The conventional wisdom links the Canadian economy in lockstep with the U.S. economy, i.e., what happens in the U.S. happens immediately in Canada and frequently with an exaggerated bump.  It’s interesting, therefore, that the Canadian economy is now nine months into recovery from its mildest and shortest recession in the recent past while the U.S. struggles to emerge from its most severe and enduring recession since the Great Depression roughly 80 years ago.

One apparent reason for the dramatically divergent recovery experiences in the two economies is a marked difference in financial regulation and public policies in the decade long run-up to the housing bust.  Canadian regulators kept a very tight lid on speculative banking activities, particularly subprime residential lending.  U.S. regulators did not.  Further, Canada managed its public finances far more prudently than did the U.S. over the run-up period. 

Today the Canadian residential housing market is quite robust.  Housing prices have never been higher, which is in great contrast to the current status of housing prices in the U.S. 

The Canadian economy has benefited, too, from recent external demand for its minerals, oil, and gas.  But at the end of the day, the Canadian economy’s recover is a tribute to effective financial regulation and conservative monetary and fiscal policy in the bubble years – two pillars of public policy long and fatally absent in the U.S. economy under our self regulating philosophy.

The debt yield is a new underwriting metric presumably gaining momentum within the commercial real estate field.  It’s defined as the current net operating income (NOI) for an income producing property divided by the amount of interest bearing debt on the property.

The debt yield is gaining attention for a couple of reasons.  The old standby loan-to-value (LTV) underwriting standard is losing favor and credibility because of the fluctuations in value and general uncertainty about any appraisal in today’s environment.  And, since cash flow repays loans, why not focus on a financing metric, such as the debt yield?  A higher debt yield translates to greater certainty that the property can throw off sufficient cash to meet the debt service…and vice versa.

But is the debt yield really so useful?  We would all agree that a 12% debt yield provides more comfort about sufficient property NOI than a 10% debt yield.  But, as we all know, debt service does not depend on the debt amount alone.  It also depends on the interest rate, the amortization period, and the payment frequency.

The table below provides a combination of debt yields and debt service coverage ratios over a range of term debt amounts financed at 6.00% interest with a 25 year amortization schedule and equal monthly payments.

                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

NOI	Loan Amount	Debt Yield	Debt Service	DSC
$1,200,000	$10,000,000	12.00%	$773,162	1.55
$1,200,000	$10,500,000	11.43%	$811,820	1.48
$1,200,000	$11,000,000	10.91%	$850,478	1.41
$1,200,000	$11,500,000	10.43%	$889,136	1.35
$1,200,000	$12,000,000	10.00%	$927,794	1.29

If we use the debt yield as our guide, we’re back where we started when LTV was the initial underwriting standard.  In effect, we begin with a minimum debt yield and determine if the debt service on that amount of term debt meets or exceeds the DSC underwriting standard.  In this instance, our preferred debt yield of 12% translates to term debt of $10,000,000 with annual debt service of $773,162 and a DSC of 1.55.  What could be better?

Many dollars of interest income, as it turns out.  Let’s assume the lender’s standard DSC minimum is 1.35.  Given our table above, the lender would be willing to provide $11,500,000 of term debt rather than the $10,000,000 dictated by a debt yield of 12%.  But if the debt service on an $11,500,000 term loan meets the underwriting standards, why give up interest income on $1,500,000?  Yet that’s exactly what we would do if we allowed our debt yield guideline to determine the amount of term debt.

It may be attractive to start the underwriting process with a preferred debt yield.  But one way or another, you’ll very likely work your way to a term debt amount whose debt service just matches or exceeds your required DSC minimum.  So why bother with a debt yield at all?

In the Question and Answer segments of our recent webcasts on Not For Profits, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: What roles do you see non-profits in the future economy?

A:  Not for profits will likely fare in direct relationship to the state of the economy.  The next year or two may be a very tough time for them until the unemployment rate begins to drop considerably, the consumers work off their debt overhang, and the economy begins to truly rebound.  Watch the unemployment figures and movements.  They are the best indicators of underlying economic strength and direction.

Q: Do you agree that non-profit organizations are especially vulnerable in today's economy particularly if restricted funds are a high percentage of assets?

A: Absolutely.  Not for profits fare in direct relationship to the state and trend in economic activity and the status and trends in the U.S. economy are hardly encouraging for either sustained or increased donations from the contributing public.  Further, a not for profit in today’s environment with a high percentage of restricted funds will likely find its flexibility severely limited in responding to crises that require the immediate use of unrestricted resources.

Q: What is your recommendation in cases where the non-profit financial statements are not of high quality (small church, etc.) and there is no ability to get personal guarantees?

A: Follow the same process you would follow for any borrower, i.e., kick the tires, in effect, and ask all the tough financial and non-financial questions you feel are necessary to provide you with sufficient information to make a credit decision.  If you fail to get the information you need, or fail to feel sufficiently comfortable with the information, then pass on the opportunity.

Q: Is a possible solution to a small church or YMCA loan request with no high quality financials to participate with other local banks if the credit decision is positive?

A: In theory it should be possible, but it would certainly depend on the quality of the credit assessment since a potential participant would look to the lead lender to assure the credit quality.  There may be comfort in numbers, but if potential participants are skeptical about the quality of the asset they are asked to acquire, it may be very difficult to spread the risk.

Q: What causes or what enables restricted assets to be released?  Is the original donor contacted for permission to release?

A: The restricted assets are released when they are used in accordance with the stipulations imposed by the donors.  Management will judge whether it has, in fact, performed as required.  It is very difficult to determine – from outside the organization – if the assets were used as intended.  Audits presumably address this issue, but there are numerous levels of audit quality.  Further, many not for profits do not provide audited statements, which makes it even more difficult to assure that contributions are used as intended. 

Q: Doesn't the diocese have a responsibility, an obligation, to the donors of restricted funds to hold those funds for the designated purpose?   Is the diocese allowed to essentially borrow those restricted funds?

A: A diocese or a not for profit organization does, indeed, have a responsibility to hold and use the restricted funds for their designated purposes.  But, as crises arise, management will use all its resources to meet the most critical needs, which may result in borrowing funds for short or longer term.  At the end of the day, whether management borrows restricted funds may depend upon a) the severity of a cash flow crisis, b) the expected duration of the borrowing need, and c) the prospects that such use of restricted funds would come to the attention of the donors in question.

Q:  In an instance where the diocese spent restricted funds, could the donors of those restricted donations demand and that the diocese return their donations?   And would the diocese be obligated to return the donations if the donors so demand?

A:  Donors could indeed make such demands.  Whether they would be successful in obtaining the funds is another question that would depend on the cash position of the not for profit organization.   The not for profit has a moral obligation to return funds it has not used or has used improperly.  Whether it has a legal obligation may depend on internal governance documents that establish its duties and responsibilities with respect to specific restricted funds.

Q: If you could kindly further explain the footnote #8 regarding interest rate swaps – that the derivative is held only for the purposes of hedging such risk and not for speculation? Does that mean it is an actual liability the org will have to pay?

A: The organization is obligated to pay the contractual fixed interest rate that is defined in the swap agreement.  That is its year-by-year obligation.  The derivative asset or liability balance on the balance sheet, which indicates that the not for profit is in or out of the money, is a score card that reflects the wisdom of the swap.  If the not for profit organization is in the money, it means that the fixed rate is – up to this point in time – less than the variable rate.  If the organization is out of the money and has a liability balance on its balance sheet, it means that – up to this point – the fixed rate is more than the variable rate.  But the company is not obligated to pay a liability balance.  Nor does it benefit from an asset balance.  The balance sheet amounts are scorecards, not obligations or benefits.

Q:  Is there really a borrowing need for Community Chapel if they are asking for short term financing (anything other than term debt)?

A:  No, there is no borrowing need – certainly not in 2008 or in 2009.  The organization has no short-term debt.  It enjoyed a cash flow surplus for the past two years, which means it had no borrowing needs of any nature.  It could encounter a cash flow deficit in 2010 if it fails to receive another $1,000,000 bequest, but it could likely fund any shortfall from unrestricted cash.  The church does use long-term debt to support long-term assets, but it is paying down that long-term debt balance.

In effect, Community Chapel seems in very good financial shape, with quite decent back-up cash support.  But the organization does need to repeat its 2009 revenue/donation performance in 2010 to ride out the storm without being compelled to use its balance sheet resources – or turn to additional interest-bearing debt.

In the Question and Answer segment of Webcast on Global Cash Flow on December 10th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q:  Why don't you add back non-cash expenses to "Business Income"?

A:   Business income is defined as reported net income from the income statement minus the sum of a) distributions or withdrawals and b) loans to owners in the period.  Distributions and loans represent cash outflows for personal income tax payments on company profit or owner compensation – or both.  Since distributions, withdrawals, and shareholder loans are not recognized as expenses according to income tax regulations and guidance – and associated GAAP – they are reflected on the balance sheet and not passed through the income statement.  Business income reclassifies these operating expenses for income taxes and compensation as proper operating expenses on the income statement and, therefore, adjusts reported net profit by the sum of these two operating expense amounts.

The key issue is whether there is sufficient actual or business income at the end of the day to pay down long-term debt as scheduled.  And even though depreciation expense is a non-cash expense, it does serve as a proxy for the actual cash outflow a company provides to maintain its fixed assets.  Maintaining property, plant, and equipment is a real expense, even though the measure of it in the income statement is an approximation only.

Business income does not pretend to represent cash flow.  It represents actual business income after adjustments for all “off income statement” expenses.  The best cash flow statement, in turn, is the Uniform Credit Analysis (UCA) Cash Flow statement, not traditional “cash flow” defined as net income plus non-cash charges. Recall that we used the UCA cash flow statement to understand cash flow movements within and between related parties in the webcast presentation.

Q:  Are we overstating Fresno's 2008 projected business profit? Should depreciation be deducted on the new apartment complex? About $120,000 a year? This would cut the estimated taxes.

A:  Absolutely right.  Projected 2008 business income would be less by this amount, offset in part by the lower distribution requirement to provide the owner with necessary cash to meet the personal income tax obligation on Fresno Properties’ taxable income.  In effect, business income will be less than we had originally projected, given this consideration, and UCA Net Cash Income will be greater, since the required distribution amount for income tax payments will fall.

Q: How would the analyst account for any capital contributions in the Global Cash Flow?

A:  Any capital contributions would be reported as a financing activity that would help meet the financing requirement for the company.  For example, Sequoia Properties’ financing requirement or financing deficit in 2007 was $6,210,322 per the company’s 2007 UCA Cash Flow statement.  The third line below that summary line captures any cash injections from owners for the period.  As we saw in reviewing the UCA Cash Flow statement, there was no capital contribution or cash injection from owners in 2007 – regardless of the fact that equity on the balance sheet increased by $4,112,432.  That increase reflected a reclassification of $4,112,432 of long-term debt to equity via a series of simple accounting entries that had no cash dimension.

 Q: Per Footnote 4 to the Sequoia Properties’ financial statement, $4,112,432 of a shareholder loan was converted to equity in 2007. This appears to have been included in the 2007 long-term debt and overstates the change in long-term debt?

A:  Actually, the change in long-term debt between 2006 and 2007, using balance sheet amounts on the financial statements alone, understates the real change in long-term debt.

According to Footnote 4, Schumacher converted $4,112,432 of debt to equity in 2007, i.e., he converted $4,112,432 of loans to the company to equity.  That means that actual new long-term debt was greater by the amount of the conversion, since that amount was replaced and then added to during the year to arrive at the totals for 2007.  In effect, 2006 long-term debt decreased in 2007 by $4,112,432 from $18,939,965 to $14,818,533 when the conversion from long-term debt to equity occurred by two simple accounting entries – a $4,112,432 debit to long-term debt and a $4,112,432 credit to a partners’ capital account.  At the end of 2007, long-term debt was the sum of $2,284,569 of current maturities and $19,710,939 of remaining long-term debt or $21,995,508.  Measured against adjusted 2006 long-term debt of $14,818,533, the amount of new long-term debt arranged by the company in 2007 was $7,176,975.

Q: Please explain the line item known as "FTB Income Taxes" that appears on the UCA Cash Flow statements used throughout today's presentation.

A:  The FTB reference refers to the Franchise Tax Board, which is the California income tax authority.  California and several other states such as New York impose a small direct income tax on Subchapter S corporations - 1.5% of taxable income or $800, whichever is more.  Both Clovis Supply and Modesto Services are Subchapter S corporations; hence the reference to this small state income tax expense.  Note that no amount was recorded at this line in the UCA Cash Flow statements for Fresno Properties and Sequoia Properties, since California does not impose an income tax directly on partnerships.

Q:  Where can I find the regulatory guidance referred to in the presentation?

A:  You can access the March 17, 2008 Financial Institutions Newsletter and the October 2009 policy statement from the FDIC at the following locations:

March, 2008
Managing Commercial Real Estate Concentrations in a Challenging Environment
http://www.fdic.gov/news/news/financial/2008/fil08022.html

October, 2009
Prudent Commercial Real Estate Loan workouts
http://www.fdic.gov/news/news/financial/2009/fil09061.html

In the Question and Answer segment of Webcast on Incomplete Information on November 19th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Please elaborate on liar loans.

A: Liar loans is a term used to describe residential mortgages granted to borrowers in the overheated residential housing market that led up to the housing collapse in 2007.  The loans were granted under the implicit understanding that the lender would not attempt to verify information about income, employment, personal assets, or personal liabilities submitted by the borrower in support of the loan application.  In other words, the borrower could lie about his or her employment and financial status with impunity.
The term NINJA loans applies as well, where NINJA refers to no income, no job, and no assets – yet lenders would provided residential home financing to such borrowers.

Q: Why do we reclassify loans to shareholders to distribution?

