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- 7/2021
Guidance
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| Wed. Jul 23rd - Series Kickoff Analytical Decision Tree and the Credit Write-Up | ||
| Wed. Jul 30th (session #2) Financial Statement Review and Ratio Analysis | ||
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| Tue. Jul 15th - Series Kickoff The CRE Analytical Process and Credit Write-Up | ||
| Tue. Jul 22nd (session #2) Borrower Cash Flow, Ratio Analysis and the First Way Out | ||
| Tue. Jul 29th (session #3) Personal Cash Flow, Guarantor Analysis and the Second Way Out | ||
| Tue. Aug 5th (session #4) Appraisal Reports and Assessing Market Value | ||
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| Tue. Sep 23rd - Series Kickoff Financial Statements and Business Organizations | ||
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| Availability: pending | ||
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| Thu. Jul 31st - Series Kickoff Business Income Tax Returns | ||
July 2021 Comments
In this issue:
Traditional Cash Flow and Debt Capacity
Traditional "cash flow" is customarily used as an estimate of a borrower's cash flow from operations available to pay down long-term debt as scheduled. As such, it is incorporated into a debt service coverage ratio (DSCR) designed to measure a borrower's performance in paying interest expense and repaying long-term debt as scheduled.
For example, Sierra Products - a Subchapter S corporation - reported the following in 2018:
Given the above information, the borrower's traditional "cash flow" available to pay down long-term debt as scheduled is $443,706 + $196,279 - $381,956 = $258,029. We increase reported net income by the amount of non-cash charges but decrease it by the amount of distributions. Distributions for a pass-through company are passed to owners or partners for a) payment of the income tax liability on their companies' income tax obligation and for b) payment of compensation if distributions exceed the income tax obligation.
In this instance, traditional "cash flow" of $258,029 is obviously far in excess of the cash flow required to pay down $46,450 of long-term debt as scheduled.
The DSCR for Sierra Products is quite robust as we would expect:
The numerator in the DSCR sums to $317,781 - "cash flow" available to service interest-bearing debt - while the debt service itself is $106,202, i.e., the sum of interest expense and long-term debt scheduled for repayment. After meeting 2018 interest-bearing debt service, Sierra Products has a 2018 "cash flow" surplus of $211,579.
The problem with using traditional "cash flow" and a DSCR based on it to measure cash flow from operations is quite simple. Traditional "cash flow" is not cash flow from operations in the year in question. It becomes cash flow from operations if and when all 2018 accrual revenue is collected in cash and all 2018 accrual expenses are paid out in cash. Such a process usually spans two years and rarely, if ever, takes place in a single year.
In effect, we can argue that a DSCR based on traditional "cash flow" - such as the above example - is a far better estimate of debt capacity than an estimate of cash flow from operations. Consequently, we can conclude that a borrower has the capacity to service its interest-bearing debt if the corresponding DSCR is equal to 1.00 or greater. Whether Sierra Products generates sufficient cash flow from operations in 2018 to meet its 2018 interest-bearing debt service, given a 2.99 DSCR and "cash flow" surplus of $211,570, depends on management of its operating balance sheet accounts, such as receivable, inventory, prepaids, payables, and accrued expenses.
In 2018, the collective cash impact of movements in the operating balance sheet accounts for Sierra Products was a net cash outflow of $509,186, explained primarily by a $420,597 increase in accounts receivable. As a result, its 2018 cash flow from operations after payment of debt service was a negative $297,607 or $211,579 - $509,186 = ($297,607).
Sierra Products had the capacity to fully service its interest-bearing debt in 2018 but did not do so, primarily because it did not convert all 2018 accrual revenue to cash. Since the accounts receivable balance increased by $420,597 in 2018, its 2018 cash revenue was $420,597 less than accrual revenue. Had accounts receivable stayed flat between 2017 and 2018, accrual and cash revenue in 2018 would have been identical.
A DSCR less than 1:00 is a significant red flag, signaling that the borrower has insufficient profit - and insufficient debt capacity - to service its interest-bearing debt.
Operating cash flow that fails to meet interest-bearing debt service is another red flag that requires a full understanding of the reasons for the deficit - which may turn out to be quite acceptable to the lender so long as the borrower has sufficient capacity to fully service its interest-bearing debt.
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Sailing Against the Wind
When Best Buy hired Hubert Joly in 2012, who is French and who had spent the previous eight years working for a privately held travel company, as its CEO, there was widespread skepticism that he had the experience, knowledge, and management skills to turn around a flailing company. Yet in the eight years on his watch, investors enjoyed a remarkable 335% return on investment, as David Gelles reports in a recent interview with Joly in the New York Times.
