Ratios, Borrower Cash Flow, and the First Way Out (#2 in series)
Q: In calculating Business Profit and analyzing a company’s ability to generate profits adequate to service debt, wouldn't we be adding back depreciation expense? It seems that adding back depreciation, even if misstated, would eliminate the distortion created by what seems to be Sequoia Properties error in reporting depreciation expense.
A: Business Profit is intended to define profits generated after all recurring expenses have been deducted and after the impact of one-time-only income or expense has accordingly been eliminated. Note that Business Profit is not considered to be a cash flow proxy. The purpose in calculating Business Profit is to be able to work with the “purest” statement of recurring profits in considering the first indicator of business success – the ability to generate profits adequate to service debt.
Depreciation expense is not added back in calculating Business Profit because it is a recurring expense, even if not a cash expense. Since Business Profit is not intended to approximate cash flow, non-cash expenses are not included in the calculation. Distributions and loans to owners of pass-through entities are, however, deducted from accrual net income in calculating Business Profit. We do so because they, in essence, represent the recurring expenses of taxes on the earnings of the company and compensation to owners if the distributions and loans exceed taxes payable.
You are absolutely right in recognizing that adding back depreciation expense, or any other expense, would eliminate the possibility of misstated profits because of incorrectly calculated depreciation expense. We saw that dynamic unfold in subsequent steps we took in analyzing Sequoia Properties.
Q: How many ways are there to calculate leverage?
A: There are several methods commonly practiced.
The traditional, and simplest method, is to divide total liabilities by total partnership capital or business net worth.
The more complex, and usually the preferred way, is to divide total liabilities excluding subordinated debt by tangible net worth. Subordinated debt is most often debt owed to owners that, by agreement, is not to be repaid during the lifetime of a loan from a third party lender like a bank. With this repayment restriction in place, “Sub Debt” is generally viewed as an equity investment. Tangible net worth is defined as net worth (or partnership capital) plus subordinated debt but minus intangible assets. The definition of intangible assets varies by lender. It may include prepaid expenses, loans to the owner or partners, and assets reported as intangible on the balance sheet since their value is often difficult to determine.
Other methods can be appropriately tailored and deployed to mitigate risk to repayment that is unique to the borrower.
Course overview: Ratios, Borrower Cash Flow, and the First Way Out