A: A company or a company’s outside accountant will usually convert, or reclassify, loans to owners throughout the year to distributions at the end of the year as a clean-up exercise to reflect the purpose of the loans.  Under usual circumstances, the owners of non-Subchapter C corporations, i.e., owners of Subchapter S corporations, partnerships, limited liability companies, and sole proprietorships, take cash from the company on a quarterly basis in order to pay quarterly estimated income tax payments on company profit.  (Recall that the income tax obligation falls on the owners of non-Subchapter C corporations and not on the corporation itself.)  If the sum of loans and distributions exceed the amount required to satisfy the income tax obligation, the excess represents compensation to the owners.

Keep in mind that neither loans nor distributions are taxable revenue to the owners.  That is, owners do not report loans and distributions as revenue on their personal income tax Form 1040.  In addition, loans from the company and distributions from the company are not recorded as expenses on the income statement. 

Q: What if the principal put money in the company?

A: If an owner puts money back into a company, it usually represents emergency financing unless the cash injection was used to reduce the balance of loans to owners.  In the case of Sierra Products, the owners did provide cash to the company in 2008 since the Due to Shareholders account increased from $57,931 to $202,397 – a cash inflow to the company of $144,466.  Had the owners intended this cash inflow to repay prior amounts borrowed by the owners from the company, we would have seen a decrease in the Due from Shareholders account by $144,466 – in addition to the $92,469 decreased explained by the conversion of loans to distributions.  But the owners decided to record the cash inflow as loan to Sierra Products, which means that they expect to get repaid at some future point.

In this instance, it is very likely that Sierra Products could not raise all the outside funding it needed for a variety of purposes in 2008.  As a result, the owners were compelled to put money back into the company to meet a financing gap that they could not cover by other means.

In the Question and Answer segment of Webcast on Fund Accounting Part II on November 12th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: What if a government entity doesn't prepare financials under GAAP reporting?

A: The first footnote should provide information about the financial statement preparation process, which will usually state that the enterprise-wide and business-type activities are prepared in accordance with GAAP but that the individual statements for the governmental entities are prepared in accordance with modified accrual accounting, i.e., fund accounting.  Some exceptions may exist (exceptions always exist, it seems) but all governmental entities must provide audited statements as the best assurance to the taxpayer that his or her tax dollars are used appropriately.

If a municipality violates a) the audit requirement or b) the specific accrual and fund accounting applications, a prudent lender may readily pass on a lending opportunity with such an organization.  However, if the lender has funds outstanding to a governmental entity that violates one or both of these two conditions, the lender’s only recourse for understanding the financial conditions of a municipality is to approach it directly with a range of information requests – beginning with a request for the necessary adjustments to conform the existing financial statements to the relevant accrual or fund accounting statements.

Q: What is our recourse if a municipality files bankruptcy?

A: In most instances, there is little if any real recourse other than to let events play out under the provisions of Chapter 9.  Most state laws prohibit an encumbrance on public assets, which means that most credits provided by the private sector to the public sector are unsecured, although that will depend on the provision spelled out in a loan agreement.   The claims of an unsecured private sector lender will be addressed by a bankruptcy judge along with all other claims, some of which would likely reflect municipal employee claims and claims by other government entities.  The latter normally take precedent over private sector claims.  The same would likely apply to private sector claims that carry some form of security.  Public sector claims would again have priority in most instances if they were coupled with security or collateral conditions.

Q: In the state of Ohio, do Tax Anticipation Notes carry a true pledge of future tax revenues, even though a lien is not filed?

A:  Tax Anticipation Notes generally pledge specific future tax receipts as the source of repayment for the Notes.  If the tax receipts are sufficient, the Notes will be repaid as scheduled.  If they are not, the lender has no other recourse than to depend on the best efforts of the governmental entity to find additional sources of revenue in satisfying its repayment obligations.

Q: How do you calculate debt per capita if not shown in financial statements?

A: The total amount of interest-bearing debt obligations will invariably be reported in a municipality’s comprehensive financial statements.  If the population of the municipality is not listed, it will be available from Census Bureau information or from information provided on the municipality’s website.  In fact, don’t underestimate the array of information that is usually available from municipality websites.  In general, it can be quite extensive and very useful.

Q: At what point would a municipality consider the taxes due as uncollectible?

A:  As with a commercial business, management determines if and when an account is considered uncollectible, where management in this instance refers to the treasurer or chief financial officer of a municipality.  Over time, municipalities develop their own rules of thumb about the time span of delinquency that generally reflects an uncollectible tax assessment.  Therefore, the point at which a municipality considers a tax assessment as uncollectible will vary between municipalities, just as the time period varies among commercial businesses reflecting the specifics of their client base.

Q: If taxes are determined to be uncollectable are these written down against revenues for the year?

A: Once taxes are considered uncollectible they are written off.  Municipalities use one of two methods – the allowance method or the direct write-off method – in their enterprise-wide accrual statements, which matches the approach used by business enterprises.  For example, the City of West Linn, Oregon uses the allowance method.  The City of Calistoga, California uses the direct write-off method.

However, the fund accounting statements generally do not include provision for uncollectible assessments in the “income statement” – either directly or indirectly – since fund accounting considers revenue as either cash in hand or the virtually certainty of cash in hand.  Therefore, the revenue numbers for all governmental entities in theory reflect an accurate estimate of cash revenue, in which uncollectible amounts are excluded.  If those estimates prove invalid, the revenue amounts are adjusted by a negative revenue or bad debt expense in the monthly statements that roll up to annual statements.  The bad debt expense is usually buried in the funds – or near cash – amount recorded for revenue.

Note that amounts not due with 60 days, for example, are booked as deferred revenue on the liability side of the balance sheet with an offsetting entry to receivables on the asset side of the balance sheet.  If an account becomes uncollectible, the deferred revenue and receivables balances are reduced accordingly.  Nothing hits the “income” statement.

Q: How do I confirm the "total system net revenue" number in the footnotes to the statement of revenues, expenses, and changes in net assets schedule?

A:  The total revenue number for a governmental enterprise is determined by the application of accrual accounting, which includes revenue for all governmental entities and business-type entities within the municipality. 

• On an individual basis, all governmental entities, such as the general fund, report their operating results according to fund accounting. 
• On an individual basis, all business-type activities report their operating results in accordance with accrual accounting.
  

With respect to the City of Calistoga, the Statement of Revenues, Expenses, and Changes in Fund Net Assets for the business-type or proprietary funds reproduces the same information included in Statement of Activities – the accrual enterprise-wide “income statement” for the City of Calistoga.   The Statement of Activities on page 13 of the comprehensive financial statements for the City of Calistoga records a negative $247,776 change in net assets for business-type activities.  That identical amount is reported on page 18 in the Statement of Revenues, Expenses, and Changes in Fund Net Assets for proprietary funds, i.e., for business-type activities.

However, the revenue and expense amounts reported for governmental funds on an individual basis will differ from the amounts included in the enterprise-wide “income statement”, since governmental funds report results individually according to fund accounting while the operating results of governmental funds included in the enterprise-wide “income statement” are reported according to accrual accounting.  Note the information on page 16 in the comprehensive financial statements for the City of Calistoga.  That information guides us through a reconciliation of the net changes in all governmental funds balances for 2008 – determined in accordance with fund accounting – with the change in net assets for all governmental funds determined in accordance with accrual accounting.  As you see, there are numerous adjustments the explain the differences between a fund accounting change in net assets or fund balances of $3,483,565 and an accrual change in net assets for all governmental funds of $1,149,676.

In the Question and Answer segment of Webcast on the UCA Cash Flow Statement on November 5th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: I have a real estate company that uses a modified cash basis of accounting where revenues (rent) are recognized when received and expenses when cash is disbursed - and then on the income statement has rental income as well as unrealized gains and losses on the RE portfolio.  Does this negate use of the UCA format? 

A: In most instances, a modified cash basis means that the income statement is virtually all cash amounts, i.e., the revenues are cash revenues and the expenses are cash expenses.  Any unrealized gains or losses would, of course, be non-cash amounts.  Therefore, to construct a UCA cash flow statement, you might follow these steps:

• Remove unrealized gains or losses from the income statement.
• Adjust the resulting income statement for any changes in operating asset or operating liability accounts, if any such accounts exist on the balance sheet.  Under a modified cash basis, there may be no amounts recorded for receivables, inventory, payables, or accruals.  But there may be amounts recorded for tax obligations of one sort or another.
• Adjust the resulting income statement for the sum of distributions and loans to owners.
  

These adjustments should bring you to Net Cash Income on the UCA cash flow statement.  At this point, make the following adjustments:

• Reduce Net Cash Income by the prior period current maturities of long-term debt to arrive at Cash after Debt Repayment.
• Adjust Cash after Debt Repayment by a) fixed asset spending and investment (be sure to adjust assets for an unrealized gain or loss before computing the resulting change in those assets), b) intangible spending, c) related party cash inflows or outflows, d) debt repayments to owners, or e) new debt provided by owners.  These adjustments should bring you to the Financing Requirement or Surplus for the year.
• Calculate a) the increase or decrease in short-term debt, b) the amount of new long-term debt, and c) the amount of any capital injections from owners to estimate the amount of financing for the period.
  

The difference between the Financing Requirement and Financing should be equal to the change in the cash balance over the year.

Q: Please explain the bottom line of cash flow statement, i.e., the financing requirement / surplus.

A: The Financing Requirement/Surplus line is the summation of all cash flows from a) operating activities, b) interest-bearing debt service (payment of interest expense and repayment of long-term debt as scheduled), c) fixed asset spending, d) long-term investments, e) intangible spending, and f) related party cash flows.  If the sum of all these events is positive, the company generated enough business cash flow to cover all its cash outflows for the period.  It needs no additional outside debt or equity to fund operations.

However, if the sum of all these events is negative, the company must seek and secure additional cash resources to meet all cash expenses.  There are four options – short-term interest-bearing debt, long-term interest-bearing debt, capital injections, and use of existing cash balances.  If there is a Financing Requirement and the sum of a) short-term debt, b) new long-term debt, and c) capital injections exceeds the Financing Requirement, cash balances increase.  If the reverse occurs, cash balances decrease and the company is compelled to use some of its cash balances to meet the Financing Requirement.

Q: We are consistently asked for quantitative measurements of cash flow from regulators and have been using a coverage ratio using EBITA/(Interest expense + CPLTD) to calculate coverage.  Is there any way to get a UCA coverage ratio?  If so, what do you use?

A: There is no simple coverage ratio, but there are two covenants that work in tandem to assure sufficient business cash flow to service interest-bearing debt absent the cash impact of sales growth. 

The first is Business Profit Coverage, which is defined as follows:

• [reported net income – (distributions + loans to owners) + interest expense] / [interest expense + current maturities long-term debt] > 1.00

The greater the risk that not all reported profit will be converted to cash, the greater the factor above 1.00, e.g., 1.25.

The second is the Financing Gap Ratio, which is defined as follows:

• [operating assets (last historical period) – operating liabilities (last historical period)] / [sales (last historical period)]

If the Business Profit Coverage is met and if the Financing Gap Ratio does not increase, a company will have sufficient business cash flow, absent the cash impact of sales growth, to fully service its interest-bearing debt.  If the Financing Gap Ratio is honored and the company grows, the growth will drain cash because operating assets, e.g., receivables and inventory, invariably exceed operating liabilities, e.g., payables and accruals.  But no further cash will escape the company caused by an increase in receivable days, for example, or by a decrease in accounts payable days. 

Business owners can readily understand these two measures, which is always a major consideration in establishing covenants or performance standards.

Q: When you have distributions from other entities in which you are invested, should that be added to the UCA cash flow?

A: It depends on the party receiving the distributions.  If the distributions, or cash flows from other entities, flow to your specific borrower, then they must be included in the company UCA cash flow statement.  By the same token, if your borrower provides cash to other entities, those cash outflows must be included in the company UCA cash flow statement.

However, if distributions from other entities flow to the owner of your specific borrower, then they bypass your company and its cash flow.  In this instance, the distributions play a role in determining the owner’s personal cash flow and associated personal liquid assets and, as such, would be instrumental in determining the value of the owner’s personal guarantee.

Q: Why was it necessary to reclassify the conversion of debt to equity in your spread? Why not show an increase in LTD of $3MM and equity of $4MM?

A: As Footnote 4 to the Sequoia Properties’ financial statement indicates, there was no cash inflow from an equity injection.  The company simply reclassified in 2007 a loan from the owner, made in prior years, in the amount of $4,112,432 to equity.  The reclassification had no cash impact.  The decrease in the long-term debt balance to reflect this classification had no cash impact.  The increase in the equity balance to reflect this classification had no cash impact. 

Once we know that the 2006 long-term debt balance was decreased by $4,112,432 via a reclassification of long-term debt to equity, we can then calculate the amount of new long-term debt raised by the company in 2007.  That amount turns out to be $7,176,975.  As a result, we know that the source of cash to meet the Financing Requirement in 2007 was new long-term debt and not a combination of new long-term debt and equity.

Q: You showed no change in equity, which contradicts the answer you just provided. 

A: There was no cash change in equity but there was a book or accrual change in equity reflecting the reclassification of $4,112,432 of long-term debt to equity in 2007.

The gross domestic product (GDP) increased by 3.5% in the third quarter, and then the fickle consumer decreased spending by 0.50% in September – the largest drop in nine months – which triggered a 250 point drop in the Dow. 

So, is the Great Recession over in view of the 3.5% increase in GDP in the third quarter or does the economy continue to languish because consumers didn’t spend as much in September as they did in August?  

The third quarter increase in GDP is heartening, but watch the consumer.  Keep in mind that the U.S. consumer accounts for roughly 70% of GDP in the U.S. and approximately 18% of global domestic product.  If the U.S. consumer falters, so does the U.S. economy and, unfortunately, so does the global economy in spite of all the hype we read about economic miracles in China and India. 

At present, the U.S. consumer hovers somewhere above life support.  We’ve all read that housing prices have stabilized and appear to be on the rise.  But after a 30% drop – or more – in many major markets, a one or two percent increase does little to restore owner equity and borrowing power.  Further, the present unemployment rate of 9.8%, which is expected to increase, sends a powerful signal about spending restraint to an anxious consumer population.   And, by the way, that consumer population remains heavily burdened by past excesses, grappling with personal debt that is roughly 1.3 times disposable income.

