing requirement, and the cash sources used to meet the financing requirement.

Rather, the FASB 95 statement of cash flows reflects the accounting profession's decisions about format and account classification that generally conform to GAAP guidelines.

Course overiview: Description and Analysis in the Credit Write-Up

Q: Please confirm and clarify if needed. A distribution reported on a Schedule K-1 is never taxable to the partner, stockholder, or member whose taxpayer identification number (TIN) is on the Schedule K-1?

A: Confirmed. Distributions are not reported as taxable income on the receiving owner's or partner's personal income tax returns. To expand our answer, distributions are not reported as a tax-deductible expense on a pass-through company's information-only business income tax returns.

There is an exception. If cumulative distributions exceed an owner's or partner's "basis" in a company, the excess amount is taxed as a long-term capital gain. The definition of "basis" varies. For a Subchapter S corporation, “basis” is the owner's equity in the company plus loans from the owner to the company. For a partnership, “basis” is the partner's equity or net worth in the partnership plus his or her share of partnership debt obligations.

It rarely happens that distributions exceed "basis".

Q: If a loan to an owner of a “pass-through” entity is subsequently converted to a distribution, the loan / distribution cash flow to that owner or partner whose taxpayer identification number (TIN) is on the Schedule K-1 is never taxable?

A: Correct. Loan proceeds are never taxable. Distributions are never taxable to the recipient so long as those distributions do not exceed "basis". When that occurs, distributions are taxed as long-term capital gains.

Course overview: Covenant Use in Controlling Cash Outflows

Q: Please confirm that the company's reported accrual profit is not impacted by distributions.

A: Confirmed. Accrual profit does not include distributions, and taxable profit does not include distributions. According to GAAP and the IRS, distributions are neither a recognized accrual expense nor are they a tax-deductible expense. In addition, distributions are not taxable income to the owner or partner who receives them from the business.

Apart from accounting and IRS definitions, distributions are by their nature very clearly operating expenses. They provide cash to the owner or partner to pay his or her share of taxes on the company's taxable income. To the extent that distributions exceed taxes to be paid by the receiving owner, they are another form of owner compensation. Both tax expense and compensation expense are operating expenses.

Q: Please confirm that distributions are never taxed unless they cumulatively exceed the capital contributions the receiving owner has made to the company.

A: Confirmed. Distributions are tax free cash income to the owner or partner until total distributions to that owner or partner exceed that owner's or partner’s “basis” in the company. Distributions in excess of basis are taxed as long term capital gains.

The definition of "basis" varies. For a Subchapter S corporation, “basis” is the owner's equity in the company plus loans from the owner to the company. For a partnership, “basis” is the partner's equity or net worth in the partnership plus his or her share of partnership debt obligations.

Q: Please clarify the partial UCA cash flow.

A: Our discussion of the UCA Cash Flow Statement centered on the Modified UCA with brief references to the Full UCA. A partial UCA presents only one section or an excerpt from the completed Modified or Full report as is the case with the Modified Operating Section displayed on page 2 in the Session 4 Exercise page.  

The Modified UCA version is sometimes referred to as an Indirect UCA cash flow statement. The Modified UCA starts with Net Income which is then adjusted upward by adding back non-cash expenses to become Traditional Cash Flow. The net change in each operating asset and liability account for the period is then displayed and used to adjust Traditional Cash Flow in a “bundled” approach. The sequence culminates in defining Business Cash Income available to service debt. The operating section is completed by identifying Cash after Debt Repayment.

The Full UCA version, also known as the Direct UCA cash flow statement, begins with Sales and then proceeds to adjust each individual income statement line item by the change in its counterpart operating asset or liability account. An example is the adjustment made to accrual sales for the change in accounts receivable, its counterpart account, in arriving at Cash Sales.

In effect, each major income statement account, such as Sales, Cost of Goods Sold, and Operating Expenses, is adjusted by the change in its counterpart account(s) to identify the cash equivalent for each of these accounts. The process culminates with the same calculation of Business Cash Income reached in the Modified UCA format.

The Modified and Full UCA versions then are identical in their method and format for reporting investing, related party, and financing activity for the period.

Course overview: Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success

Q: What is the difference between Schedule K-1 (Form 1120S) and Form 7203?

A: Form 7203 is titled S Corporation Shareholder Stock and Debt Basis Limitations

Form 7203 and its separate instructions were developed, and revised in December 2022, to replace the three-part worksheet for figuring a Shareholder's Stock and Debt Basis formerly found in the Shareholder's Instructions for Schedule K-1 (Form 1120S).The intent is to provide greater precision for the amounts reported in Part II and Part III on Schedule K-1 (Form 1120S).

Form 7203 is submitted by the shareholder who is required to do so if he or she a) sells shares, b) receives a payout, or c) receives a loan repayment from the Subchapter S corporation. The IRS recommends shareholders complete and save Form 7203 in years where none of the above reporting requirements apply in order to better establish their Subchapter S corporation stock basis.

Course overview: Understanding Schedules K-1

Q:  Please review how “adjusted EBITDA%” based on Illinois Painting Supply "Business Profit" is calculated for year 2017 in the Credit Refresher  on Accounting Profit and Business Profit.

A:  Thank you for this question! It appears that the Illinois Painting Supply Adjusted EBITDA% in the Credit Refresher is incorrect. We will make the appropriate adjustments to the Credit Refresher to correct the information presented.

In short, Illinois Painting Supply 2017 “Adjusted EBITDA%” was 3.99% and 2018 “Adjusted EBITDA%” was 4.75%.

The computations for 2017 are as follows:

• 2017 EBITDA: Operating Profit + Depreciation Expense = $129,760 + $7,713 = $137,473
• 2017 EBITDA %: EBITDA / Sales = ($137,760 / $942,647) = 14.58%
• 2017 Adjusted EBITDA: EBITDA – (Distributions + Loans to Owners – Taxes) = $137,7473 – ($64,318 + $69,163 - $33,641) = $37,633
• 2017 Adjusted EBITDA%: Adjusted EBITDA / Sales = ($37,633 / $942,647) = 3.99% 

The computations for 2018 are as follows:

• 2018 EBITDA = Operating Profit + Depreciation Expense = $227,531 + $19,259 = $246,790
• 2018 EBITDA % = EBITDA / Sales = ($246,790 / $1,601,000) = 15.41%
• 2018 Adjusted EBITDA: EBITDA – (Distributions + Loans to Owners – Taxes)  = $246,790 – ($141,904 + $90,278 – $61,422) = $76,030
• 2018 Adjusted EBITDA%: Adjusted EBITDA / Sales = ($76,030 / $1,601,000) = 4.75% 

Q:  Is there a reason that you didn't adjust Net Income for one-time events on the Income Statement?

