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- 4/2022
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April 2022 Comments
In this issue:
Schedule C and Assessing Sole Proprietorships
Assessing a sole proprietorship's prospects for successfully meeting its debt service on new or existing loans should be, in theory, an easy task. The personal income tax returns of the sole proprietor report all sources of taxable income, including income from the sole proprietorship, that sum to total taxable income for the year. The returns also report all tax-deductible expenses, estimated tax payments made during the year, and federal income taxes either due and payable by the sole proprietor or subject to refund because of overpayment. A quick review of the first two pages of a sole proprietor's Form 1040 can usually signal the sole proprietor's financial health and the associated implications for properly servicing the sole proprietorship's interest-bearing debt.
In addition, Schedule C in Form 1040 captures all the taxable revenue and tax-deductible expenses for the sole proprietorship. Information at Line 31 on Schedule C for 2021 reports the profit or loss for the year. The computation of traditional "cash flow" is only a step away. Add the profit or loss at Line 31 to the amount reported at Line 12 for depreciation expense and the Section 179 Deduction. Use traditional "cash flow" to identify if the company can generate sufficient cash flow to service its interest-bearing debt - the first and preferred way out.
A personal financial statement and credit report should round out the necessary documents in assessing support from the sole proprietor in a company crisis - the second way out. A secured transaction with proper loan documentation addresses the third and final way out to the deal.
And depending on the lender's use of, and appetite for, credit scoring, the credit decision process may be expedited quickly in lieu of nothing more than a cursory review of personal income tax returns and personal financial statements.
But if credit scoring is not the primary credit decision tool, it may be useful to focus on information gaps that exist with the use of personal income tax returns, personal financial statements, and credit reports in reaching a credit decision.
But the amount of taxable revenue reported on Schedule 1 and carried to Line 10 on Form 1040 may not be cash, in whole or in part. Schedule C Business Income reported at Line 3 on Schedule 1 is non-cash to the sole proprietor and taxpayer. The same holds for amounts reported at Line 5 on Schedule 1 for taxable income received from partnerships and Subchapter S corporations.
The only cash flowing from a sole proprietorship to a sole proprietor are withdrawals. Withdrawals are not reported on Form 1040 as taxable revenue. Nor are they reported as tax-deductible expenses on Schedule C.
Every analysis of a borrower's performance requires both income statement and balance sheet information for at least two years, regardless of whether the business takes the form of a sole proprietorship, a partnership, a limited liability company, a Subchapter S corporation, or a Subchapter C corporation.
These accrual financial statements identify cash withdrawals and any company loan to the owner. They provide the necessary information about movements in the operating balance sheet accounts and their net effect on company cash flow. They identify last year's current maturities of long-term debt due to be paid out in the current year. In effect, they flesh out an analysis based solely on Schedule C information in identifying the actual amount of a sole proprietorship's cash flow available to service its interest-bearing debt and whether it was able to do so.
Old, old story. Get the accrual financial statements and use them in place of income tax returns in assessing a borrower's track record and prospects for servicing its interest-bearing debt.
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Fluke or Trend?
In a recent New York Times article, Ben Casselman reviewed the various reasons attributed to the 0.4% decline in GDP in the first quarter of 2022 compared to the fourth quarter of 2021. On an annualized basis, the decline translated to a 1.4% contraction - the first such GDP contraction since the early days of the pandemic. In view of increasing inflation, Federal Reserve interest rate hikes, the termination of most federal relief programs, continued supply chain disruptions, and the war in Ukraine, the obvious question is whether this decline is a temporary phenomenon or the beginning of a recession.
Recall that the GDP is the roll-up of four spending streams - consumer spending, business investment spending, government spending, and net spending on foreign goods and services.
The good news among the numbers was consumer spending, which increased 0.7% in the first quarter, contrary to most expectations. Business investment slowed, primarily because of a slowdown in inventory purchases following a spending spree on inventory in the last quarter of 2021. Government spending slowed from its fourth quarter 2021 level as federal relief programs wound down. But the real culprit in the decline was spending on foreign goods and service that substantially exceeded foreign spending on U.S. goods and services. The trade deficit ballooned in the first quarter of 2022, which apparently knocked off three percentage points in annualized growth. In the other words, if the trade deficit had remained at its fourth quarter 2021 level, annualized GDP based on first quarter results would be a positive 1.8%.
The recession storm clouds remain, nonetheless and they center around the likely future course of inflation. There are five forces at play working to abate excess demand:
Since consumer spending accounts for at least 60% of GDP, the future course of consumer spending is critical to the fate of the U.S. economy.
On the supply side of the equation, there is little progress to report in untangling supply chain issues, which have reduced the supply of innumerable materials and products at a time of excess demand in the U.S. The recent re-emergence of the virus in China and the impact from the war in Ukraine further intensify supply deficiencies and the resulting impact on prices. In addition, the labor shortage in the U.S. is a supply issue that works to push up prices as companies increase wages and benefits to attract and retain an adequate work force.