The suspicion is, of course, that he engineered the turn-around the old fashion way by freezing salaries, eliminating jobs, reducing fringe benefits, renegotiating supply contracts, and delaying fixed assets spending. Not so, as it turned out. Instead, Joly followed a simple road map:
In the process of the interview, Joly suggests the present business mentality - capitalism in the 21st century - could benefit greatly from two fundamental changes.
The first is to abandon the entrenched conviction that the sole and overriding objective of every business operation is to maximize profit and, therefore, to maximize shareholder value. Joly contends that a business organization works better and is more profitable if it is a responsible corporate citizen that honors its employees and its community as its first order of business.
The second is to discard top-down management, in which the smartest guys in the room set the strategies, policies, and procedures and expect subordinates below to produce the anticipated results. Rather, he argues for continuous input from everyone on the front lines of customer contact and support in setting strategy, policies, and procedures.
One size never fits all, but Joly may be ahead of the curve in some areas of successfully running a department, a division, or a business itself.
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Office Space in Abundance
Downtown America has changed profoundly over the past several decades as city dwellers left for the suburbs, followed by an exodus of small retailers, theaters, museums, and department stores. As Emily Badger and Quoctrung Bui put it in a recent New York Times article, today's downtown in numerous U.S. cities has been created by subtraction, i.e., by the removal of the parties that have traditionally populated downtown.
As a result, downtown America frequently possesses a preponderance of office space. Five U.S. cities top the list of office space as a percentage of commercial real estate - Boston (83%), San Francisco (74%), Washington, D.C. (72%), Chicago (68%), and Pittsburgh (66%). City planners have argued for years that downtown commercial real estate should be highly diversified - like an investment portfolio - to provide a cushion against unforeseen crises and unexpected challenges to a city's tax base and financial status.
The pandemic and its emerging impact underscore the wisdom of commercial real estate diversity in the downtown area and the necessity of a return - in full or in part - to the traditional composition of downtown inhabitants, especially residents. The crux of the problem is the emergence of working remotely and the negative impact it has on the demand for office space. The ultimate impact is anything but clear. However, the trends and preferences to date point decisively to falling demand for office space, which translates to downward pressure on commercial real estate values, spending on downtown restaurants, bars, and shops, and sales and property taxes.
For cities such as Boston and San Francisco, a successful path forward will be especially difficult to navigate as the impact of working remotely unfolds. However, a city such as San Diego can breathe a bit easier with only 19% of its downtown commercial real estate represented by office space.
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Variations by Industry and Country
As The Economist notes in a recent report, the resolutions to the remote working phenomenon across industries and among countries may be both protracted and disruptive. Even so, the phenomenon is here to stay.
In general, remote working has become quite popular, first among employees and then among employers bowing to the pressure and preferences of their employees. Prudential recently conducted a survey of 2,000 employees working at home and found that 87% of those surveyed wanted to continue doing so once the lockdowns had been finally lifted. 42% of those surveyed felt strongly enough about remote working that they would look for a new job if required to return to the office and give up remote working. At the other end of the spectrum, 20% stated they opposed working at home but, rather, welcomed a return to the office on a full-time basis. Surveys among European employees produced similar results.
Employers generally reflected the attitudes and preferences of remote workers. In the knowledge industries, employers across the board favor partial or complete remote working, in large part to accommodate highly skilled employees who can quickly move to other jobs if they dislike their employers' remote working policies. However, major money market banks and investment firms, such as J.P. Morgan and Goldman Sachs, adamantly require a full-time return to the office at the pandemic's end. Wall Street obviously attracts highly skilled employees with numerous employment options, but Wall Street pay may more than compensate for the inconvenience of the daily commute if a full-time return to the office is required. European counterparts to the major Wall Street institutions are far more flexible and generally favor liberal remote working provisions, perhaps in large part as a hiring perk to pick off Wall Street talent that prefers remote working.
There is no general remote working pattern clearly emerging, but from all available indicators it seems that the more common model may be three days working at home and two days back at the office. In many instances, employees will get to decide which days to stay home and which days to commute. It seems reasonable to assume, too, that remote working policies will become a key consideration in attracting and retaining quality personnel. Such policies are certain to undergo continuous adjustment and revision as trial and error plays out over time.
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Eight Sessions of Focused Analysis
On August 4th, Shockproof! Training conducts the first of eight weekly sequential sessions in its Credit College Course on Commercial Business Underwriting, which examines in detail the application of essential analytical tools and technique in working through the entire analytical process to reach a credit decision.
In the first of the eight live sessions, the instructor:
Each session in this Credit College Course includes a five question Review Quiz designed to reinforce the key issues from each session. There is a 50 question Final Exam to both reinforce the key issues addressed in the course as well as to estimate participant mastery of the material. All testing is at the option of the participant.
If you would like more detailed information about this Credit College Course, about any of our five other Credit College Courses, or about any of our 27 single-topic Webinars, 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.