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Instructor Blog - Credit College - Commercial Business

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  4. Credit College - Commercial Business

Session #4: Management Assessment, Projected Cash Flow, and the First Way Out


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  • 10/15/2020 3:12:59 PM

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  • Credit College - Commercial Business
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Q: How can we expect that Larry Crevin, the owner of Total Coverage, Inc. won't take out distributions that include excess compensation in 2019, if historical trends point to him always taking out cash from the company in this manner? Isn't saying he won't take out any cash from the company just wishful thinking?

A: It is indeed wishful thinking unless there is a loan covenant in place that restricts compensation or is structured in such a way to cause Mr. Crevin to choose not to take distributions in excess of taxes. We'll get into such restrictions in depth in Session 7 where we focus on covenants.

Covenants are a contractually enforceable part of the lending contract. One way to control the use of distributions is through a debt service covenant (DSC) to which the lender and borrower agree. A DSC covenant simply requires the borrower to generate profit adequate to exceed debt service by some factor.

The covenant will work to assure that the owner’s incremental compensation (distributions and loans) is limited if both are included in the calculation as a reduction of net income. In setting this covenant, the lender would define profit available to service debt as, for example, net income increased by removing interest expense but decreased by subtracting distributions and loans to owners. This amount of profit must then exceed debt service – the sum of interest expense and last year's current maturities of long-term debt – by some factor, e.g., (Profit Available for Debt Service) / (Debt Service) = 1.25 or greater. In this way, the borrower decides on the amount of distributions and loans to owner(s) that allows the company to meet the covenant. 

Course overview: Management Assessment, Projected Cash Flow, and the First Way Out

Categories
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  • Contractors(52)
    • Understanding and Analyzing Contractor Financial Statements: Part I of II(32)
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  • Covenants(11)
    • Complex Loan Structuring(1)
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    • Covenant Use in Controlling Cash Outflows(5)
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    • Session #4: Recording Transactions and Creating the Balance Sheet and Income Statement(21)
  • Credit College - Cash Flow(14)
    • Session #1: UCA Cash Flow Statement, Traditional "Cash Flow," and EBITDA(8)
    • Session #2: Cash Impact Analysis, Borrowing Causes Revisited, and Management Assessment(2)
    • Session #3: FASB 95 Statement of Cash Flows Conversion to UCA Cash Flow Statement(1)
    • Session #4: Cash Flow Proxies, Debt Capacity, and the UCA Cash Flow Statement(3)
  • Credit College - Commercial Business(208)
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    • Session #2: Financial Statement Review and Ratio Analysis(43)
    • Session #3: Cash Flow Analysis and Borrowing Causes(34)
    • Session #4: Management Assessment, Projected Cash Flow, and the First Way Out(20)
    • Session #5: Guarantor Analysis and the Second Way Out(30)
    • Session #6: Non-Financial Red Flags and Performance Implications(13)
    • Session #7: Identifying and Mitigating Repayment Risks(21)
    • Session #8: The Credit Write-Up Again(18)
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    • Session #3: Guarantor Analysis, Global Cash Flow, and the Second Way Out(40)
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    • Session #5: The Income Capitalization Approach and the Cap Rate(24)
    • Session #6: Underwriting Standards. Actual vs. Stabilized NOI, and Breakeven Analysis(54)
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    • Session #8: Repayment Risks, Covenants, and the Credit Write-Up Revisited(14)
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    • Section 263A(1)
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  • Not for Profit Analysis(24)
  • Personal Income Tax Returns and Cash Flow(65)
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    • Session #4: Personal Income Tax Returns and Cash Flow(38)
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  • Working Capital and UCA Cash Flow(27)
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