Jobs make the world go round, literally.  The third quarter surge in GDP was encouraging, but economic recovery depends on jobs and not on one-time tax credits or fixed term stimulus packages, such as cash for clunkers, or on a falling dollar that promotes exports.  Those are temporary phenomena, not sustainable events.

Global cash flow is the combined cash flow of all related parties, which lenders are tempted to use in assessing whether one or more of the related parties will be able to meet its debt service obligations.

At the most basic level, owners and their companies are related parties.  But related parties also refer to companies with common ownership.  For example, if an individual owns 1% of one company and 100% of a second company, the two companies are related parties.  The first company, therefore, has two related parties – the owner and the second company via common ownership.  The same holds for the second company.  It, too, has two related parties – the owner and the first company via common ownership.

Cash flow has many definitions, unfortunately.  At one end of the spectrum, company cash flow is defined as follows:

• Net income + Depreciation – Distributions and Withdrawals – Loans to Owners

To arrive at global cash flow, a lender combines this “cash flow” with owner personal cash flow available to support company debt service.  Such personal cash flow includes distributions and loans from the company.  Distributions and loans to owners flow from one internal department to another, in effect, and remain within the related party family.

If a single individual owns more than one company, the same methodology applies, i.e., combine all company “cash flows” with the owner’s personal cash flow available to support company debt service, including the sum of all distributions and loans from the companies to the owner.  Multi-owners simply broaden the computation process within the same analytical framework.

At the other end of the definition spectrum, company cash flow is defined as follows:

• Net Cash after Operations (from the Uniform Credit Analysis or UCA cash flow statement) – Distributions and Withdrawals – Loans to Owners

To arrive at global cash flow, a lender again combines this cash flow with owner personal cash flow available to support company debt service.   And, once again, the personal cash flow includes distributions and loans to owners.  All related party cash flows stay in the family.

There is one fundamental problem in using global cash flow as credit decision tool, regardless of the appropriate definition of cash flow.  Keep in mind that all combined related party cash flows sum to zero.  Distributions and loans to owners are a cash inflow for one related party – the owner – but a cash outflow for another related party – the company.  The net of those cash flows is zero.  The same holds with respect to a cash outflow from one company in the related party family to another company in that family.  The cash outflow is precisely offset by the cash inflow within the related party framework. 

Therefore, if a lender focuses only on global cash flow, which may reflect a cash flow surplus because a single related party’s massive cash flow surplus swamps all other cash flow deficits, it could readily conclude that the cash poor borrower is in good shape.  In fact, the cash poor borrower may be in awful shape because it does not have the remotest possibility of laying claim to the cash surplus of a rich relative.

If the rich relative is another business operation, it would seem the common owner could assure surplus cash flows from the rich to the poor.  But that would be likely only if the surplus cash flow ended up in highly liquid investments that the rich relative did not need for operating purposes and fixed asset acquisition in the next period.

The same holds if the rich relative is the owner.  The cash flows to this related party in the form of distributions and loans would only be available to the poor relative if they ended up in highly liquid investments that the rich relative did not need for operating expenses, taxes, personal debt service, or investment in illiquid assets.

The bottom line is fairly simple.  It is the ready cash, or highly liquid assets, of related parties that count as debt service support, not the global cash flow of all related parties.  If a rich related (business) party has excess cash it does not need for operations or fixed asset purchases, those amounts could be channeled back to the cash poor relative.  If the rich related (owner) party has excess cash he or she doe not need to support a lifestyle, those amounts could be channeled back to the cash poor relative.

In other words, it is the individual balance sheets of each related party that matters to a cash poor relative (and to its lender), not the global cash flow of all related parties.  At the end of the day, the ready cash of each related party – including the owners – is the relevant consideration in making a credit decision.  And ready cash sits on the balance sheet rather than in a global cash flow statement.

It is fairly common to find a Due from Shareholders account on the asset side of a borrower’s balance sheet and then a Due to Shareholders account on the liability side of the same balance sheet. Further, the balances in both accounts normally change from period to period.  Depending on the direction and magnitude of the changes, the shareholders or owners either put cash into the company or take cash from it on a net basis.  Consequently, it seems simplest to collect the changes in one location on the cash flow statement and designate that line item as either a) a cash inflow to the company, which decreases its financing requirement, or b) a cash outflow from the company, which adds to its financing requirement.

But it is not so simple.  There are two separate accounts because the cash flows into and out of these accounts take place for very different reasons.

• If an owner borrowers from his or her company – which increases the balance in the Due from Shareholders account – it is invariably to a) use the cash as an advance distribution to pay personal income taxes on company profit or b)  to use the cash for compensation – or both. 

• If an owner lends money to his or her company – which increases the balance in the Due to Shareholders account – it is usually to provide emergency financing in the absence of necessary financing from outside third parties.

We could argue, of course, that a loan by an owner to his or her company rightfully offsets and reduces, in theory if not in fact, the amounts he or she has borrowed from the company.  For example, assume a $100,000 balance in the Due from Shareholders account at the time an owner provides a loan to the company in the amount of $100,000, which increases the balance in the Due to Shareholders account by $100,000.  Shouldn’t we simply assume the $100,000 cash inflow was intended to eliminate the loan – even though the $100,000 balance remains in the Due from Shareholders account?

The answer is no.  If the owner had wanted to eliminate his or her loan from the company with a $100,000 payment to the company, he or she would have specified that the $100,000 was for the purpose of repaying the loan.  The balance in the Due from Shareholders account would have been eliminated by the cash inflow from the owner.  But the owner obviously had no intention of repaying the loan. Furthermore, by designating the $100,000 cash inflow to the company as a loan and not as a capital injection, the owner very definitely intends to be repaid the full $100,000 when the company has the cash resources to do so.

There are some further complications in interpreting movements in the Due from Shareholders and Due to Shareholders accounts.  If the balance in the Due from Shareholders account decreases, we quite naturally assume that the owner has repaid some or all of the money he or she has borrowed from the company. 

But the facts may be very different.  If the company in question is a Subchapter S corporation, partnership, limited liability company, or sole proprietorship, the reduction in the Due from Shareholders account may simply reflect the conversion of a loan to a distribution or withdrawal via a set of offsetting accounting entries,.  That is, the owner borrows from the company during the year either to make quarterly income tax payments on company profit or to increase his or her effective compensation.  At the end of the year, the internal bookkeeper or outside accountant decides to convert some or all of the loan balance to a distribution or withdrawal with a credit entry to Due from Shareholders, which decreases that account balance, and an offsetting debit entry to Distributions or Withdrawals, which decreases retained earnings or proprietor’s capital. 

The reduction in the Due from Shareholders balance does not reflect a cash repayment of some or all of the outstanding loan balance.  Quite the contrary.  Cash went out of the company to the owner when he or she borrowed the money initially that increased the balance in the Due from Shareholder account.  The subsequent reduction in the Due from Shareholders account reflected a non-cash event that converted some or all of the loan balance to a distribution or withdrawal.

For a Subchapter C corporation, a reduction in the Due from Shareholders balance will not reflect the conversion of loans to distributions, but it frequently reflects the conversion from loans to an owner to additional salary to that same owner.  In the conversion process, the company will provide the owner with the additional cash necessary to meet the tax withholding requirements on the newly provided “salary”.

Loans to owners and distributions or withdrawals, on the one hand, represent either income tax expense or compensation or both.  Regardless of how we classify these events in accordance with accounting conventions, they are operating expenses for the company and need to be recognized as operating expenses, which effectively decrease reported profit and decrease debt service resources.

Loans from owners, on the other hand, represents financing and, usually, emergency financing.  Such loans are not offsets or reductions to loans to owners but a very separate event with a very different objective. 

Consequently, it is critical in assessing the risk profile and the debt service prospects of a borrower that we fully acknowledge the fundamental difference between these two categories of cash flows.  One is an operating event, which belongs in the expense stream on the income statement and in the operating section of the cash flow statement.  The other is a financing event, which does not touch the income statement but, rather, belongs on the balance sheet and in the financing section of the cash flow statement.

In the Question and Answer segment of Webcast on Personal Income Tax Returns on September 3rd, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Why would we not use the actual cash received from the sale of stock versus the capital gain?

A: If we follow the conventional approach, we would use the cash capital gain as part of the cash revenue streams that ultimately sum to personal cash revenue. But it really makes more sense to use the amount of cash received from the sale of stock, rather than just the capital gain or loss component.  After all, we include loan repayments as part of cash revenue. This is really no different. 

Q: If a company accrues interest expense on a loan from a shareholder, but that expense is recapitalized rather than paid in cash, is that non-cash interest income for the individual reported on the personal tax return, and if so, is there any way to tell that it's non-cash from looking at the PTR.

A: If the company accrues interest due a lender, e.g., a shareholder, it would initially debit interest expense and credit an accrued liability account such as interest payable (rather than cash, assuming it has yet to pay the obligation in cash).  If it then capitalizes the interest expense, i.e., transfers it from the income statement to the balance sheet, it does so by a credit entry to interest expense (to remove interest expense from the income statement) and a debit entry to an asset account (very likely to an intangible asset such as financing charges or fees).  Over time, the company will amortize that asset and bring the interest expense back into the expense stream on the income statement.

From the stockholder’s perspective, he or she must report interest income based on the Form 1099–INT provided to him or her by the company, regardless of whether he or she actually received the interest income in cash.  If the company did not file and submit the Form 1099–INT, then the shareholder would very likely not report interest income from the company.

Whether the interest income amount were cash or not (assuming the company issued a Form 1099–INT and subsequently did capitalize the interest expense) is virtually impossible to determine from the personal income tax returns.  We would need to ask the shareholder if he or she did receive the amount in cash.  However, in general assume the interest income amount reported by the taxpayer is indeed cash unless you have a reason to suspect otherwise.

Q: How do you incorporate credit bureau information into personal cash flows?

A: In general, use credit bureau information to confirm or refute the amounts of revolving debt reported on a personal financial statement or stated by a borrower or guarantor on a lender’s format.  To be conservative, use the greater debt amount and estimate debt service on that amount, which is then included in the final section of a personal cash flow statement – the section that focuses on personal debt service obligations.

Q: Please explain the qualified non recourse financing and recourse financing section of the K-1.

A:  Qualified non recourse financing falls into a gray area between recourse and non recourse, i.e., full recourse to a guarantor versus no recourse to a guarantor if the primary obligor is unable to satisfy its debt service obligations.  If qualified non recourse financing is secured by real estate assets, then, in practical terms, it usually becomes recourse financing.  Therefore, when you see an amount listed as qualified non recourse financing, consider it an amount for which the guarantor would be fully liable in a crisis.

Q:  Why not use the federal taxes listed on schedule A instead of the 1040 statement?

A:  All the supporting schedules roll up into the amounts listed on the Form 1040.  There should be no contradiction between supporting schedule amounts and summary amounts on the Form 1040.  As general guidance, it makes sense to use the supporting schedules, e.g., Schedule A and associated statements, to determine the individual amounts that roll up into Form 1040 totals.

Q: Can you comment on the increasing use of TurboTax or other self prepared computer based returns and the accuracy of the Returns & associated Forms & Schedules vs. CPA prepared?

A:  On the surface, we should be concerned with the increasing number of TurboTax preparations in lieu of preparations completed by CPAs or other professionals.  But TurboTax, as one example, has a very impressive series of checks in place to assure that revenue and expense areas are properly addressed.  The bottom line issue is whether the tax payer declares all revenue. That might be easier to do if the taxpayer is preparing his or her own returns independent from the probing questions of a professional tax preparation expert.  On balance, though, if someone wishes to cheat on taxes, he or she can do it regardless of whether the taxpayer uses a software application such as TurboTax.

In the Question and Answer segment of Webcast on Fund Accounting Part II on July 30th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Are the numbers on page 84 of the West Linn, Oregon, comprehensive financial report fiscal year-end numbers or amounts due at the end of 2008?

A: The amounts listed in the June 30, 2007 column were the amounts of uncollected property taxes as of June 30, 2007.  The amounts listed in the June 30, 2008 column were the amounts of uncollected property taxes as of June 30, 2008. For example, at June 30, 2007, the amount of uncollected property taxes for the 2006/2007 fiscal year was $250,415.  Yet over the following year – the time span from June 30, 2007, to June 30, 2008, that balance was worked down to $76,804.  That is, the City of West Linn collected $173,611 of fiscal year 2007 property taxes due and payable in its 2008 fiscal year.

Q: What was the major change from 2006 to 2007 in primary government net assets on page 91?  The amount increased from about $53MM to $280MM.

A: The City of West Linn added some fixed assets during the year, but the massive increase reflects an extensive revaluation of its fixed assets as a footnote to its 2008 comprehensive financial report indicates.  Presumably, such revaluation is allowed under GASB.  

Q: Would you please remind us of possible events that would cause negative unrestricted funds and the analytical implications of those situations?

A: Negative unrestricted funds means that the amount of net funds – the difference between assets and liabilities – is less than the amount of restrictions attached to revenues and contributions.  In other words, the organization was unable to control expenses relative to revenue sources in such a manner that it net assets exceeded the amount of restriction placed on revenues and contributions.  It was compelled, in effect, to use more revenue to satisfy expenses than it had pledged to use. 

With respect to future operations, a negative unrestricted fund balance implies that the organization will be compelled to take some action – such as increasing taxes – to eliminate the negative unrestricted fund balance.

Q: For a municipality or for a not-for-profit, do you use a different debt service coverage ratio (DSCR) than for a commercial business?  For example, if you used a DSCR of 1.20 for a commercial business, would you use a different DSCR for a municipality or not-for-profit organization?

A: With respect to a proper DSCR, I think there are two issues that should determine the risk factor, i.e., the spread over 1.00.

