CPA firms and legal firms
Q: We are looking for resources in analyzing CPA firms and legal firms.
A: The key issue in assessing either of these two types of businesses is to properly identify distributions and loans to owners or partners. Years ago, a lender lamented that their spreading system hadn't detected problems with a major law firm that declared bankruptcy. The problem was in the spreading. The spreader did not identify distributions over a series of years in which actual Business Profit was negative and actual Business Cash Income was negative. But that didn't show up in the spreads.
Loans can be a particular problem, as well. Since loans to partners are simply loans to partners, most lenders refuse to classify them as a quasi-dividend or operating event. They can be a significant and increasing cash drain.
Guaranteed payments to partners are picked up in the income statement, so they should not be a problem.
Finally, lenders need to use accrual financial statements as the source financial information document and not business income tax returns. One key reason is that any set of accrual financial statements must include a (FASB 95) Statement of Cash Flows. It's not equal to the UCA Cash Flow but it's a vast improvement over anything available in the business income tax returns.
We discuss distributions and loans to owners or partners in many of our sessions. And we review the issues with using tax returns in the tax series.
Course overview: Using Federal Tax Returns for Ratio and Cash Flow Analysis