How these various forces unfold in impacting inflation and GDP depends largely on the Federal Reserve's action on interest rates. If the Fed is too aggressive in raising interest rates, it can tip the economy into recession as further brakes on demand compound those forces already at work. If it is too hesitant in raising interest rates sufficiently now, it may be forced to take drastic action in the near future, which would invariably throw the U.S. economy into recession.
If history is any guide, the Federal Reserve's chances of taming inflation while avoiding a recession are slim indeed. Its next decision on interest rates will undoubtedly come under intense scrutiny and debate.
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Economists versus Consumers
In a recent review, The Economist explores the vastly different attitudes and opinions about the damage of inflation to wages and incomes, production decisions, and economic growth.
The general consensus among economists is that inflation doesn't really matter and has no lasting cost for the economy and personal well-being, unless it hits astronomical levels such as those that collapsed Germany's Weimar Republic in the early 1930s. The general consensus among the consumers, however, is vastly different. Inflation is a plague to be contained and avoided at any level and at virtually any cost.
Economists view of inflation rests on the results of numerous academic studies. For example, several studies show no predictable relationship between inflation and real incomes - incomes adjusted for inflation. In some periods, inflation erodes real incomes. In others, real incomes increase with inflation.
With respect to production distortions, other studies conclude that inflation does not result in poor business decisions about product concentration and development that subsequently turn unprofitable.
Regarding economic growth, several academic studies found that an inflation rate less than 40% a year has no impact on GDP growth.
As The Economist notes, the consuming public is generally unaware of these academic studies which, at any rate, contradict the reality it experiences in the midst of inflationary times. Inflation eats up paychecks and depletes savings. Inflation makes it much more difficult to plan, since future costs and prices may differ significantly from those prevailing today. And inflation signals corporate greed in which corporations raise prices at the expense of the consuming public. Recent earnings reports seem to confirm this impression as numerous U.S. corporations report record earnings amidst the highest inflation rate in four decades.
Do these differences in opinion matter or is this another example of academia living in its own bubble? They probably matter since the consuming public is a voting public that strongly supports a vigorous fight against inflation. The danger is that a Federal Reserve with its ear attuned to public sentiment, and certainly subject to political pressure, may act too aggressively on interest rate increases pleasing the public until the onset of a nasty recession.
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Success Despite Overwhelming Odds
The Economist suggests, in a recent commentary, that the IRS is a badly maligned agency whose virtues and contributions are routinely overlooked by its critics and detractors. It is certainly true, however, that the IRS currently sits on a 22 million backlog of filed returns, which may or may not be processed and cleared away by the end of this year. In addition, its telephone help desk is woefully inadequate in accepting and answering taxpayer calls and questions. Apparently no more than one in nine callers gets through to a live person. Further, it must re-enter data from paper returns sitting in its unprocessed backlog into a database written in a 1960s programming language that is no longer taught as a useful language in the 21st century.
But, on the other hand, the IRS was extremely efficient in disbursing federal stimulus funds during the pandemic. It did so primarily via direct deposit to taxpayer accounts that it had on record. For example, within a two-week period in March 2021, it paid out $325 billion in the form of 127 million payments, many of which were direct deposits. In fact, the IRS paid out more than $600 billion in pandemic relief in 2021. To put this amount in perspective, it represents roughly two-thirds of all Social Security spending.
Because of its extensive database, the IRS is positioned to increasingly become the distributor of federal transfer payments, such as monthly child tax credit payments and subsidies for the earned income tax credit. But it badly needs more money and people. Since 2010, the agency's budget has declined by roughly 20% while the number of tax returns has increased by 20%. Further, roughly one-fifth of its current employees are nearing retirement, which will leave a serious experience and expertise gap in the agency. In addition, the agency's audit capabilities have diminished in view of the increasing number of returns and the inefficiencies attributed to antiquated software systems.
Additional funding for the IRS should marshal widespread support across the political spectrum. It is the one agency in the federal government where a larger budget can trigger rather massive cash returns to the federal government and, indirectly, to the U.S. taxpayer. The current director of the IRS estimates that tax cheating, unpursued because of the lack of resources, costs the U.S. government $1 trillion annually. Few dispute his estimate, yet it remains a very hard sell to convince a skeptical Congress of the benefits from a highly functioning IRS.
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Personal Cash Flow versus Liquid Personal Assets
On May 12th, Shockproof! Training conducts Global Cash Flow, a live online seminar that runs approximately two hours, including a five-minute break and a post webinar question and answer session.
The webinar is designed for analysts and lenders who wish to explore the benefits and limitations of combining personal and business cash flows into a global cash flow statement in assessing a borrower's prospects for servicing its interest-bearing debt. It explores the following issues in depth:
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.
If you would like more information about this Webinar, 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.
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To access a 12 minute company overview, please click here.
To access a postcard PDF of our upcoming live sessions, please click here.
Please note, too, that Shockproof! Training recently incorporated a learning path function into its website that suggests single topic webinars and Credit College Courses that might be applicable for selected positions within financial institutions. The positions in question range from newly appointed credit analysts in commercial business and commercial real estate lending to experienced loan review officers, specialty lenders, and board members.