• The first is the risk that not all reported profit, adjusted for the sum of distributions and loans to owners, would be fully converted to cash.  For example, if the lender were 100% certain that all reported profit, after adjustments, will be converted to cash, then a DSCR of 1.00 will suffice, i.e., so long as the borrower meets the 1.00 DSCR, it will have sufficient cash flow from business operations to properly service its interest –bearing debt.  But the greater the risk of fully converting adjusted profit to cash, then the higher the appropriate DSCR, e.g., 1.20, or 1.35, or 1.50, etc.

• The second is the risk that profit available for debt service will fall below expectations.  Consequently, the risk then determines the maximum amount of interest-bearing debt – and, therefore, the maximum amount of interest-bearing debt service – the lender is willing to provide. 
  

For example, if the lender is 100% certain that a) all profit available for debt service will be converted to cash, and b) the borrower will achieve the expected amount of profit available to service interest-bearing debt, then a 1.00 DSCR suffices.  But the greater the uncertainty about future profit available to service debt, then the higher the appropriate DSCR.
Setting an appropriate DSCR is a very inexact science.  1.20 seems a very reasonable base.  

With respect to converting available profit to cash, it seems the conversion risk would be higher for a not-for-profit organization (NPO), since an NPO uses standard accrual accounting in reporting its results, than for a governmental entity reporting under fund accounting.   The fund accounting operating statement is virtually identical to a cash flow statement.  Therefore, there is little risk of conversion.  However, keep in mind that the business enterprises within a governmental entity report on an accrual basis, which would argue for a larger DSCR.

With respect to achieving expectations, it seems that the most difficult to anticipate would be NPO revenues and available debt service in bad times, since so much of their revenue stream depends on contributions and grants.  The latter tend to shrink dramatically when economic conditions turn.

The same is basically true for governmental entities.  Tax collections fall and state and federal grants to municipalities, for example, are under great downward pressure.  But since governmental entities are so dependent on outside financing, they are compelled to reduce all other expense streams to assure sufficient cash resources to meet interest-bearing debt service.  

Because of the inherent uncertainty about future revenue streams and debt service resources for NPOs and governmental entities, it seems prudent to set a higher DSCR for both sets of borrowers.

Q: What do you feel is the greatest risk in lending to a municipality, and what is the best way to identify and assess that risk?

A: The most pressing risk is usually whether the municipality can control or reduce all non-debt service expenses, e.g., wages, salaries, and benefits, sufficiently to have the cash resources available to service interest-bearing debt.  The following is one sequential approach to assessing risk:

• Check total and partial change in net assets, i.e., enterprise-wide vs. governmental activities and business activities.  If you lend only to general fund, in effect, focus primarily on developments in the general fund and governmental activities.
• Identify why change occurred, i.e., increase or decrease in tax collections, increase or decrease in grants and contributions, increase or decrease in transfers, increase or decrease in expenses.  Follow usual income statement assessment.
• Check liquidity position via unrestricted or undesignated funds measured against non-capital asset expenses.  We would like to see around 20%.  Repeat for business activities if you buy revenue bonds but focus on debt coverage.  May be hard to dig out.
• Identify pending debt service obligations.  Can get the current maturities from the enterprise-wide balance sheet.  Can project interest expense, given the level of outstanding debt.
• Dig into background information via the statistical section, e.g., movements in tax collections, changes in tax base, employment trends, indebtedness per capita, changes in municipal employees, and so on.  Search for any local information about inflexible operating expenses, e.g., strong union opposition to changes in salaries and benefits.  Check unfunded liabilities for pensions and benefits.

In the Question and Answer segment of Webcast on Incomplete Information on July 23rd, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Because the company prepared financial statements contain so many differences from the compiled statement, wouldn't that cause a lender to check the quality of inventory, accounts receivable, prepaid expenses and fixed assets in order to ensure that even more errors exist in the quality of financial statements especially when an accountant does not thoroughly check a compiled statement?

A: You would certainly want to verify the account balances.  It seems, however, that the best way of doing so is to require that an outside accountant “touch” the numbers, e.g., require compiled statements at a minimum.  This might be the cheapest and most efficient way to get at the issue.  That is, you either require the company to verify the numbers via use of an outside accountant or you, the lender, would have the option of doing so – but by using third party experts such as internal audit personnel.

Q: Maybe we should remind lenders to also "kick the tires" with an on-sight visit?

A: It’s always a very good idea to kick the tires, simply because no one knows as much as company management and company personnel about the business and all of its nuances.  In fact, a 30 minute conversation with the bookkeeper or chief financial officer can provide invaluable information about the company, the competence of the accounting department, and the integrity and approach of company management to preparing and using quality financial information.

Q: Shouldn't we record the cash received in the asset sale (regardless of tax loss) and note that it is non-recurring?

A: Absolutely.  It’s the cash that counts, regardless of a gain or loss recorded for income tax purposes.  Usually, it is indeed a non-recurring event – something we would not depend on to be repeated in the future.

Q: Do you count the capital loss if it is a carryover since it really isn't a use of cash in 2008?

A: No.  The issue is, first, whether it is a cash gain or loss in the period in question and, second, the amount of the asset sale, which represents the cash amount associated with the gain or loss.  A tax loss carryover tells us the event occurred in a prior period, rather than the present period, and that the cash dimension of that event occurred in the prior period as well.

Q: Why were dividends kept in personal cash flow as we don't know if they are automatically reinvested or pass-through from another S Corp, LLC or partnership?   Also, we would need to know the amount of the shareholder loan change due from Joe Robie to subtract from his distributions from the company that he actually received.

A: Distributions take place for two purposes – to provide cash to the owners of non Subchapter C corporations to a) pay personal income tax on company profit and b) provide compensation to owners if the amount of the distributions exceed the income tax obligation.  How the owners use the money is a separate issue, very similar to the issue of how employees use salaries.  Distributions, if they exceed the amount needed for income tax payments, may be used for virtually any purpose from paying daily living expenses to investing in solar energy partnerships – and everything in between.

To determine the actual amount of cash received by Joe Robie, in this instance, we would need to know if the reduction in the Due from Shareholder account reflected a reduction in company loans to Joe Robie alone.  The balance decreased by $92,469 while the amount of distributions to Joe Robie in 2008 was $308,376.  The net cash amount distributed to Robie would then be $308,376 - $92,469 = $215,907.

Note that the UCA cash flow shows cash distributions at $474,425 - $92,469 = $381,956.  Of that amount, $215,907 went to Robie under the assumption that the reduction in the Due from Shareholder account applied only to loans made by the company to its majority owner.

Q: Regarding capital gains, shouldn't we ask if the funds were re-invested?

A:  This really raises a larger issue about getting more complete information from the guarantor so we can piece together a full personal cash flow statement.  If we have information about investment activity, along with information about changes in personal debt obligations, we could make rough estimates of a full personal cash flow statement.

But progressing as far as we have can be very revealing.  For example, let’s assume that we know the amount of cash provided the guarantor from the sale of an asset that resulted in a capital loss.  If we were to include that amount of cash in the stream of personal cash revenue and found that there was no surplus cash available to help support debt service on company debt, we would know that the proceeds from the asset sale were not reinvested.  They were consumed in covering an array of living expense, cash taxes, and personal debt obligations.

Q: Do you subtract from personal cash flow if they have contributed money to the business?

A: I keep them separate.  I consider distributions as operating expenses that, given the tax code, pass through the balance sheet instead of through the income statement.  Distributions satisfy two needs.  They provide cash for income tax payments on company profit, an operating expense.  If the amount of distributions exceeds the income tax obligation, that excess amount provides compensation to the owner, an operating expense.

Loans from an owner or guarantor, on the other hand, is a financing activity and, generally, emergency financing at that.  Owners put money back into the company if they cannot acquire the financing the company needs from other sources.

Joe Robie took money out of the company in 2008 to pay income tax on company profit and to provide himself with additional, and tax-free, compensation.  He likely put money back into the company at some point during the year when he couldn’t arrange the additional financing the company required to meet pressing needs.  Those are two separate events with very different objectives.

Q: Do you consider CSVLI a liquid asset?

A: Yes, but it usually requires a bit more time to request and receive the cash value of the policy than it does to arrange a sale of marketable securities.  Nonetheless, I would consider the cash surrender value of a life insurance policy to be a liquid asset.

Q: If you had a company prepared tax return and a co-prep statement for the same period, which one would you use generally?

A: I would be inclined to use the company prepared financial statement since the company prepared income tax return would be prepared from the financial statement information.  In other words, the financial statement information represents the source document. 

In addition, the company prepared financial statement would be prepared, generally, in accordance with generally accepted accounting principles, where the business income tax return would be prepared according to the tax code.  The differences in revenue, expense, and profit amounts can be considerable.  It’s usually easier to sort through the company prepared financial statements than it is to fully understand the necessary adjustment to conform business income tax returns to accrual financial statements.

In the Question and Answer segment of Webcast on Working Capital vs. Cash Flow on May 21st, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Working capital is current assets - current liabilities. Why is long term debt being financed with short term working capital?

A: It may be the other way around.  Long-term debt has financed the increase in working capital.  For working capital to increase a) long-term debt must increase, or b) long term assets must decrease, or c) profitability must increase, or d) owners must make capital contributions to the company – or the combination of these four events must sum to a positive amount.  For example, a long-term debt increase could be sufficiently large that it offsets a) an increase in fixed assets, plus b) a decrease in profitability, plus c) a capital withdrawal in the form of distributions. 

Keep in mind that working capital is simply a definition.  Whether it goes up or down depends on the combination of the four factors that drive and determine working capital.

Q: Why consider long term changes in long term accounts in figuring working capital? I thought working capital was current assets - current liabilities.

A: It is.  But a change in working capital is a residual event determined by profit for the period and the cumulative net change in a) long-term debt, b) long-term assets, and c) owners’ capital (excluding changes in retained earnings).

Q: What is an example of a liability write-up?

A: If a company carried a liability expressed in a foreign currency, such as a trade payable in Sterling or Euros, it would be obligated to write-up that liability if the dollar fell in value vis-à-vis Sterling or the Euro.  That is, it would now take more dollars to satisfy the Sterling or Euro liability.  As a result, the company would credit (write-up) the appropriate liability account and debit a miscellaneous or foreign exchange expense account on the income statement.

Q: Please discuss negative working capital.

A: If current assets are less than current liabilities, a company would record negative working capital.  Trucking companies, for example, frequently report negative working capital.  Their accrued liabilities, including short-term interest-bearing debt, may exceed the sum of cash, receivables, and inventory.  But such companies may enjoy very robust cash flow from business operations.  The point, again, is that working capital is not cash flow.  Positive working capital may signal positive cash flow or it may not.  Negative working capital may signal negative cash flow or it may not.  The ultimate answer about operating liquidity rests with the UCA cash flow statement and not with working capital.

Q: Changes in working capital identify causes - growth vs. management of terms with clients and /or vendors?

A: Hard to say.  For example, a company may collect its receivables rapidly and pay its suppliers quickly enough to take discounts, yet experience a decline in working capital driven by a drop in profitability along with an increase in short-term debt that allows the company to take advantage of supplier discounts.  On the other hand, a company may borrow heavily from a related party and classify the debt as long-term, thereby increasing working capital.  The amount of cash flowing into the company is the same regardless of whether the company classifies the cash inflow as short or long-term debt.  But working capital will be impacted profoundly by the classification decision.

Whether growth contributes or uses working capital depends on the combination of profits, changes in long-term debt, changes in long-term assets, and changes in capital (apart from retained earnings).  The UCA cash flow statement is designed to address these issues and does so quite well.

Q: Why is interest income classified as contra operating income while interest expense is classified as a non operating expense on the cash flow analysis?

A: In the UCA cash flow statement, interest income and interest expense are classified in a manner identical to their classification in the accrual income statement.  Interest income is classified in a miscellaneous income/expense area of the statement.  Interest expense is classified as interest expense.  Both appear above Net Cash Income in the UCA cash flow statement, i.e., both appear in the operating section of the statement.

Q: We normally only receive company prepared financial statements (with no footnotes). How would we get information like footnote 4 in Sequoia Properties?

A: This is a critical issue with company prepared financial statements, i.e., lack of clarifying footnotes.  The only real solution is to go back to the company and ask about any account that appears suspicious – or requires more information – for any reason.  For example, there is every reason to ask if a) all depreciation expense has been posted for the period, b) the prepaid balance has been adjusted to recognize prepaid amounts used up, c) all interest expense has been posted for the period, d) there are bad debts or write-offs, e) the owners have borrowed from the company, f) the owners have received payment on loans to the company…and so on.  Identify financial statement accounts and amounts that catch your attention and ask questions.

Q: What are the effects on UCA of:

1. FOREX adjustments;
2. Seasonality;
3. Bad debt expense and A/R adjustments; and
4. Annuals and interims to compare cash conversion cycle and turnover.

A: 1) The most common adjustment would be to an asset or liability account denominated in a non U.S. currency and translated to U.S. dollars that requires adjustment over the period if the underlying exchange rate moves up or down.  For example, if a business held receivables denominated in Euros, the reported dollar balance of the receivables would increase as the dollar falls against the Euro and vice versa.  If the dollar fell against the Euro from one reporting period to the next, the company would increase the dollar value of its receivables by posting a debit to receivables.  It would then recognize a foreign exchange gain by posting an offsetting credit entry to a miscellaneous income statement account or to foreign exchange gains on the income statement.  Without an adjustment for this non-cash transaction, the resulting UCA cash flow statement would over-report the increase in receivables for the period (an implied cash outflow) but then over-report other income (an implied cash inflow). Since both accounts are accommodated and accounted for in the operating section of the UCA cash flow statement, the two entries offset each other resulting in no impact on Net Cash Income.

If we were purists about the matter, we would remove the non-cash write-up to the receivables (eliminating the implied cash outflow) and reverse the non-cash foreign exchange gain (eliminating the implied non-cash inflow).  Net Cash Income, however, would remain the same, i.e., as if there were no non-cash adjustments.