A:  Our purpose in choosing not to adjust Net Income for one-time events was to bring out the importance of one-time events, whether income or expense, to the performance of the borrower. The company must be able to withstand the burden of one-time costs while also avoiding becoming reliant on one-time income sources. The reality of these events is that although they originate outside the operation of the core business, they are real and merit being part of our analysis.

Course overview: Critical Ratios and The First Necessary Condition for Business Success

Q: How do you calculate personal living expenses?

A: Only the borrower or guarantor can provide credible information about personal living expenses if they choose to and if they’re able to do so. Many times, borrowers and guarantors misstate living expenses out of embarrassment because they don’t know, they want to exaggerate, or they wish to keep living expenses confidential.

Since living expenses span a great range of cash outlays, such as food, clothing, travel, lodging, entertainment and more, living expense information can only come from the borrower or guarantor. Under the best of circumstances, this estimate is invariably an extremely rough guess that is never documented. Any estimate of a borrower’s or guarantor's personal cash flow surplus available to support company debt service is, therefore, highly suspect because the living expense component cannot be verified.

Unfortunately, there is no hard and fast general rule for estimating living expenses, and no readily available statistics that link disposable income levels to living expense amounts. Living expenses simply vary greatly by individual and family and their sense of financial responsibility.

One option available to lenders in estimating living expenses might be to build off the concept of disposable income, defined as the amount of money that households have available for spending and saving after all income and other taxes, medical expenses and debt service have been accounted for. In doing so, the lender can estimate the guarantor’s effective income tax rate (federal and state), estimate other taxes the individual is required to pay, and compile the individual’s annual debt service from credit reports. After subtracting these items and estimated savings from gross income, the result could be considered as the amount available to cover the individual’s living expenses. Please be guided by your institution’s policy and practices in doing so.

Once disposable income has been estimated, an analyst can then account for possible savings at the current savings rate to arrive at income available for personal living expenses. It is from this estimate of disposable income that the individual determines his or her lifestyle to include investment decisions or support for company debt service from liquid assets in a crisis.

Q: Why was Mr. Schumacher’s loan to Clovis Supply, Inc. and other contributions to related companies not captured in his personal cash flow?

A: The personal cash flow statement is intended to provide an initial estimate of Mr. Schumacher’s personal cash flow surplus or deficit available to service guaranteed company debt service, invest in equities, or lend to one or more of the guarantor's companies. Our analysis then focuses on the disposition of Mr. Schumacher’s personal cash flow surplus to identify, if possible, how it was used. One of the choices he apparently made was to use of the $1,770,493 surplus to lend $641,122 to Clovis Supply, Inc. This loan and any other loans or capital contribution are post-cash flow surplus activities rather than components of the actual calculation of the surplus.

If it were possible to construct a true and comprehensive personal cash flow statement equivalent to a UCA cash flow statement for a business organization, the lender could identify precisely how any personal cash flow surplus was used by the guarantor. Instead, we must simply separate cash flow activities into groups of pre-surplus and post-surplus events without use of an appropriate template or process.

Note that a true and comprehensive cash flow statement for a business or for an individual requires that all financial data be recorded at historic cost and not at estimates of current market value. Personal cash flow information available to us is a hodge-podge of data recorded at historic cost and data estimated a current market value.

Q: Are the related companies guarantors? Why include them in the global cash flow if they are not legally obligated as guarantors?

A: No determination has been made to this point as to whether the related parties will stand as guarantors of the not yet approved or structured Fresno Properties loan request.

We have chosen to include all related parties in the global cash flow analysis because it has apparently become Mr. Schumacher’s practice to freely move cash between himself and the companies regardless of any guarantor obligations that do or do not exist. Mr. Schumacher has also demonstrated his willingness to move cash between the companies as he deems necessary.

Our intent is to reveal the extent and impact of all the related party cash flows, even in the absence of a guarantee, so we can more readily create covenants or loan structure to mitigate risks to Fresno Properties’ ability to service debt as a result of Mr. Schumacher’s demonstrated willingness to shift cash between the companies he owns and controls. As we noted, some of Mr. Schumacher’s related companies may experience severe cash flow deficits in 2019, which suggests that Fresno Properties may be compelled to survive on the cash flow it can generate from its own activities and not look to a related company or to Mr. Schumacher for cash support.

Q: Regarding “limited guarantees” of the personal obligors, particularly a “carve out” guarantee; would you include those loan obligations in the global cash flow analysis?

We do not include “carve out” global cash flows citing the triggers to force the limited guarantee to a full guarantee are based on fraud and/or misrepresentation. Then and only then would a full repayment guarantee kick in. As a Loan Review function of the bank I’m considering suggesting that carve out guarantee be included because there is a actual limited guarantee document executed and for the reasons you cite of tightening lending standards for CRE in which we are heavily involved in.

A: We'd be inclined to include nonrecourse loans with a carve out guarantee in a global cash flow analysis. It would depend on the specific language in the carve out.  but it seems very likely the carve out provisions will increasingly convert non-recourse to recourse loans, especially since lending standards are tightening in commercial real estate lending and expected to tighten more in the second half of 2023. As always, the devil is in the details so I'd approach it on a case by case and carve out by carve out basis.

Course overview: Global Cash Flow

Q: Why wouldn't the liability for pension benefits be included on the balance sheet?

A: The liability for unfunded pension obligations is included on the balance sheet of governmental entities but not, so far, on the balance sheet of not-for-profit organizations.

There is no good rationale for excluding the unfunded pension liability from the balance sheet of a not-for-profit. The argument in favor of excluding it is twofold.

• First, the unfunded obligation is always mentioned in a footnote, so the donor, investor, or lender is aware of the size and potential impact of the liability on the company' s cash and net asset position.
• Second, the estimated pension obligation and the projected asset value available to meet the projected pension obligation are very rough estimates subject to significant alteration as market conditions change.

