Q: Can you explain operating deposits?
A: Operating deposits represent advance cash payments from clients to Total Coverage for work on a project. Total Coverage uses the advance payments to purchase floor coverings and materials in preparation for a forthcoming job. And so these deposits are a funding source for Total Coverage to complete the various projects. Operating Deposits are a liability because Total Coverage has not yet provided the product but has an obligation to provide and install the flooring.
Q: Please explain again how loans to owners do not affect retained earnings – which accounts on balance sheet are affected?
A: Retained earnings are determined by net income – the sum of all revenue less the sum of all expenses – and distributions to owners. The greater the net income, the greater the positive impact on retained earnings. The greater the distributions, the greater the negative impact on retained earnings.
Loans to owners are not an expense according to Generally Accepted Accounting Principles even though loans frequently represent advance distributions or outright compensation. According to GAAP, loans to owners are reported in the assets on a company's balance sheet – usually in an account called Due from Officers / Stockholders.
Owner loans would not affect Retained Earnings. The Due from Officers / Stockholders asset account would go up by the amount of the loan, and the Cash account would go down by the amount of the loan – debit Due from Officers / Stockholders and credit Cash. There would be no effect on retained earnings.
Q: Could you please kindly explain what's subordinated debt when calculating leverage ratios?
A: Subordination means debt is placed behind other debt obligations in order of debt service priority. A lender will usually require a subordination agreement with the borrower for all loans from business owners to the borrower. The terms of the subordination agreements vary but, in general, the agreement will likely state that no principal repayment may occur without the express written consent of the lender. In some instances, the agreement may prohibit payment of both interest and principal without the lenders express written consent.
The intent of a subordination agreement is to assure that the borrower meets the lender’s debt service requirements from available cash flow before diverting company cash flow to debt service payments for company owners who have loans outstanding to the borrower. In other words, the lender wants to be sure it is first in line.
We reclassify subordinated debt as equity in the calculation of the leverage ratio because, from the perspective of a lender, it is quasi equity in that the lender gets paid pack before the subordinated debt gets paid back.
Subordinated debt is usually specifically reported on the balance sheet and / or identified and explained in a footnote.
Q: Could you please explain where you get the Adjustments – Loan to Shareholders numbers on Slide 59 for the Net Income Adjustment Worksheet? On the balance sheet we see the Due from Officers / Stockholders of $64,478 for 2017 and $132,732 for 2018.
A: Due from Officers / Stockholders is money loaned by the company to the officers and stockholders – in this case to Larry Crevin who is the sole owner. The balance went from just $192 in 2016 to $65,478M in 2017, an increase of $65,286. What that means is that in 2017, the company loaned $65,286 to Larry Crevin. Then, in 2018, the balance increased by $67,254 from $65,478 in 2017 to $132,732 in 2018. This $67,254 increase is money out of the company as a loan to Larry Crevin. The amount of the money loaned to the shareholder in each year, the cash out of the company to Larry Crevin, is the amount of the adjustment.
Course overview: Financial Statement Review and Ratio Analysis