However, if the business in question held long-term assets denominated in a foreign currency, the resulting impact from a change in the exchange rate would require adjustments.  For example if long-term assets held in Euros increased in value, the company would post a debit entry to the proper fixed asset account and an offsetting credit entry to a miscellaneous income or foreign exchange account on the income statement.  Without adjusting for these non-cash events, Net Cash Income would now be over-reported, since the offsetting entry to a foreign exchange account impacts an account below Net Cash Income on the UCA cash flow statement.

2) With respect to seasonality, the UCA cash flow statement can be immensely insightful and helpful.  Since we can create a cash flow statement for any period of time, we can track a borrower’s seasonality by constructing a UCA cash flow statement for the seasonal period, perhaps on a month-by-month basis over the period.  The resulting monthly UCA cash flow statements will then identify precisely those events that explain the borrower’s monthly financing requirements. We may be surprised to learn that much more is driving monthly borrowing requirements than the usual build up in receivables or inventory.

3) The adjustments for bad debt expense are similar to the adjustments noted above for a foreign exchange gain or loss.  For example, since a bad debt expense is a non-cash charge, we should restore the receivables balance and eliminate the bad debt expense from the income statement.  But if we fail to do so, it all comes out in the wash, so to speak, because the unadjusted decrease in the receivables balance (an implied cash inflow) is precisely offset by an unadjusted bad debt expense on the income statement (an implied cash outflow).  Both accounts are accommodated and accounted for prior to Net Cash Income on the UCA cash flow statement.  Therefore, Net Cash Income will not be impacted if we do - or do not - make the non-cash adjustments.

4) Finally, with respect to annual and interim comparisons, all the usual caveats apply about such comparisons regardless of whether they involve balance sheet amounts, ratios, or cash flow statements.  Interim financial information is frequently incomplete or flawed.  Consequently, the comparison may be flawed and provide misleading signals about performance. 

In the Question and Answer segment of Webcast on Business Income Tax Returns on March 26th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: What is the difference between guaranteed payments to partners and distributions?

A: Guaranteed payments are treated like salary and reduce reported income for a partnership by the amount of the guaranteed payment.  The partner receiving a guaranteed payment must declare the amount as taxable income on his or her personal income tax returns.  Distributions are not tax-deductible expenses and do not reduce reported profit.  Further, a partner receiving a distribution does not report that amount as taxable income on his or her personal income tax returns.

Q: What would be a common reason for significant differences in taxable receipts and accrual revenue?

A: Contractors customarily use the percentage of completion method of accounting.  As such they will record amounts on the asset side of the balance sheet that represents costs in excess of billings to clients.  On the liability side of the balance sheet, they will record amounts that represent billings in excess of costs and profit.  The costs in excess of billings are not recognized as accrual expenses but, rather, are recorded on the balance sheet.  By the same token, billings in excess of costs and profit are not recognized as accrual income but, again, are recorded on the balance sheet.

The rules change for income tax purposes.  The same contractor may consider costs in excess of billings as a tax deductible expense.  The same contractor, however, must report billings in excess of costs and profit as taxable revenue.  Consequently, the difference in accrual and income tax revenue and expense amounts can frequently be quite significant.

Q: Where did the $112,115 come from?

A: The $112,115 is the ordinary income for Information Access, Inc. reported on the first page of Form 1120S.  That amount does not include additional income earned by the company, such as interest income.  Further, it will not include certain deductions that are separated from the expense stream and may be claimed by the owner as a tax deduction on his or her personal income tax return.

Q: Are the distributions of $581,746 only applicable to Subchapter S corporations?

A: Distributions are facts of life for Subchapter S corporations, partnerships, limited liability companies (LLCs), and sole proprietorships.  For sole proprietorships it’s customary to refer to distributions as withdrawals.  Both are identical in purpose and intent.  And neither distributions nor withdrawals are classified as expenses and, therefore, do not reduce reported company profit.  In addition, neither distributions nor withdrawals are reported by the recipients as taxable income on their personal income tax returns.

Q: Is there any specific benefit/detrimental affect to accelerating depreciation?

A:  Accelerated depreciation drives down taxable profit, so long as the assets in question are not fully depreciated.  Once they are fully depreciated, then no further amount of depreciation may be claimed as an expense to reduce taxable profit.

So long as a company continues to add depreciable assets at a fairly healthy rate, it can offset some of the acquisition cost by reducing its tax burden via accelerated depreciation.  But it must maintain its asset acquisition appetite in order to reap the benefits from accelerated depreciation.  It can be an interesting surprise to a company if and when it exhausts its depreciable assets and has no further depreciation expense at its disposal to drive down taxable profit.

Q: So, for 2008 Schedules K-1 it will be at the accountants' discretion whether or not they include owners' distributions?

A: Yes. Actually, I think the change in the format goes back to at least 2006.  But it is at the discretion of the accountant.  In most instances, the accountant will list the amount of an item that affects base.  As a precaution, always check Schedule K, which should invariably report the full amount of distributions for the year.  Using information about an individual’s percent of ownership from Schedule K-1, you can then work out the likely distribution to the individual (assuming more than one owner) in the absence of specific information on Schedule K-1.  And, at a minimum, it might be helpful to ask the accountant specifically about the existence and size of a distribution.

Q: Recently heard of a limited liability limited partnership (LLLP). Any special tax consequences to that type of entity?

A: A tax accountant would be the best source of information about an issue such as this.  However, any type of business organization that uses the term “limited” usually refers, at least in the first instance, to protection against responsibility for satisfying the organization’s debt obligations.  “Limited liability” and “limited partnership” together may apply to the conditions that determine ownership, e.g., minimum dollar investment, minimum number of owners, and so on, which also protects the limited partner from responsibility for partnership debt obligations.

Q: Who pays taxes on the $581M distribution?

A:  The $581,746 distribution to Peter Keys is tax-free.  No one pays taxes on that amount of cash provided by Information Access, Inc. to Peter Keys.  According to the income tax regulations and the associated accounting standards that mirror those regulations, distributions are not an expense for the business, i.e., they do not reduce taxable profit, nor are they taxable income to the recipient, i.e., Peter Keys does not report $581,746 of cash inflow to him on his personal income tax returns.

Q: What is the difference between the $581K distribution in the K-1 schedule and the $37.7K listed in schedule M-2?

A: In this instance, there is no relationship.  The amount at Line 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796.  The accountant failed to enter the beginning balance, so we have no way of knowing the final balance.  However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute.

The $581,746 distribution reported on Schedule K-1 is a different issue.  It is the amount of cash actually distributed by the company to Peter Keys in 2001, regardless of the amount of retained, taxable profit available for distribution.  Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, Keys will not be subject to income tax on the distribution, since he has likely guaranteed company debt. By doing so, he increases his equity base, in effect.  Therefore, if Keys provides a guarantee for the short-term credit line of $2,000,000, his equity base increases by $2,000,000.  So long as distributions do not exceed the sum of his combined business and guaranteed base, they are tax-free to Keys.

Q: How do we determine principals' contributions to the entity on the new Schedule K-1 forms?

A: On the Schedule K-1 (Form 1065) for partnerships, the information about contributions is captured in box L.  On the Schedule K-1 (Form 1120S) for Subchapter S corporations, the information is not captured.  You’ll need to review Line 25 on Schedule L and any attachment that would provide information about capital contributions by owners.

Q: Could you discuss deferred revenue?

A: Deferred revenue occurs when a company has either invoiced a client for goods and services it has yet to provide or receives cash from a client for goods or services it has yet to provide.  For example, if Information Access, Inc. billed a client $100,000 for a software system it will deliver in 60 days, it would post a $100,000 debit to accounts receivable, thereby increasing that asset account by $100,000, and it would post a $100,000 credit entry to deferred revenue, thereby increasing that liability account by $100,000.  These entries affect only the balance sheet.  The company cannot properly recognize revenue until it ships the product or service.  When it does so in 60 days, it will post a $100,000 debit entry to deferred revenue, thereby decreasing the account by $100,000, and it will post a $100,000 credit entry to revenue, thereby recognizing revenue and increasing that account by $100,000.  In effect, the company moves $100,000 from the balance sheet to the income statement.

Q: How do you reconcile differences in M-2 distributions to Schedule K and Schedule K-1 distributions?

A:  There is no reconciliation.  The amount recorded at Line 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796.  The accountant failed to enter the beginning balance, so we have no way of knowing the final balance.  However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute.

The $581,746 distribution reported on Schedule K-1 is a different issue.  It is the amount of cash actually distributed by the company to Peter Keys in 2001, regardless of the amount of retained, taxable profit available for distribution.  Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, Keys will not be subject to income tax on the distribution, since he has likely guaranteed company debt. By doing so, he increases his equity base, in effect.  Therefore, if Keys provides a guarantee for the short-term credit line of $2,000,000, his equity base increases by $2,000,000.  So long as distributions do not exceed the sum of his combined business and guaranteed base, they are tax-free to Keys.

Q: Why are the distributions on Schedule K different from the distributions on Schedule M-2?

A: The amount recorded at Lines 6 on Schedule M-2 is the addition to the accumulated adjustments account – an increase in that account of $37,796.  The accountant failed to enter the beginning balance, so we have no way of knowing the final balance.  However, we do know that the company has $37,796 of 2001 taxable profit after additions and deductions, which it could distribute – listed at both Lines 6 and 7.

The $709,446 distribution reported on Schedule K is a different issue.  It is the amount of cash actually distributed by the company to the owners, regardless of the amount of retained, taxable profit available for distribution.  Even though the distribution exceeds the amount of 2001 taxable profit available for distribution, the owners will not be subject to income tax on the distribution, since they likely guaranteed company debt. By doing so, they increase their equity base, in effect.  Therefore, if the two owners provide a guarantee for the short-term credit line of $2,000,000, their equity base increases by $2,000,000.  So long as distributions do not exceed the sum of the combined business and guaranteed base, those distributions are tax-free to the owners.

Q: If the customer is taking more in distributions than income earned, where does the difference come from?

A: It all depends on the cash resources available to the company.  For example, I
reviewed a rather fascinating credit a couple of years ago in which a borrower lost roughly $800,000.  It was a Subchapter S corporation with a single owner.  The owner reported the $800,000 loss on Schedule E and again at Line 17 on his Form 1040.  It had the effect of driving his adjusted gross income into negative territory – more than offsetting salaries, bonuses, and other sources of taxable income – and eliminating any personal income tax obligation for the year.

However, his Schedule K-1 recorded a $1,000,000 distribution from the company to this single owner – tax free, of course, to the owner.  So where did the cash come from?  As it turned out, the company maxed out its short-term working capital line, which it did not need to support receivable and inventory as it turned out, and used the proceeds to provide the $1,000,000 distribution to the owner.

So, in the final analysis, excessive distributions always depend on available cash, which can come from many sources.  In the above instance, the lender thought it was financing receivables and inventory.  In fact, it was financing the owner’s lifestyle.

Q: Has the corporation distributed more than its accumulated profits?  If so, is the excess amount taxable to the individual?

A: Not necessarily and usually not at all.  Even though distributions exceed the amount of 2001 taxable profit available for distribution, the owners will not be subject to income tax on the distribution, since they likely guaranteed company debt. By doing so, they increase their equity base, in effect.  Therefore, if the two owners provide a guarantee for the short-term credit line of $2,000,000, their equity base increases by $2,000,000.  So long as distributions do not exceed the sum of the combined business and guaranteed base, those distributions are tax-free to the owners.

Q: What about line 21 on Schedule K-1. They show loan from shareholders of $200,000. However, line 19 on Schedule L shows an increase of 230,000.

A: I think the amount at Line 21 on Schedule K-1 (Form 1120S) for Peter Keys is $160,000.  The amounts at Line 19 on Schedule L – $363,164 in 2000 and $131,164 in 2001 – reflect a decrease in loans to shareholders of $232,000.  Of that payback amount of $232,000, $160,000 went to Peter Keys in 2001. The remaining $72,000 of debt reduction must have gone to his co-owner.

Q: If an LLC is owned by another LLC, are both required to file a tax return even though the income and expenses are passed through one entity into the other or only the one LLC that is the owner of the other LLC?

A: All LLCs are required to file Form 1065.  The LLC at the bottom of the chain files its information-only income tax return – its Form 1065 – indicating the amount of profit its parent LLC must report on the income tax return it files – its own Form 1065.  If the parent LLC is owned by two private individuals, for example, each must report their pro-rata share of LLC income on their Form 1040. So, in effect, the LLC at the bottom of the chain passes its taxable profit all the way up the chain to the ultimate taxpayers.

In the Question and Answer segment of Webcast on Commercial Real Estate on March 19th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Is current vacancy considered "stabilized"?

A:  Usually not.  “Stabilized” is a term used by an appraiser to designate a value at the point of equilibrium for the market in question.  The existing vacancy rate may turn out to be identical to the appraiser’s assessment of a “stabilized” vacancy rate at the point of market equilibrium.  The same considerations would apply to existing and “stabilized” rental rates and to existing and “stabilized” operating expenses.

Q: If property is 100% occupied by a single tenant, does the lease term play a more important role?

A: The lease term would play a critical role.  This is a concentrated customer base, so to speak, and if anything happens to the single customer, the property could encounter rather massive cash flow problems.  For a single tenant, it is always important to match the term of the lease with the amortization period – the more closely they match, the better for the property, for property cash flow, and for debt service.

Note, too, how important the financial health and prospects of the single tenant are to the financial health and prospects for the property.  It’s usually very difficult to get relevant information about a single tenant, even if it is a location of a larger retail chain that is publicly listed.  The publicly listed company may be quite robust while its local outlet in this instance is struggling badly.  Depending on the specific lessee, the larger company may not be a source of financial support in bad times.

Q: Do you provide a template that would calculate the various break even scenarios?

A: We offer such a template as part of our Resource Center, which is available to
organization members.

Q: What is IREM?