Therefore, based on these two considerations, it is prudent to report the projected unfunded liability only in a footnote rather than include it on the balance sheet since it may require frequent re-statement. Even so, the majority of donors, investors, and lenders would very likely prefer to see the unfunded pension liability reported explicitly on the balance sheet, along with the associated adjustments to the organization’s cash and net asset position.

Course overview: Not for Profit Analysis

Q: Partners liability for all Partnership debt. Does that mean that personal guarantees of the Partners on commercial loans are not necessary?

A: It is always prudent to require a personal guarantee from one or more general partners even though, in theory, general partners are legally responsible for all partnership debt. In bankruptcy, it can become very messy sorting out and enforcing legal obligations. Further, there may be provisions in the partnership agreement that limit one or more general partners to specific debt amounts or to no debt amount at all. Therefore, a personal guarantee from all general partners in a partnership is a very practical step in protecting the lender.

Course overview: Business Income Tax Returns

Q: You mentioned loan fees can be classified as an asset. Can you explain how that is allowable?

A: If the loan fees are levied for a long-term loan payable over multiple periods, they are considered an intangible asset, and the loan fee expense is recognized over a timeframe not to exceed the life of the loan. This treatment starts when the loan fees are paid in full at the outset of the loan but not expensed at that time. The fees are instead amortized or expensed over a period of time that may match the tenor of the loan. It's like a prepaid expense – something paid for in advance and then used up over time. Prepaid expenses are classified as an asset. Prepaid loan fees are classified as an intangible asset and used up over time.

Course overview: Understanding Financial Statements and Business Organizations

Q: In my area we work with mostly small businesses that are owned by one or two people where we do not use UCA cash flow. We typically rely on global cash flow to determine how the business can handle the proposed debt. Is there a class offered that discusses more small business cash flow where we don't usually use UCA cash flow?

A: There is one webinar in particular that addresses this issue. It is entitled Global Cash Flow and will be conducted on July 25th. It uses traditional “cash flow” as a proxy for UCA cash flow. The case in question is a real estate investment company owned by two individuals. A key point that we examine is whether the lender should use a guarantor’s personal cash flow surplus or his or her highly liquid personal assets to adjust a company’s operating cash flow in compiling global cash flow.

Q: For commercial real estate lending, is UCA cash flow still relevant?

A: Absolutely. It’s relevant because the property is not the obligor for repayment of a term loan for an income producing property. The obligor, which may be a corporation or pass-through entity such as a partnership, is responsible for meeting the debt service. The obligor may, and usually does, own and manage more than one income producing property. It has the usual array of business operating expenses, such as wages and salaries, rent, communications, office expenses, distributions, or guaranteed payments to partners, and so on.

If we limited our analysis to the sufficiency of a property’s net operating income (NOI) relative to the term loan debt service and made a credit decision on that basis alone, we may find ourselves greatly surprised that the obligor could not properly service some or all of its interest-bearing debt, which includes debt service on this particular term debt. Therefore, it is critical to fully assess the obligor’s ability to meet all its debt service responsibilities from operating cash flow or other sources using, among other analytical tools, the UCA cash flow statement.

Course overview: Description and Analysis in the Credit Write-Up

Q: If Costs and Profits in Excess of Billings declined, that means that Accounts Receivable went up because they billed for that work. It doesn't necessarily mean that the cash was received. Can you explain how this is a cash inflow?

A: The question just focused on two of the three accounts that determine cash inflows or outflows from billing practices. The intent was to examine if the company's 2018 billing practices would tend to increase or decrease its cash inflow from those practices. That is, we wanted to see if the company was able to decrease Cost and Profits in Excess of Billings and increase Billings in Excess of Cost and Profits. Such a reversal can have a very positive impact on a contractor's ability to increase cash inflows from clients to help finance the project as it unfolds.

Focusing just on Cost and Profits in Excess of Billings and Billings in Excess of Cost and Profits, the movements in those two accounts signal a cash inflow. An asset account decreased – a cash inflow according to the standard rules of thumb – and a liability account increase – another cash inflow according to the rules of thumb.

However, if we had included movements in all three accounts that determine cash inflows or cash outflows from billing practices, we would conclude that the billing (and collections) in 2018 resulted in a cash outflow. We reach this conclusion since Contracts Receivable increased by $417,472 – a cash outflow that more than swamps the cash flow movements in the other two accounts.

Q: I have come across notes in financial statements several times similar to the note below. Net income for the period was $9,000,000. Does this mean that Net Income would have actually been a net loss if this change in estimate had not taken place?

Change in Estimate
During the year ended December 31, 2022, the Company had an increase in estimated profit on contracts, which resulted in a current period increase in net income of approximately $15,500,000, net of income taxes of ($144,000). The increase would have been reported in the preceding period had the increase in estimated profit been known at that time. Revisions in the estimated profits are made in the period in which circumstances requiring the revisions become known.

A: The 2022 financial statements should be re-stated.  That is, after the fact, the company needs to go back and include all the income, expenses, and taxes that it failed to properly acknowledge at the time it took place, which was 2022.

To include 2022 net profit in the 2023 financial statements only makes sense if the company files its tax returns on a cash basis.  However, to do so, gross receipts must be less than $25M under the 2018 Tax Cuts and Jobs Act.  And if the contractor had net profit of $15,500,000, the gross receipts associated with that level of profit must be at least twice this amount - which puts it over the limit for using a cash-based approach to filing - and recognizing - revenue and profit.

So, if the contractor is filing taxes on an accrual basis, which appears to be the only possibility, it must take the $15,500,000 and all associated revenue and expenses back to 2022 and not recognize these events in 2023.

Course overview: Understanding and Analyzing Contractor Financial Statements: Part II of II

Q: Is it better to have a higher or lower owner payout rate?

A: A quick answer to your question is that “lower is better” because the company’s cash flow and cash position is better preserved. A more well thought answer is that distributions should be adequate to fulfill their purpose. Distributions are inescapable for tax “pass-through” entities like Subchapter S Corporations, Partnerships, Limited Liability Companies, and Proprietorships. Owners of these entities are personally responsible for paying federal and state income taxes on business earnings. Distributions are, in turn, the primary vehicle by which cash is made available to owners to pay the taxes due to avoid additional tax impact or eroding the owner’s personal financial resources.

