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