A: IREM is the acronym for the Institute for Real Estate Management.  Among other things, it plays a role in the commercial real estate world similar to a role played by the RMA in the commercial business world.  That is, the IREM conducts surveys about vacancy rates, rental rates, and operating expenses in various metropolitan areas and sub-areas.  It provides the results of those surveys to members who may then use the results for comparative purposes – rather like comparing a property’s vacancy rate, rental rate, and set of operating expenses with its peers in the local market.

Q: How do you derive the 'debt constant'?

A: The debt constant comes from a fairly complex formula that reduces to a number for each interest rate and amortization period for either annual, semi-annual, quarterly or monthly mortgage payments – or for any other debt repayment frequency you wish.  The appropriate constant is then multiplied by the loan amount to provide the periodic payment.  The conceptual formula underlies the mechanics that transpire when you enter the loan amount, the interest rate, the amortization period, and the payment frequency into any calculator that supports that function.  In addition, debt constant tables are widely available from a variety of sources, accessible via the Internet and a Google search.

Q: If you feel the collateral value is the 3rd repayment option (tertiary), what do you see or hear the FDIC feels in today's economic times?

A: I don’t hear anything that provides great clarity about the issue.  From all comments
I’ve received, the regulators would tend to allow collateral value to trump net operating income, i.e., if a property had sufficient cash flow to service debt but had more debt on the property than an estimate of current market value, the regulators would tend to consider the property an impaired asset.  Personally, I think this makes little sense.  The first way out for a performing asset is sufficient cash flow to service interest-bearing debt.  If an income producing property is, indeed, providing sufficient net operating income to do so, that should be the relevant consideration in assessing loan performance – not some fleeting estimate of collateral value.

Q: Does FIRREA require new appraisals on loan modifications vs. refinances?

A: A very good question but one I think should be properly answered by the regulators.  I suspect it depends on the extent of the loan modifications.  If those modifications changed the debt service obligations and periodic payment amounts, they would likely be considered a de facto re-financing.  But if loan modifications impacted other elements of the financing, such as payment dates or reporting requirements, then I would guess that a FIRREA-driven appraisal would not apply.

Q: On the Reasonable Tests, you compare the cap rate to prime rate and Baa yields. How does the prime rate relate to assessing reasonableness to the cap rate used?

A:  I use Baa yields – or, better, junk bond yields – to approximate the risk associated with investment in income producing properties.  The prime rate presumably represents the rate applied to the highest credit quality.  Therefore, it would not represent the required yield on a comparable risk asset.

However, a very relevant issue is whether the capitalization rate on an income producing property is greater or less than Baa or junk bond yields.  If it is less, that implies the investor expects to make up his or her required yield via property appreciation.  If it is more, that implies the investor expects to suffer a decrease in property values and, hence, a reduction in overall yield.

If you wish, you could compare a capitalization rate to the prime rate as a very rough guide about investor price expectations.  If the capitalization rate ever fell below the prime rate, it would represent a very strong signal that the investor expected significant price appreciation in the underlying asset.  In more normal circumstances, we would expect the capitalization rate to be higher – by some considerable margin – than the prime rate.

Q: Why did we assume a 5% interest rate on the Proposed Refinancing vs. 8.5% at origination, whereas the cap rate was higher by .25%.

A: The applicable interest rate represents, primarily, the cost of money plus a risk premium.  In mid 2007, five year LIBOR was about 5.75%.  In January 2009, five year LIBOR was about 2.25%.  If the lender funded itself at a five year LIBOR rate in June 2007, its spread would have been 275 basis points with the transaction lending rate set at 8.50%.  By the same token, if the lender funded itself, again, at a five year LIBOR rate in January 2009, its spread would be an identical 275 basis points even though the lending rate had dropped to 5.00%.

The capitalization rate did not change.  It remained at 9.50% for both financings, in the opinion of the appraiser.  However, a 9.50% cap rate in January 2009 in a much lower interest rate environment represents a considerably higher risk premium than did a 9.50% cap rate in June 2007.  In June 2007, the prime rate was 8.25%.  In January 2009, it was 3.25%.  In general, there is a high level co-relation between movements in market interest rates and movements in capitalization rates.   But capitalization rates should be very specific to the property in question, in addition to reflecting the general interest rate environment. 

With respect to 1200 Columbia Pike, the appraiser obviously felt a relatively higher capitalization rate was appropriate and, therefore, kept it at 9.5%, although the general interest levels had dropped dramatically from those prevailing at the time of the initial June 2007 financing.

In the Question and Answer segment of Webcast on the Credit Write-up on March 12th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Tony asks: During an economic downturn, can one assume that the business will return to prior levels of sales and income?

A: I don’t think so.  In fact, the economic downturn will likely lead to a major restructuring of the U.S. economy.  A company that did well prior to the downturn may be poorly positioned to do well as the economy rebounds.  There have been several interesting articles lately about the possible fallout of the present recession.  Some geographical areas will likely emerge far stronger when the economy emerges from its present depressed state – especially those areas that have a highly educated workforce and a synergy of technical and administrative competence.  Other areas will continue to decline and suffer extensive job losses.  The bottom line is that all bets are off.  The post-recession world may be very different from the pre-recession world. And what worked before the recession may not work after the recession ends.

Tony asks: Borrower concurrence in this case means that the borrower needs to come up with an additional $200,000 down payment. Shouldn’t this be discussed as a major point as well?

A: Absolutely.  The deal may fall apart if the lender is unwilling to provide more than $800,000 of term financing for a property selling for $1,365,874.  The buyer must now provide an additional $224,406 of equity (the difference between $1,024,406 – 75% of $1,365,874 – and the $800,000 the lender is now willing to provide).  Whether the buyer is willing to do so is a critical issue.  But, presumably, the lender is willing to walk away from the deal if the buyer will not, or cannot, provide the additional cash necessary to make the transaction work.

Antonio asks: The seven-day decrease in A/R days resulted in a cash inflow of $304,152.  How did you determine that amount?

A:  The solutions provide the computations in some detail. Briefly, however, the $304,152 represents the difference between the accounts receivable balance in 2005 if receivables had grown at the 2005 sales growth rate of 47.33% and the actual 2005 ending balance. 

If receivables had grown at 47.33%, accounts receivable days would have remained at 35 days (actually at 34.57 days) and the 2005 receivables balance would have been $1,488,624.  In fact, receivables did not grow at the sales growth rate. They grew at a lesser rate since the company collected its receivables seven days more rapidly.  As a result, the ending 2005 accounts receivables balance was $1,148,472.  The difference between 2005 accounts receivable at 35 days and actual 2005 accounts receivable at 28 days was $304,152 or $1,488,624 – $1,148,472.

Antonio asks: What is the difference between Stabilized NOI and actual NOI?

A:  Stabilized net operating income (NOI) represents the NOI that the property would be expected to generate at the point of equilibrium – which would occur at some future point in time.  It’s customary and conventional for appraisers to assess the rental rate, the vacancy rate, and the operating expenses at the point of equilibrium, which is usually different from the state of affairs at the time of the appraisal.  Those three assumptions collectively determine stabilized NOI.

Actual NOI is the present net operating income of the property.  Stabilized and actual NOI may be significantly different for a variety of reasons.  The critical point, however, is that actual or current NOI is the property cash flow available to service interest-bearing debt.  Stabilized NOI is a future, and rather idealized, concept.  It may or may not ever materialize.

Antonio asks: What about the owner's credit worthiness?

A: The property owner’s credit worthiness is certainly a key factor.  But an equally as pressing problem is an assessment of the amount of ready cash the owner could provide in a financial crisis to support the property’s debt service.  In the best of all worlds, the owner would be highly credit worthy as well as able to access highly liquid personal assets to support the property’s debt service in the event of difficulties. 

Assessing ready cash is far more complex than identifying an owner’s estimate of net worth on his or her annual personal financial statement.  It requires a close and frequent review of the owner’s personal assets, usually by reference to monthly or quarterly bank or broker statements.  To the extent the property’s net operating income is marginal or diminishing, the value of the personal guarantee becomes increasingly important – which means that a current assessment of that guarantee becomes increasingly important.

Cecil asks: How do you treat taxes on DCR for Subchapter C corporations?

A: Since income taxes are paid directly by a Subchapter C corporation, net income will include the income tax expense.  Therefore, you need make no adjustment to net income for income taxes if, for example, you used net income as your starting point in structuring a debt coverage ratio.  In such a case, net income would need to be sufficient to cover scheduled long-term debt repayment.  To be safe, you should also specify that net income must exceed the sum of scheduled debt repayment and loans to owners.  Such loans do indeed exist for Subchapter C corporations, just as they do for all other types of business organizations.

If you chose to use EBITDA as your starting point for a debt coverage ratio, then EBITDA would need to be sufficient to cover income taxes, interest expense, scheduled long-term debt repayment and loans to owners.  In this instance, income taxes are identified separately, since they are not included in EBITDA.

In the Question and Answer segment of Webcast on Estimating Debt Capacity on February 26th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Cathy asks:  The Due to Shareholders account increased from $57,931 in 2007 to $202,397 in 2008.  Would that amount be added to the amount of cash available to service debt? 

Answer: The $144,466 cash inflow from a shareholder in the form of a loan to the company is not part of operating profit or operating cash flow.  It plays no role in estimating Sierra Products’ debt capacity in 2008.

However, the cash inflow from the loan represents financing, and, as the 2008 UCA cash flow statement indicates, reduced the company’s need for outside financing by the amount of the loan, i.e., by $144,466.  Apart from that cash inflow, Sierra Products was compelled to raise a further $413,992 of short-term debt and $314,000 of new long-term debt to meet its shortfall – an increase in outside party interest-bearing debt of $727,992.

Whether it used any of the shareholder loan for debt service is unclear.  Very likely it used additional short-term debt to meet its debt service shortfall of $297,607 at Cash after Debt Repayment. The remainder of the increase in short-term debt of $116,385, the new long-term debt of $314,000, and the $144,466 loan from the shareholder probably represent the company’s cash sources in 2008 to pay for $587,082 of fixed asset acquisition.  The sum of those three cash sources is $574,851 – $12,231 less than the amount required.  The additional $12,231 came from the company’s existing cash balances.

In general, consider loans to owners or shareholders as compensation.  It’s an easy and quick way to pull money from a company.  Consider loans from owners or shareholders as “emergency” financing.  That is, the company could not arrange the outside financing it needed and, in the final analysis, was compelled to rely on the owner’s resources.

Melissa asks: In computing an appropriate leverage ratio, would you adjust net worth down or exclude the difference between due from and due to shareholders?

Answer:  It might be a bit more transparent to reduce net worth by the amount of the Due from Shareholders balance, i.e., treat the amount due from owners or shareholders as an intangible.  Such a reduction to net worth would increase the leverage ratio, which is appropriate since this type of expense signals an increase in risk. 

On the other hand, you would reduce total liabilities by the amount of the Due to Shareholders balance – if all loans from shareholders are subordinated – and add the Due to Shareholders balance to net worth.  The underlying assumption is that subordinated debt is similar to equity, particularly if a strong subordination agreement is in place and actively monitored.  This adjustment, in turn, decreases leverage, since it represents a quasi debt-to-equity switch.

In effect, you might apply a two-step approach.  First, consider the Due from Shareholders balance as an intangible asset and reduce net worth by the amount of the outstanding balance, which increases leverage.  Second, consider the Due to Shareholders balance as quasi equity, if a subordination agreement is in effect, and move the full balance from debt to equity in computing a leverage ratio. 

The two steps taken together should provide a fair representation of the change in risk, reflected in the leverage ratio, from loans to and loans from owners and shareholders.

But regardless of the impact on leverage, keep in mind that the immediate impact of a new loan to an owner or shareholder is to decrease debt capacity.

In the Question and Answer segment of Webcast on Commercial Real Estate on February 19th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Sam asks:   Can you expand on Class A commercial properties versus Class B commercial properties and the potential impact of the recession on each?  That is, some Class B may weather the storm better…particularly as big box stores close.

Answer:  I would tend to agree.  Tough times put a premium on lower rents and that suggests an advantage of Class B vis-à-vis Class A commercial properties.  In addition, Class A commercial properties may carry a relatively higher debt burden than Class B commercial properties, particularly if the Class A commercial properties are more recent.  The higher debt burden, if it does exist, suggests higher financial cost rigidities and less flexibility to reduce rents.

However, as with virtually all real estate issues, so much depends on local market conditions.  What might apply in one market may not apply in a neighboring market.

Melissa asks: Why use an appraisal for value with 5% vacancy when actual rent rolls represent a higher vacancy percentage?

Answer:  The appraiser attempts to determine a “stabilized” vacancy rate at the point of market equilibrium.  That “stabilized” rate may be far different from the prevailing vacancy rate at the time of the appraisal, which is quite common.  But the problem for the lender is that it has to contend with actual market events in attempting to determine if the property can cash flow, i.e., generate enough cash to properly service the debt.  Consequently, a “stabilized” vacancy rate, a “stabilized” rental rate, and a “stabilized” set of operating expenses are really irrelevant in assessing present – not “stabilized” – debt capacity.  My point is to always focus on current events and current net operating income and do not be lead astray by the prospects of what might be at some point in the future.

Amber asks:  If this is a subsequent transaction, why is a new appraisal required? This assumes an in-house evaluation/review indicates no substantial changes in market value from appraisal and no new funds are disbursed.

Answer: Given the terms and conditions specified in FIRREA, a lender must request a new appraisal for refinancing of an existing property if the refinancing amount exceeds a certain minimum, such as $500,000.  Your internal review may show no substantial change, but the examiners may emphasize the need for a new appraisal in the process of enforcing the provisions of FIRREA.

Melissa asks:  What is TI claw back?

Answer:  A TI claw back is a refund for tenant improvements (TI) that were initially paid for by the landlord but then charged back to the tenant in the form of an increase in the rental rate over some period of time.

Doug asks:  Do you have available canned formulas via Excel our another source to calculate the break-even figures?