The company must be sure to distribute enough to pay the tax bill since none of the cash flow associated with the business’ earnings routinely flows to the owners. Even so, since distributions are tax-free to the receiving owners, there is always a motivation to make distributions exceeding the amount needed to cover the tax payment due. As a rule, excess distributions should be avoided to reduce the consequence of distressing business cash flow or triggering an IRS review.

The IRS is always interested in this issue since a switch from salaries to distributions minimizes tax revenues, social security, and Medicare payments to the federal government for pass-through business owners. In the case of a Partnership or LLC, it is more difficult to identify excessive distributions since partners’ salaries are not tax deductible for these business organizations. Tax deductible compensation for these individuals comes from distributions or guaranteed payments.

Course overview: Ratios and Messages about Profitability and Cash Flow

Q: Is contract revenue earned determined by the contract once certain requirements are hit?

A: The contractor estimates revenue , usually by dividing the number of man-hours used up on the job to date by the total man-hours estimated originally to finish the job. The key point is that the contractor provides the estimate of revenue earned to date. Further, keep in mind that it is only an estimate that may be revised as the job unfolds.

Q: Why would you be permitted to bill more than what has been earned?

A: Billing practices are usually stated in the contract. It is common for a contractor to overbill in order to obtain financing to help complete the project or job.

Q: Are under billings generally created when a contractor has completed work but only bills monthly or every other week?

A: Frequently, a contractor will submit the same bill monthly but then find that it has completed more work than it billed for. In such a situation, the contractor has under-billed. At times, too, the bookkeeping may be inadequate, and the contractor finds out a week or month later that it has billed for less than its estimate of revenue earned.

Course overview: Understanding and Analyzing Contractor Financial Statements: Part I of II

Q. Would the answer still be “Yes” even if sales increased and the COGS stayed about the same?

A. Poll Question 1 is as follows:

“The change in the gross margin indicates that Total Coverage, Inc. managed production costs better in 2018 than in 2017.

• Agree.
• Disagree.”

The gross margin increased from 53.98% in 2017 to 56.75% in 2018, which means that the company managed its production costs better in 2018 than in 2017. As the gross margin increases, the cost of goods sold as a percentage of sales decreases. The company produced its products cheaper in 2018 than in 2017. That is, it managed its production costs better in 2018 than it did in 2017.

If COGS relative to sales is about the same, then the company is managing the production costs at the same level as in the previous period. Improved management of the COGS would be reflected by a lower COGS relative to sales and, therefore, a higher Gross Margin since one is the flip side of the other.

If the company produces products more efficiently, its Gross Margin will be greater since it uses up less costs per dollar of sales in producing its products. All increases, decreases, or flat results for the Gross Margin are based on the performance ratios and not on the changes in the dollar amounts.

Course overview: Critical Ratios and The First Necessary Condition for Business Success

Q: Are the leases on the 1200 Columbia Pike on rent roll considered to be gross leases?

A : Yes. Under the terms of a gross lease, the lessor pays all expenses customarily associated with ownership. These expenses include utilities, repairs, insurance, and taxes as examples. Please see the 1200 Columbia Pike Appraisal Excerpts on (Page 5 in the PDF excerpt) for a more extensive list.

Q: Could you briefly explain how the $1.78 per square foot is calculated? I am missing something in my calculations.

A: We have assumed that you’re citing the $1.78 per square foot monthly rental for Myron Peterson CPA/CFA in Unit 240 displayed in the Columbia Pike Rent Rolls. This amount also appears in Slide 35, which captures an excerpt from the Rent Rolls.

The $1.78 is calculated by dividing the Unit 240 Monthly Rent of $1,794.24 by the Unit Size of 1,008 square feet or ($1,794.24) / (1008) = $1.78. It’s important to note that the monthly rent of $1,794.24 does NOT appear in Slide 35.

Q: Can you describe the Debt Constant calculation please?

A: The debt constant is a unique number for every combination of a) an interest rate, b) the associated amortization period, and c) the payment frequency, e.g., monthly quarterly, semi-annually, or annually.

The most common use of the debt constant is to multiply it by the loan amount to calculate the required debt service on that amount of debt at the stated interest rate, amortization period, and payment frequency. In addition, the debt constant is used to identify the maximum amount of debt that can be serviced from a property’s net operating income available for debt service.

Shockproof! Training provides an online worksheet that identifies the debt constant from the user’s input for the interest rate, amortization period, and payment frequency.

Course overview:  Commercial Real Estate

Q: I feel like this is a trick. How can labor be removed from physical inventory?

A: Labor along with materials are cost components of products in process of completion. The full cost of labor and materials is included in the completed product. The completed product is then classified as inventory on the balance sheet until the product or service it is sold. Once it is sold, the total cost of the product held in inventory, including all labor cost embedded in it, is transferred to the income statement as cost of goods sold.

Course overview: Recording Transactions and Creating the Balance Sheet and Income Statement

Q: Our credit folks are having a difficult time understanding and reconciling prior period adjustments to the equity section.

A: Since a prior period adjustment can be triggered by many events that generally boil down to a prior period adjustment for accrual expenses or accrual revenue - assuming the institution is using accrual statements for analysis.  The same causes apply for business income tax returns.  

If a prior period net income number gets revised, it no longer reconciles with an unadjusted retained earnings and net worth. The difference between the adjusted prior period net income and unadjusted prior period retained earnings is the amount that needs to be explained or identified. That, in turn requires an adjustment in prior period retained earnings and net worth so everything is back in balance.

Q: If cost of goods sold in question 7 were to increase to $40,000 and no change is given for inventory, wouldn't that break the accounting equation?

A: Yes. The $40,000 increase in COGS decreases net profit and net worth by $40,000. But total assets do not decrease by $40,000 as they should when inventory is moved from the balance sheet to the income statement. Therefore, the failure to reduce inventory by $40,000 means that total assets remain the same as before, but total liabilities plus net worth decrease by $40,000. The accounting equation is out of balance. Total assets would no longer equal the sum of total liabilities and net worth.

Course overview:  Double Entry Accounting, the Accounting Equation, and Debits and Credits

Q: Can you please re explain how an asset converts to an expense at Point of Sale.

A: When a business purchases products for resale, such as shoes for resale at a retail store, these products are initially classified as inventory, an asset account on the balance sheet. However, once the business sells a pair of shoes, the original cost of the shoes becomes an expense included in the price of the sale and reflected in Cost of Goods Sold on the income statement. At that point, the original cost of the shoes is deducted from the inventory (asset) account on the balance sheet and is transferred to the Cost of Goods Sold (expense) account on the income statement.

Course overview: Financial Statement Structure and Composition

Q: For a sole proprietor, do we need a resolution of authority always, even if it is a DBA business name.

A: A lender’s intent is to have the borrower certify that they are, as the individual signing the loan documents, indeed the person that formed and is still doing business as a sole proprietorship. Whether or not the sole proprietor is doing business under his or her own name or under a DBA does not change the need for this document. A Sole Proprietorship Resolution of Authority accomplishes that purpose as we outlined in today’s webinar. In submitting this document, the sole proprietor identifies the proprietorship, stating that he or she is the founder and sole owner of the business and that the business is a sole proprietorship. It contains all the key elements of a borrowing resolution. As always in questions of documentation, be guided by legal counsel.

Course overview: Commercial Loan Documentation

Q: What is the impact of the Employee Retention Credit (ERC)?

A: Reviewing the Employee Retention Credit, it appears the ERC cannot exceed the actual withholding taxes paid by a company for employee FICA and Medicare between March 31, 2020 and December 31, 2020 - a nine month period.

As a refund credit, it offsets withholding taxes paid by a company - and every company with actual employees must pay FICA and Medicare withholding taxes - when it prepares and files its business income tax returns. The maximum withholding tax payments a company can avoid is $21,000 per eligible employee but, it applies some or all of that maximum amount to withholding tax due. If it could not claim the full amount since its total withholding taxes did not reach or exceed $21,000, then it can apply the unused portion to later returns. The cut off date for doing so are returns due no later than December 31, 2024 (at least it appears so).

From a credit perspective, the impact of the ERC is lower cash out lays for withholding taxes. This increases ordinary business income, which means it increases the tax obligation on ordinary business income. Sub C Corps pay this increased tax directly. Non C Corps, including sole proprietorships, pass this obligation to owners or partners. So for pass-through companies, the company itself pays out less cash for withholding taxes and has more cash to work with, but the owner or partners are now subject to a larger income tax liability on taxable business income.

This trade-off may be a tempest in a tea pot since the true impact can only be quite minor. The company's survival during the pandemic was hardly impacted by withholding tax payments but, rather, by a significant and perhaps fatal loss of revenue during 2020. What may be more important than the exact ERC impact in assessing borrower risk is revenue developments - then and now.

Course overview: Business Income Tax Returns

Q: Why do we exclude checking accounts in estimating guarantor cash support in a crisis?

A: We assume the guarantor will use cash in his or her checking account for daily living expenses and payment of ongoing personal monthly bills, so we have no idea how much might be available in a crisis to help support company debt service. Therefore, it seems practical to assume no cash support from checking account balances, which likely vary considerably over time.

Note that we can feel relatively certain about cash available from a savings account since these types of accounts are usually quite stable. And note, too, that our 80% estimate of cash from the reported market value for securities is somewhat of a heroic assumption. We don't know when a crisis will occur and obviously don't know what the cash value of the marketable securities will be at that point.

Course overview: Guarantor Analysis, Global Cash Flow, and the Second Way Out

Q: We have run into a company that shows a mark on Schedule E / Part 2 that is under “Foreign Partnership”. Do these companies file a Schedule K-1 (Form 1065) even if they are foreign partnerships? It did have its own EIN number.

A: A foreign partnership with a domestic U.S. taxpayer as a partner will issue a Schedule K-1 (Form 1065) to the U.S. partner. Any guaranteed payments or business income reported on Schedule K-1 (Form 1065) must be reported on Schedule E / Part II. Any other pro-rata shares of foreign partnership income, such as interest income, would be reported on Schedule B in Form 1040. And so on.

Q: Is there any way to determine if an individual has ownership interest in a Subchapter C corporation if they do not disclose such information?

A: To our knowledge, there is no organization that compiles ownership information for privately held Subchapter C corporations. With respect to publicly held Subchapter C corporations, a company in question could provide a full list, or response to an inquiry, but would likely not do so for protection of privacy reasons.

Note that if you asked a customer to list all companies for which it may be an owner and the customer provide you with a very incomplete list, this could be called an ethics violation.

Q: For a Schedule K-1 (Form 1120S), does Box E report payment for only shareholder loans or all existing business loans?

A: Box E reports only loans to the specific shareholder – the taxpayer receiving the Schedule K-1 (Form 1120S). Such loan repayments impact his or her basis in the company.

Q: We have a customer, Misty, that owns 100% of Kite LLC. Kite LLC owns 62% of Realty LLC. Misty has no direct ownership of Realty LLC yet both Realty LLC and Kite LLC appear on Schedule E Part II of her Form 1040. I thought an entity only appeared on Schedule E if there was a K-1 associated with it. Realty, LLC doesn’t show a K-1 in Misty's name, only Kite, LLC.  Why would Realty, LLC appear on her 1040 without a K-1 for Misty?

A: Please check with a tax specialist if the taxable income or distributions from Realty LLC are significant. If they are trivial, then it may not be worth the effort.

Assumptions:

1. Kite LLC owns 62% of Realty LLC.
2. Misty (the personal taxpayer) owns 100% of Kite but has no direct ownership of Realty LLC.
3. Kite LLC's annual business income includes its pro-rata share of Realty LLC's annual income - 62% in effect.

If the above is correct, Misty receives a single Schedule K-1 from Kite LLC. All taxable business income reported on the Schedule K-1 is carried to Part II on Schedule E in the personal income tax returns. If the Schedule K-1 reports other sources of taxable income, e.g., interest income, this amount is initially reported on Schedule B in the personal income tax returns. And so on.

Either the taxpayer or her preparer appears to have made a mistake by including Realty LLCs business income in Part II on Schedule E. The entry from the Schedule K-1 issued by Kite LLC should include Realty LLC business income either in whole (all of Kite's ordinary business income) or in part (only some of Kite's ordinary business income, which means Kite LLC owns another entity) passed from Kite LLC to Misty the taxpayer. To include amounts from both LLCs appears to be double counting. If there is only one Schedule K-1, you might check for the source of Realty LLC taxable business income.