Answer:  We have an electronic worksheet that provides numerous break-even computations as well as provides the format and process for computing estimates of market value using the income capitalization rate.  The worksheet is housed in our Resource Center and is available to Organization Members and Enterprise Wide Licensees. 

Kristi asks:  How would you assess an interest only situation?

Answer:  With care.  In the final analysis, the property must throw off enough cash to pay interest as well as meet required debt reductions.  Consequently, you might match projected net operating income against interest-only debt service over the interest-only debt service period and then match projected net operating income against full debt service from that point to maturity.  If you have any doubt that the property’s net operating income will not increase sufficiently to match full debt service, then be very careful about the transaction.  If you’re already in it, search for and identify all likely back-up sources of debt service, such as likely cash support from one or more guarantors.

An interest-only loan may look attractive today in a low interest-rate environment, but this low interest-rate environment finds itself in the midst of a severe economic recession that drives down rental rates and increases vacancy rates.  That, in turn, places a great premium on current information about the property, especially about existing rental rates, existing vacancy rates, and likely future vacancies.

Matt asks  On the 1/1/09 Columbia Pike rent roll, four vacancies are shown as opposed to the three that were referenced in the slides. Was the fourth vacancy (unit 210) accounted for in the analysis?

Answer:  It was accounted for in the analysis.  I simply overlooked the fourth vacancy in putting together my comments but did compute the effective gross income properly.

Peter asks:  Could you go over the revised estimate of market value calculation again?

Answer:  The intent of the revised approach to estimating market value via the income capitalization approach is to more correctly capture net operating income and an appropriate capitalization rate during a transition period to “stabilized” or market equilibrium. 

During that interim period, the task is to estimate net operating income as accurately as possible and to determine an appropriate capitalization rate for the subject property as accurately as possible.  A further task, which is much more difficult, is to estimate likely net operating income at the later point of market equilibrium and a capitalization rate at that later point of market equilibrium.  There are many historical markers to use as reference points for both a market equilibrium net operating income and capitalization rate but, nonetheless, the two values we decide on are only our best guesses at the time.

But the real advantage of this approach is that it attempts to better approximate what is happening today and what will likely happen tomorrow.  To apply a single capitalization rate to a single estimate of net operating income can be very misleading about market value over any time period – either misleadingly high or misleadingly low.

The equation below reflects our assumptions about working through a transition period for 1200 Columbia Pike.  Those assumptions, in turn, as are follows:

• The real estate market in the property’s area will not return to equilibrium until 2012.
• Over that three-year horizon, the appropriate cap rate is indeed 9.50%.
• NOI will remain at $81,091 over the three-year horizon, then jump to a stabilized value of only $103,515.
• At the point of market stability, the stabilized cap rate will fall to 7.00% for this market and property.

          $81,091        $81,091        $81,091           $103,515
Market Value = ———— + ———— + ———— + —————— = $1,410,580
         (1.095)         (1.095)²            (1.095)³        (1.07)³ x (0.07)

Once we work through all the computations, the present value of the property is $1,410,580, vastly in excess of our prior estimate of $982,921.  That estimate implicitly assumed that NOI would remain at $81,091 forever into the future.  It also implicitly assumed that the investor’s required rate of return on property NOI would remain at 8.25% forever into the future – both quite unrealistic assumptions. 

Jay asks:  If a bank has not traditionally done this type of self-underwriting, how do they undertake it in today's environment?

Answer:  The most practical approach may be to either engage a consultant who has worked as an underwriter for a real estate lender and, therefore, should understand the information and analytical requirements or bring someone on staff with those qualifications.  Hiring the expertise can frequently be a long and arduous task.  In the short run, it might make more sense to search for a qualified consultant.

Jay asks:  Is there a banking source or report, which estimates the percentage of loans under stress by region and/or banks?

Answer:  The Federal Deposit Insurance Corporation produces monthly reports that provide much of this type of information.  You might visit their website and probe the information available.

In the Question and Answer segment of Webcast on Working Capital vs. Cash Flow on February 12th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Mark asks: In order to compute the reconciliation to changes in working capital you must consider long-term debt and not CMLTD. Is that correct? Please explain.

Answer: The issue gets back to the definition of working capital and what explains changes in it.  The point you raise is quite interesting because it illustrates how critical balance sheet classification decisions are to the resulting dollar amount of working capital. 

For example, if a company increases its short-term financing, the amount of the increase has no impact on working capital.  Cash (until used) goes up but so, too, does short-term debt. The increase in a current asset account is matched by an increase in a current liability account and working capital is unaffected.

However, if the company had classified the increase in interest-bearing debt as a long-term liability, then the cash account would increase but no current liability account would be impact by the classification of interest-bearing debt as a long-term liability and, therefore, working capital would increase.

This classification issue is in play with CMLTD.  Even though CMLTD is still long-term debt, it is classified as a current liability.  Therefore, it has no impact on working capital.  However, the remaining long-term debt balance does impact working capital since it is classified as a long-term liability.

Note how different working capital is from cash flow.  If a company increases its interest-bearing debt, cash flow is impacted regardless of how the company classifies the event on its balance sheet.  Not so with respect to working capital.  An increase in interest-bearing debt can leave working capital untouched or not, depending on account classification.

At the end of the day, cash flow counts.  Working capital is not cash flow.

Jack asks:  What caused Seaside's current maturities to rise so drastically in 2004, while long-term debt only rose slightly from 2003?

Answer: It’s very unclear why the current maturities rose so dramatically in 2004.  It is in the company’s interest to stretch out the repayment period rather than to shorten it, but it looks as if its term debt repayment schedule went through a severe revision in late 2003 or 2004 that carried into 2005.  In very general terms, the term debt on the books in both 2004 and 2005 seems to roughly follow a three-year amortization schedule.

The most likely explanation for this structural adjustment may lie with the type of fixed assets the company purchased and financed.  If those fixed assets were hardware or software systems, the company may have selected a more rapid depreciation schedule.  However, without better information, we can only guess at this point.

Sean asks: Please cover the measurements you discussed in closing, i.e., the profitability covenant and the financing gap ratio. 

Answer: Because the UCA cash flow statement is difficult to properly interpret, particularly for a borrower unaccustomed to its format and terms, we can get at the issue of containing business cash flow by using two covenants that work in tandem to do so. 

The first – a debt service covenant – is designed to provide maximum assurance the borrower will generate sufficient business profit to service interest-bearing debt.  We define business profit as reported net profit less the sum of distributions (or withdrawals) and loans to owners.  Loans to owners may increase or decrease over a period.  If they decrease, i.e., if a Due from Owner balance on the asset side of the balance sheet decreases, that frequently reflects the conversion of some, or all, of the outstanding loan from the owners to a distribution.  The resulting sum represents the amount of cash flowing from the business to the owners to satisfy their personal income tax obligation on company profit or to provide additional compensation.  Regardless of purpose, the sum of these two amounts drains cash from the company and impacts its debt service ability.

Given these comments, a debt service covenant (DSC) can be expressed as follows:

         Net Profit – sum (Distributions + Loans to Owners) + Int. Exp.
DSC =  ———–———————————————————————————   > 1.25
                      Interest Expense + CMLTD (prior period)

The 1.25 factor in the equation above is for illustration only.  We want the DSC to be at least equal to 1.00, which means the borrower just meets the debt service.  However, if we have doubts about the prospects of fully converting accrual profit to cash, we increase the requirement above 1.00 by some risk factor, such as 0.25 in this instance.

Meeting the DSC is only half the battle in assuring proper cash flow.  The second useful, and complementary, covenant is a financing gap ratio based on a borrower’s performance in the last historical period.  If a borrower can maintain the financing gap ratio in the next period, it means that any cash outflow from movements in operating balance sheet accounts, e.g., receivables, inventory, or payables, will be attributed only to sales growth and not to poor management of those operating balance sheet accounts.

For example, if a financing gap ratio for the last historical period were calculated at 15.00% and the borrower maintained that ratio in the next period, it tells us that the operating balance sheet relationships remained stable.  Even so, a net cash outflow would occur if the set of operating assets exceeded the set of operating liabilities – which is usually the case – as the borrower increases sales in the period. But the cash outflow would reflect the impact of sales growth and not management’s inability to maintain receivables at last year’s number of days, for example.

The financing gap ratio is defined as follows:

                             Operating Assets – Operating Liabilities
Financing Gap 
Ratio =                   ———–———————————————   x 100
                                                     Sales
 
The lender must determine those operating assets and operating liabilities to include in the ratio.  For example, receivables and inventory may represent major operating asset accounts while prepaid expenses play no role.  Further, accrued expenses and deferred revenue may represent a significant operating liability accounts while the accounts payable balance is minor or non-existent. Therefore, the applicable financing gap ratio in this instance would be the sum of receivables and inventory minus the sum of accrued expenses and deferred revenue divided by sales for the period. 

If that ratio increases in the next period, it means the borrower let the operating assets grow more rapidly than the operating liabilities, which will add to the cash outflow.  On the other hand, if the borrower reduced the ratio in the next period, it means the borrower squeezed cash out of its balance sheet by constraining operating asset growth relative to operating liability growth.

In the Question and Answer segment of Webcast on Global Cash Flow on January 22nd, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Question: I’m still unclear why interest expense is added to EBITDA on the Covenant Implications slide. You are already starting with earnings prior to interest expense.  Then you add it back?  Please clarify.

Answer: Completely an error on my part.  It should not be added back.  It shows up as part of debt service in the denominator only.  The covenant begins with EBITDA and then reduces that amount by the sum of distributions and loans to owners or shareholders.  The resulting amount must be sufficient to cover debt service – the sum of interest expense and scheduled long-term debt repayment.  We add a risk factor of 25 basis points, for example, which represents our assessment of the risk that EBITDA will be converted fully to cash.

Question: Is cash flow Net Income + EBITA + the 95 FASB statements?

Answer: Cash flow as we use the term is the Uniform Credit Analysis (UCA) cash flow statement.  It is similar to the FASB 95 statement of cash flows, except for some very significant classification decisions.  For example, in the UCA cash flow statement, distributions are considered expenses for income taxes and owner compensation.  They are included in the operating part of the UCA cash flow statement. FASB 95, however, classifies distributions as a financing event and does not include it in the operating part of the cash flow statement. 

The difference in classification decisions can have a very material impact on our ultimate assessment of the borrowing cause, for one thing, and whether a borrower was able to service interest-bearing debt from business cash flow, for another.  The UCA cash flow statement is much more useful in addressing these two important issues.

Question:  Regarding distributions, why are they not taxable?

Answer: They are not taxable in accordance with Congressional legislation and the resulting income tax regulations.  For a Subchapter S corporation, partnership, limited liability company (LLC) and sole proprietorship, the owners are subject to income tax on their pro-rata share of company profit only.  Distributions from the company to the owners are not taxable events, given the income tax regulations.  They are not reported on the owners’ personal Form 1040 as taxable revenue.  In fact, they are not reported as expenses on a company’s accrual financial statements or business income tax returns.

Question:  Shouldn't you consider Schumacher's personal tax return in case he has other cash flow, such as wages, in the global analysis as well as his debts?

Answer: We should attempt to pick up all the personal revenue streams flowing to the guarantor and certainly wages represent one of those streams in most instances.  But the key point is that cash flows from a business to an owner dry up in a financial crisis.  An owner may enjoy very robust personal cash flow – including wages – prior to a crisis.  But once the crisis hits, those cash flows diminish considerably or dry up completely.  Therefore, the value of a guarantee is the amount of ready cash a guarantor can access from highly liquid personal assets – not from personal cash flow – to help support debt service on the interest-bearing debt he or she guarantees.
 
Question:: Why are we not considering the $4,112,432 in Capital Contributed on Sequoia Properties' 2007 Changes in Partners' Capital statement? Wouldn't this be a cash inflow from the shareholder or affiliate(s)?

Answer: On the surface, it definitely looks like a capital contribution from the owner and, therefore, a cash inflow from the owner to the company.  But Footnote 4 to the Sequoia financial statements clearly indicates that the company reclassified a loan from the owner in the amount of $4,112,432 as equity.  There was no cash injection in 2007.  The cash injection took place when the loan was made at some point in the past.
 
Question:  Why isn't the tax return history used in calculating any part of the cash flow?

Answer: If we had only the business income tax returns – the Form 1065 in this case for Sequoia Properties – we could construct a UCA cash flow statement.  But the accrual financial statements, which represent the source documents for the business income tax returns, are generally more accurate and complete.  They usually provide more detail, especially with respect to short and long term debt.  In addition, the accrual financial statements will include all expenses, some of which are disallowed in preparing the business income tax returns.

Question:: Isn't it possible that company equity going out the door in the form of loans and cash to owners or to other related entities explains increasing debt, payables, and accruals?

Answer:  Absolutely.  You see this clearly with Sequoia Properties, which distributed $1,230,735 to Clovis Supply, apparently bought $1,143,016 of fixed assets-in-process from Fresno Properties, and so on, while running up huge amounts of accruals and borrowing massive amounts of long-term debt.  There is a very clear cause and effect relationship that proves your point.

Question: The materials say that the ownership of Modesto is 82% Schumacher and 18% Clovis Supply.  Should the "Due From Clovis Supply" amount of $97,926 be considered as "Due from Shareholders", and thus, added into the "Due From Shareholder" amount of $1,457,397 making total "Due from Shareholders" $1,555,323 for Year 2007?

Answer:  It could be, but I prefer to separate out cash flows to a business and cash flows to owners directly.  We frequently have enough financial information about a business to assess whether the cash flows can be returned in the reasonable future.  And frequently they are when the fortunes of the recipient change.

But cash outflows to owners directly are really a different matter.  Owners take money out of companies for a variety of reasons, virtually none of which are remotely related to returning the cash at some later date.  When we track cash flowing out of a company to an owner in the form of distributions or loans, we can consider that cash gone and unavailable to return and support interest-bearing debt service in a crisis. 

The only way we can determine if an owner has the capacity to support company debt service in a crisis is to review the owner’s personal financial statement and determine what he or she did with the money from the company.  You’ll rarely find that it’s sitting in highly liquid assets such as Treasury bills.