Course overview: Personal Income Tax Returns and Cash Flow

Q: I'm interested in a session on Covenant Testing.

A: Below is a webinar we offer on the most useful covenants, in our opinion, rather than a webinar about how and when to test if covenants are honored or violated.

Covenant Use in Controlling Cash Outflows

As a general rule, the riskier the credit, the more often covenants are monitored or tested, which means that the borrower has to provide the financial data for such testing.  That, in turn, should be stated clearly in the loan agreement, e.g., borrower shall provide a company-prepared income statement, balance sheet, and FASB 95 cash flow statement within 15 days after the end of each calendar quarter.

If you're interested in what to do when a covenant is breached, we address that in Session 7 of the Commercial Business Underwriting series.

Identifying and Mitigating Repayment Risks

Course overview: Covenant Use in Controlling Cash Outflows

Q: How come we didn't put in the capital contributions in the business cash flow? We took out distributions, but not contributions.

A: Distributions and capital contributions are two different sets of activities. Distributions are operating activities that pay income taxes and owner compensation. As such, they directly reduce business cash flow.

Capital contributions, on the other hand, are financing activities. They provide cash to help meet the cash flow shortfall from business cash flow. Therefore, they are classified as financing activities that do not impact business cash flow.

Further, the equity injection of $4.1MM was a conversion of debt to equity. Therefore, no cash capital contributions were made in 2018. Mr. Schumacher had loaned this amount to Sequoia Properties. As a result of the conversion, the loan balance of “Notes Payable – Due to Shareholder” decreased by $4.1MM and equity increased by the same amount.

Course overview: Ratios, Borrower Cash Flow, and the First Way Out

Q: What is considered a good Debt Capacity Coverage Ratio? Does that Ratio differ depending on the loan amount?

A: In general, the Debt Capacity Coverage Ratio should be linked to the prospects that all accrual revenue will be converted to cash. In theory, if there is absolute certainty that all accrual revenue will be collected in cash during the period, then a 1 to 1 ratio works. Since there is never absolute certainty that such a complete conversion will happen, we need to set the coverage ratio higher as the certainty decreases.

One indicator of the borrower’s performance is a review is the borrower’s experience with bad debts and how well that experience matches the bad debt provisions. If actual write-offs exceed the estimate of bad debts, then the Debt Capacity Coverage Ratio should increase because such a performance indicates that a lower portion of accrual revenue is actually being collected in cash for use in the business.

The Debt Capacity Coverage Ratio doesn't need to vary with size since it is generally written as a percentage rather than as a dollar amount.

Note that setting a Debt Capacity Coverage Ratio is very subjective and requires that the lender know his or her borrowers.

Course overview: Cash Flow Proxies, Debt Capacity, and the UCA Cash Flow Statement

Q: Should we be putting the loans to owners into our debt service calculations?

A: It is very prudent to do so since loans to owners are usually converted to distributions for owners and partners of the pass-through entities, and they are frequently either forgiven or later converted to salary for owners of a Subchapter C corporation.

The critical thing to keep in mind in setting a debt service calculation is that loans to owners or partners are cash outflows that reduce the amount of cash available to service the borrower's interest-bearing debt.

Course overview: Understanding Schedules K-1

Q: Why on the Modified UCA is the amount used for CMLTD based on the amount from last year instead of the amount for this year?

A: It is last year's CMLTD that are due and payable in the present year. This year's CMLTD are due and payable next year. Therefore, the UCA Cash Flow Statement captures the amount of CMLTD paid in 2021, which was the amount due and payable at the end of 2020 – the 2020 CMLTD.

Course overview: Cash Based Income Tax Returns

Q: For Community Chapel, it appears revenues increased because of a $1 million bequest, which is likely non-recurring. Should we take that into account when analyzing the customer?

A: One should definitely take the $1 million bequest into account since projected revenue is critical in assessing repayment prospects. We can only rely on routine and customary contributions in looking forward, and it is difficult to properly estimate this revenue stream under most circumstances.

Course overview: Not for Profit Analysis

Q: How is depreciation expense related to accumulated depreciation?

A: Depreciation expense is an accounting methodology used to charge the acquisition cost of fixed assets to earnings over the useful life of the fixed asset. Generally Accepted Accounting Principles (GAAP) and the IRS define the accounting useful life of various classes of fixed assets. If the company is using straight line depreciation, the purchase price, or cost, of the asset is divided by the number of years in the useful life of the asset class to determine the annual expense incurred and charged to earnings for the period.

As an example, assume the acquisition cost of a vehicle is $140,000. If its useful life is seven years, the annual depreciation expense is $20,000.

Accumulated Depreciation is the sum of all depreciation expense charged to earnings since acquiring the asset. Accumulated depreciation is presented as a contra account to fixed assets on the balance sheet. Fixed assets are presented at historic cost – the original purchase prices – which is reduced to the present book value of the assets by subtracting accumulated depreciation from the historic cost of fixed assets.

To refer back to the example above, after three years accumulated depreciation is $60,000 accumulated depreciation. The book value at the end of year three is $140,000 – $60,000 = $80,000.    

Q: What is the reason(s) for correcting 2018 depreciation expense for Sequoia Properties? It seems that depreciation expense is a soft cost, so it doesn't seem to affect cash flow or debt service. Is this to figure out what actual tax liability is?

A: The quick answer in this situation is that the income statement is wrong as presented, and it is incumbent on us to work with accurate information in conducting meaningful analysis.

Let’s extend the conversation by citing the primary reason for making the adjustment. Doing so eliminates an understatement of 2018 expenses (even if a non-cash expense like depreciation) and eliminates a corresponding overstatement of 2018 profit. When this combination of understated expense and the resulting overstatement of profit occurs, lenders lose the ability to conduct credible analysis in areas other than cash flow. Every ratio or metric that relies on profitability in making the calculation is incorrectly stated if we fail to adjust the Sequoia Properties income statement. Leverage is the ultimate example of a key area impacted since equity is overstated in the absence of corrections to the misstated income statement.

Note also that traditional cash flow (Net Income + Non-cash Expenses) is the same before and after the adjustment to depreciation. That’s an important consideration in predicting cash flow using traditional cash flow as a proxy. Perhaps it is even more important to note that “real cash flow” as expressed in preparing the FASB Statement of Cash Flows is also unchanged by this correction.

Course overview: The Credit Write-Up and the CRE Analytical Process

Q: When we are doing cash flows do we add the Section 179 Deduction back to the cash flow?

A: Do not add back the Section 179 Deduction for the pass-through entities – a Subchapter S corporation, a partnership, or an LLC. The Section 179 Deduction is not included on the tax return income statement for those entities. Other depreciation expense is included, but not the Section 179 Deduction. If you add back the 179 Deduction, you would improperly inflate "cash flow" by the amount of the Section 179 Deduction.

However, the Section 179 Deduction is included with depreciation expense on the tax return income statement for a Subchapter C corporation and a sole proprietorship. Therefore, add it back in estimating traditional "cash flow".

Q: If an owner owns 50 % of a company, is the Section 179 Deduction split equally between owners?

A: Yes. In general, the split is along ownership or partnership relative shares of ownership.

Course overview: The Section 179 Deduction

Q: With respect to Statement 13 on Slide 11, is there a requirement to include what the 'Other Costs” contain?

A: There is no requirement but the accountant may add a Statement if he or she felt the amount needed clarification. Similarly, if you feel you need more information, contact the customer or accountant.

Q: Under Financing (Requirement)/ Surplus, where do we get the "New Long-Term Debt" of $517,021?

A: The general formula for computing New Long Term Debt is to sum all present year LTD, including current maturities, and match this amount with all of last year's LTD excluding the current maturities which are paid down in the present year. The table below displays the computations for Benson Manufacturing, Inc.

Course overview: Business Income Tax Returns and Cash Flow Analysis

Q: What's the difference between services and capital guaranteed payments on Schedule K-1 (Form 1065) at Line 4a and 4b?

A: Guaranteed payments are a minimum amount that is “guaranteed” to be paid regardless of a partnership’s or LLC’s profitability. These payments are the equivalent of a salary – scheduled payments made to partners for their services or capital provided.

Line 4a reports the guaranteed payment for services provided by the partner or member. Line 4b reports the guaranteed payment for capital provided to the partnership or LLC by the partner or member.

In addition to these guaranteed payments, the partners or members who receive them also benefit from their share of company income and from distributions provided by the partnership or LLC. Partners and members must report their share of the company’s taxable income on Form 1040. Distributions, however, are not taxable to the recipient unless they exceed the partner’s or member’s “basis.” Therefore, they are not reported on Form 1040 for a partner or member.

Guaranteed payments are not the same as draws or distributions. Guaranteed payments are fixed obligations that must be paid. Distributions, in turn, provide cash to the partner or member for payment of income taxes on his or her share of partnership or LLC taxable income, which a partner or member must report on Form 1040. In addition, distributions serve as compensation for a partner or member in lieu of, or in addition to, guarantee payments. The amount of distributions will vary depending on a) estimates of partners’ or members’ income tax liability for the company’s taxable income, b) the existence or absence of guaranteed payments, and c) cash available to the partnership or LLC.

Course overview: Business Income Tax Returns

Q: With the advent of ACS 842, have you done, or will you do, any training on how cash flow needs to be reconsidered?  

A: From what we understand, ASC 842 will have virtually no impact on the income statement. It will have no impact on the operating sections of both the UCA and FASB 95 cash flow statements but it will impact the capital spending and financing sections of both the UCA or FASB statements. It has the greatest impact on the balance sheet and on disclosure requirements.

The payments recorded on the income statement for capital or finance leases remain unchanged. The payments for operating leases reported on the income statement remain unchanged. Therefore, the operating sections of the UCA and FASB 95 cash flow statements remain unchanged.

The balance sheet will now include Right of Use (ROU) assets and liabilities associated with operating leases. This ROU liability account will generally be segregated into a current portion and remaining long-term portion, which means at least three new balance sheet accounts. Consequently, leverage will be affected but the cash flow statements will still balance to the change in cash, which does not change before or after the implementation of ASC 842.

Finally, the footnotes to the accrual financial statements now need to include detailed information about all aspects of the operating leases, including the methodology used to record the asset and liability values reported on the balance sheet.

You might check with an accountant you work with to get his or her views and interpretation of the impact ASC 842 will have on the income statement, balance sheet, cash flow statements and disclosure requirements.

Course overview: UCA Cash Flow Statement, Traditional "Cash Flow," and EBITDA
 

Q: I am a small business credit analyst and, at my institution, we only require tax returns for underwriting. It seems as if borrowers want to supply as little financial information as possible. We seem to be fine with it as they would most likely go elsewhere to get financing that required less financial information if we asked for additional accrual statements. In your experience is this a standard practice amongst banks or is this specific to my institution, and what do you think the impact on our portfolio this would have?

A: As a general comment, many lenders require only the accrual financial statements and do not use federal income tax returns (nor ask for them) as the basic document to assess a borrower’s credit worthiness. They frequently ask for a personal guarantee accompanied by a personal financial statement drawn up by the lender and signed by the guarantor, along with one or more years of the guarantor’s personal income tax returns.

If your institution requires federal income tax returns, it would be very difficult to ask your borrower for additional information in the form of accrual financial statements as you point out. But if your institution is prepared to use accrual financial statements in place of federal tax returns, then it would be appropriate to ask the borrower about his willingness to provided them. Many borrowers provide federal tax returns with some hesitation since they can be voluminous and, on occasion, require the help of an accountant for assembling them properly for transmission to the lender, an added expense for the borrower.

To recall, federal tax returns are not intended to be used to analyze commercial businesses for several reasons. They do not represent an impartial look at a company’s financial statements based upon Generally Accepted Accounting Principles (GAAP). Federal tax returns do contain an accrual balance sheet based upon GAAP. However, the quasi income statement on the first page of the return is prepared according to the United States Tax Code. This means that the balance sheet and the income statement are not compatible with each other, i.e., they do not reconcile to the change in net worth on the balance sheet.

As a result, financial statement ratio and cash flow analysis cannot be done correctly with a balance sheet and income statement that are not compatible. It is therefore necessary to either get the accrual financial statements or convert the tax-based income statement to one that is based on GAAP.

In addition, federal tax returns are somewhat incomplete in that they do not include any income that is not taxable (U.S. bond income, for example) nor do they include any expenses that are not tax deductible (one-half of meals and entertainment expenses, etc.).

And finally, the accountant needs the accrual GAAP-based financial statements to complete the federal tax return. Evidence that a GAAP income statement does exist can be found on Line 1 of Schedule M-1 which reports GAAP-based accrual income or loss.

Course overview: Business Income Tax Returns and Ratio Analysis

Q: Could you please explain the change in EBITDA on Slide 65? Where are those numbers coming from? I don’t see them in the financial statements provided.

A: Operating Expenses and EBITDA come from the Total Coverage, Inc. income statement. EBITDA% is computed by dividing EBITDA by Sales, which we get from the income statement. And we get Net Profit before Tax from the income statement as well.

The Maximum Personal Income Tax Rate is a combination of the maximum federal personal income tax rate and maximum California personal income tax rate in 2018 and 2017 – 35.00% and 9.30% in 2018 and 40.00% and 9.30% in 2017. These two amounts are listed in the EBITDA Adjustment Worksheet attached to the Exercise.

The Implicit Income Tax Obligation is the result of multiplying Net Profit before Tax by the Maximum Personal Income Tax Rate. It is the maximum amount Larry Crevin, the sole owner of Total Coverage, Inc. would be obligated to pay if all this taxable income were taxed at the Maximum Personal Income Tax Rate. It is the maximum amount of distributions he would use to satisfy the income tax obligation on taxable company income pass through to him for payment.

Distributions and Withdrawals and Loans to Shareholders come from the Total Coverage, Inc. financial statements.

The Amount in Excess of Personal Tax Obligation is the sum of Distributions and Withdrawals and Loans to Shareholders minus the Implicit Income Tax Obligation. This amount is, in effect, additional compensation for Larry Crevin.

Adjusted Operating Expenses are Operating Expenses from the income statement adjusted upward by the Amount in Excess of Personal Tax Obligation.

Adjusted EBITDA is Sales from the income statement minus the Amount of Excess Personal Tax Obligation or, in effect, minus additional owner compensation.

Adjusted EBITDA% is Adjusted EBITDA divided by Sales from the income statement.

Course overview: Financial Statement Review and Ratio Analysis

Q: How much do you get into things like the prepaid and depreciation issues if statements are CPA reviewed / audited rather than compiled?

A:  As an analyst or lender, completing a high-level review of the financial statements for quality and content needs to be a part of every analysis to understand what is driving any material changes and trends year over year. In this process, issues like the non-recognition of prepaid expenses or miscalculation of depreciation can be revealed. Although it is less common to encounter these types of issues on CPA audited or reviewed financial statements, even CPA reviewed and audited financial statements are subject to errors and omissions.

We briefly address these issues in this course as they relate to the compiled statements in our case study, but we also cover them in some detail in our single topic webinar on Minimum Financial Data for Assessing Borrower Risk. In addition, in our self-paced Credit Curriculum Course on Financial Statement Quality, we address the issue of likely difficulties in computing proper performance ratios and cash flow statements based on company-prepared and compiled financial statements.

Course overview: Analytical Decision Tree and the Credit Write-Up

Q: Are the letters used to categorize items affecting shareholder basis on Schedule K-1 used every time? For example, on line 16D on Part III of Schedule K-1 is distributions. Is D always for distributions or is there further digging needed every time to discern what that item is affecting shareholder basis?

A: For a Sub S corporation, 16A refers to tax-exempt interest income, 16B to other tax-exempt income, 16C to non-deductible expenses, and 16D to distributions. The designations do not vary. However, distributions may be either cash, marketable securities, or property. 16D does not distinguish the type of distributions. Therefore, you must keep digging by asking the accountant or the taxpayer for that information.

For a partnership or LLC, Line 19 captures similar information but is a bit more specific in some instances. 19A refers to cash and marketable securities specifically, 19B to property distributions with a built-in gain, and 19C to other property distributions. With respect to 19B and 19C you'll need to dig further to get full information. Back to the accountant or taxpayer.

Course overview: Personal Income Tax Returns and Cash Flow

Q: Why would we use accrued liabilities and not accounts payable for Poll Question 8?

A: It's customary to use Accounts Payable for amounts due and payable to companies that supply inventory/materials to a business for use in producing or reselling products. For operating expenses due and payable, it is customary to use Accrued Liabilities to record amounts due and payable for a range of selling expenses – advertising and promotion, employee bonuses due and payable, etc. – that fall within the Operating Expenses category.

Course overview: Recording Transactions and Creating the Balance Sheet and Income Statement
 

Q: Schedule K-1 (Form 1065) Part II Section L. Do withdrawals and distributions include cash and non-cash distributions? Distributions at Line 19A are cash only distributions? Distributions at Lines 19B or 19C are non-cash distributions?

A: Distributions at Line 19A are cash and marketable securities distributed to the taxpayer by the partnership. These distributions reduce the basis that the taxpayer has in the partnership. No amounts reported at Line 19A flow to Form 1040.

Distributions at Line 19B are Section 737 property. Section 737 property is property contributed to the partnership by another partner. In addition, to reducing the taxpayer’s basis in the partnership, the property may include a recognized gain that flows to the taxpayer’s Form 1040 as taxable income, thereby further reducing the taxpayer’s basis in the partnership.

Distributions at Line 19C are property distributed to the taxpayer that is not cash, marketable securities, or property that was contributed to the partnership by another partner. These distributions reduce the basis that the taxpayer has in the partnership. No amount reported at Line 19C flows to Form 1040.

Please note that Schedule K-1 (Form 1120S) has only one line for distributions. Although most distributions are in cash, it would be necessary to check with the customer or accountant to determine if any of the distributions are property.

Course overview: Understanding Schedules K-1

Q: Poll Question 4 Solutions (Slide 32) indicate a decrease of 12 days in AP not AR?

A: Poll Question 4 Solutions on Slide 32 show a 12 day decrease in A/R days and a 10 day increase in A/P days. Therefore, the correct answer is All of the Above.

Course overview: Cash Flow Proxies, Debt Capacity, and the UCA Cash Flow Statement