In the Question and Answer segment of Webcast on Estimating Debt Capacity on January 8th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Question:  If you use depreciation expense to approximate cost of fixed assets, would you factor out change in fixed assets on the UCA cash flow?

Answer:  One weakness of the UCA cash flow statement is that it does not provide for the cash cost of replacing fixed assets.  Depreciation expense is a proxy for that cost.  Therefore, it makes sense to include depreciation expense as a proxy for the cash cost of replacing fixed assets and show that expense prior to Net Cash Income.  Net Cash Income will be less positive or more negative than it would otherwise be.

Question:  Do you mean "debt clean up" as the requirement to pay down on lines of credit at least once a year?

Answer:  Yes.  A clean up provision simply means that any amount of short-term debt outstanding has to be reduced to zero for some time period – such as 30 days – at some point during the year.  If such a provision exists, the cash repayment, or clean-up amount, must be treated identical to the payment of current maturities of long-term debt.  Cash is used up in the principal reduction but taxable profit is untouched.
 
Question: Are the rules on business interest write-offs similar to residential interest write-offs?

Answer:  If principal and interest payments on a loan are 90 days past due, the loan should properly be placed on non-accrual, which means that the lender no longer books interest due as interest income.  That provision applies to business and consumer, or residential, loans.  However, the lender determines the timing of an actual write-off, based on all the information at its disposal.  Either the full or partial amount of principal and interest due could be written off at the end of 90 days, as one option, or at some other time beyond the 90 days depending on the lender’s judgment.

Question:  So the tax rate for a company is taken from prior tax year, plus individual's, in the case of distributions?

Answer:  The tax rate is the current year tax rate, which is the sum of the maximum state and federal personal income tax rates for owners of a Subchapter S corporation, partnership, limited liability company (LLC), and sole proprietorship or the sum of the maximum state and federal corporate income tax rates for a Subchapter C corporation.
 
Question:  To me, it looks like you're counting the income tax obligation of the company twice. The company makes a distribution to the owner in order to pay income tax on the net profit of the company. However, you seem to be saying that additional cash needs to be set aside to pay the income tax on the distribution in excess of the income tax obligation. Can you clarify this? 

Answer:  We’re attempting to determine how reported operating profit can be used to maximize debt capacity, given the amount of compensation for other cash operating expenses that do not pass through the income statement, e.g., distributions and loans to owners in excess of personal income tax obligations and principal debt repayments.  In effect, we compute the debt capacity of a company on the assumption that it has not necessarily paid out any amount for income taxes per se.  We assume that the extra amounts paid to the owners in the form of distributions and loans would take place regardless of the actual income tax obligation.

Question: What about the average short-term and long-term interest rates on outstanding debt? Short of obtaining statements, how do we determine that? 

Answer:  You can estimate the average interest rate from the financial statements by dividing the interest expense for the year by the average interest-bearing debt outstanding for the year.  If interest expense on the financial statements is broken into short-term interest expense and long-term interest expense (which happens very rarely), divide the short-term interest expense by average short-term debt outstanding.  Do the same for long-term interest expense and average long-term debt outstanding.  To get average debt balances, simply add the amount of interest-bearing debt outstanding at the end of the prior year to the amount of interest-bearing debt outstanding at the end of the current year and divide by two.
 
Question: Explain again why you tax the $2,100 LT debt.

Answer:  We don’t actually tax the current maturities of long-term debt that are paid down.  That repayment does not reduce taxable profit even though it reduces cash flow by $2,100.  Therefore, we set aside the income tax amount associated with the $2,100 repayment.  By focusing on cash, we underestimate taxable profit in this instance by $2,100 and, therefore, underestimate the tax on that profit.
 
Question:  If you are not given CMLTD on the statement how do you calculate it?

Answer:  It’s not easy to estimate CMLTD if it is not broken out on the financial statements or on Schedule L in the business income tax returns.  You can attempt to estimate if by dividing total long-term debt (if you can identify that number) by the likely amortization period.  If it appears the long-term debt supported computer equipment, it probably has a three-year amortization period.  If it supports vehicles, it may have a five to seven-year amortization period…and so on.
 
Question:  If distributions paid are not enough to cover the taxes, is that the cash inflow on the sheet?

Answer:  No. To be conservative, it seems best to make no adjustment if distributions and loans to shareholders fall short of the maximum personal income tax obligation.  If they do so, it may reflect the fact that the owner is in a lower tax bracket by virtue of losses he or she can claim on the Form 1040.  The actual amount of distributions and loans, even if below the maximum, may be more than sufficient to satisfy the personal income tax obligation because of other events that flow into personal taxable income.
 
Question:  Set aside for long-term debt repayment?  Please explain again?

Answer:  The long-term debt repayment reduced cash but not taxable profit.  Even though $2,100 of operating profit and cash flow was used up, the taxable profit did not change.  Therefore, the $2,100 reduction in cash still leaves a tax obligation on $2,100 of profit that was not affected by this cash expense.  The company has to set aside the tax on that amount of profit, since it will be due and payable.

Question:  Please explain again why there is a tax set aside for compensation, if the P&L already shows tax expense on the YE operating profit.

Answer:  Distributions and loans to owners are recorded on the balance sheet and not on the income statement.  Distributions and loans to owners that exceed the maximum personal income tax obligation on company profit represent compensation.  But that compensation is not reflected on the income statement in the form of salary or bonuses, given the income tax regulations and the way we account for distributions and loans to owners.  Therefore, these compensation expenses drive down the amount of cash available to service interest-bearing debt but do not affect taxable profit.  As a result, we need to set aside the income tax obligation on the amount of operating expenses that are paid out in cash but do not impact taxable profit.

Question: Can days turn in A/R be a tool to determine the percentage of cash conversion?

Answer:  Absolutely.  If this year’s A/R days is less than last year’s, it tells us that the company is converting sales to cash more quickly, which implies that it is very likely to convert all operating profit to cash.  However, if the A/R days slowed respective to last year, that would begin to raise questions about whether the company would be able to fully convert all operating profit to cash.  The same would apply, of course, to relative movements in Inventory days and A/P days.

In the Question and Answer segment of Webcast on Working Capital vs. Cash Flow on December 11th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Question:  How does the computation for changes in long-term debt in the UCA cash flow statement differ from the computation for changes in long debt in determining the forces that explain movements in working capital?

Answer:  The computations for changes in long-term debt in the UCA cash flow statement calculate the amount of new long-term debt for the period.  In doing so, the current maturities of long-term debt play a role.  The prior year current maturities are paid down in the current period.  Therefore, the amount of new long-term debt raised in the current period is the difference between the prior period remaining long-term debt and the current period long-term debt.  The latter is the sum of the current maturities of long-term debt (long-term debt but reclassified as current) and the remaining long-term debt.

The computations for changes in long-term debt in determining the forces that explain movements in working capital focus only on those amounts of long-term debt that are classified on the balance sheet as long-term debt. The current maturities are ignored, since – by definition – an increase in a long-term liability account increases working capital.  Unless the current maturities in the current and prior period are identical, this computation process will not accurately calculate the amount of new long-term debt raised in the current period.

Question: Does the term working capital mean that I can write a check based on working capital or retained earnings?

Answer: No.  It does not.  Working capital is not cash.  It’s simply the difference between current assets and current liabilities and has no implication for the amount of cash a company has in its checking account.  The same is true for retained earnings.  That account reflects the amount of earnings – after adjustment for distributions and withdrawals – that remains in the company at some point in time.  It has absolutely no implications for the amount of cash a company has in its checking account.

Question: Working capital lines of credit?  Cash flow lender or working capital lender?  Are we talking about the same thing?

Answer: No.  Working capital and cash flow are two totally different concepts.  Working capital is the difference between current assets and current liabilities.  Cash flow reconfigures the income statement on a cash basis to determine the points at which a company enjoys a cash surplus or deficit in its array of cash receipts and expenses for the year. 

A working capital lender will use movements in working capital and the associated current ratio to assess risk and prospects for repayment.  A cash flow lender will refer to both actual and projected cash results of a company’s performance in assessing risk and the prospects of repayment.

Question: I've never used working capital to try and determine a borrower's repayment ability.  Should I?  And what about the current ratio?

Answer: No.  For working capital and for the current ratio.  You are much better served by projecting a company’s cash flow and using those results to assess the likely sources of cash to service interest-bearing debt. 

The assumption is that the greater working capital and the greater the current ratio, the greater the prospects the current assets will convert to sufficient cash in the next period to pay down all the current liabilities.  But a business is not static.  When the next period arrives, a business is back to generating sales, incurring expenses, booking receivables, buying inventory, using trade credit, running up accruals, and so on.  Business cash flow services interest-bearing debt.  Therefore, focus on business cash flow and not on the most recent relationship between current assets and current liabilities – which plays only one part of subsequent business cash flow.

Question: Can a debt service coverage ratio be calculated using the UCA statement? Would you use Net Cash Income divided by existing + proposed debt?

Answer: You could indeed fashion a debt service coverage ratio using elements of the UCA cash flow statement.  The problem, however, is that the borrower may have great difficulty in properly understanding the covenant and, therefore, difficulty in attempting to honor it.

There is an alternative approach.  Put in place a business profit coverage ratio – net income + interest expense – distributions – loans to owners divided by the sum of interest expense and scheduled debt repayment.  Set that ratio at something above 1.00, such as 1.25.  The extra 25 basis points represents the risk that not all of the accrual profit will be converted to actual cash.

Then complement the business profit coverage ratio with a financing gap ratio. Define the financing gap as operating assets, e.g., receivables and inventory, less operating liabilities, e.g., payables and accruals divided by sales.  That translates to a ratio.  Require the borrower to maintain that ratio going forward.  If the borrower does so, the only cash impact from balance sheet changes will be driven by sales growth and not by mismanagement of receivables, inventory, or payables.

The combination of the two covenants will assure that the borrower will experience a cash flow deficit at net cash income only if it grows.  And we like to finance growth for a healthy company.

In the Question and Answer segment of Webcast on the UCA Cash Flow Statement on December 18th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Question: Why do you take depreciation from cost of goods sold (COGS) and include it in fixed assets?

Answer: In computing cash production cost, we remove any depreciation expense included in cost of goods sold on the income statement, since depreciation expense is a non-cash expense.   We then adjust cost of goods sold, absent depreciation expense, by changes in the balance sheet counterpart accounts – usually changes in inventory and accounts payable.  We follow a similar process in computing cash operating expenses.  That is, we remove any depreciation or amortization expense included in operating expenses on the income statement and then adjust the resulting amount by changes in the balance sheet counterpart accounts – usually changes in prepaid expenses and accrued liabilities, in this instance.

However, the discarded amount of depreciation expense plays a subsequent role in computing the cash amount of fixed asset spending.  One approach in computing fixed asset spending is to begin with the change in net fixed assets from the balance sheet and increase the change by the amount of depreciation expense recorded on the income statement.  We do so since the ending balance for net fixed assets is, in effect, the sum of the beginning balance for net fixed assets and the amount of fixed assets acquired in the period less the amount of depreciation expense for the period. 

Therefore, if we know a) the beginning balance of net fixed assets, b) the ending balance of net fixed assets, and c) depreciation expense, we can figure out the amount of fixed asset spending.

• Net Fixed Assets (beginning balance) – (Net Fixed Assets (ending balance)  + Depreciation Expense) = Fixed Asset Spending, or

• Change in Net Fixed Assets – Depreciation Expense = Fixed Asset Spending

If net fixed assets increase over the period, it represents a cash outflow and vice versa.  By adding the amount of depreciation expense to the change, we increase the cash outflow, i.e., we increase the change in an asset account.

A second approach is to use the difference in gross (not net) fixed assets for the period, if there were no sale of fixed assets by the company during the period.  We would arrive at the same conclusion.  However, if there were a sale of fixed assets during the period and if the company reported a loss on the sale, then the formula for computing fixed asset spending would be as follows:

• Change in Net Fixed Assets – Depreciation Expense – Loss on Sale = Fixed Asset Spending

If the company reported a gain on sale, the formula would change slightly.

• Change in Net Fixed Assets – Depreciation Expense + Gain on Sale = Fixed Asset Spending

Question: Is there a maximum time when you can change a loan to shareholder to a distribution?

Answer: There is no time limitation for converting some or all of a loan to shareholder to a distribution.  Neither loans to shareholders or distributions have any impact on the income tax obligation associated with profit for a Subchapter S corporation, partnership, limited liability company, or sole proprietorship.  That is, loans have no impact on reported profit. Distributions have no impact on reported profit.  Neither loans to shareholders or distributions pass through the income statement. They are recorded via adjustments to balance sheet accounts.

However, the tax authorities do have an interest in assuring that owners pay themselves a reasonable salary and, therefore, do not avoid FICA contributions to Social Security and Medicare.  In other words, if an owner took all his or her compensation from a company via loans or distributions, he or she would not be burdened with income tax or FICA withholdings. 

Note, however, that with respect to income tax withholdings it doesn’t matter whether the owner pays himself or herself a salary.  On the one hand, the absence of a salary increases reported company profit and, therefore, increases the owner’s income tax obligation on that profit.  On the other hand, an owner’s salary decreases reported company profit and, therefore, decreases the owner’s income tax obligation on that profit.  Yet the owner is now faced with an offsetting increase in income tax payments on personal salary.

Question: Can I get your cash flow method in an Excel spreadsheet format?

Answer: We don’t have the UCA cash flow statement in an Excel spreadsheet, but we do have the full methodology as part of our online Shockproof! Analytics.  You gain access to Shockproof! Analytics via an individual or organization membership to Shockproof! Training.  If you do so, you may enter complete financial data for any business borrower and generate a range of analytical reports, including the UCA cash flow statement.

Question: The difference in accumulated depreciation for Sequoia Properties was approximately $16,000 but the company truly depreciated $470,795.  Please explain again the adjustment of the $16,000.

Answer: Depreciation expense for the period was $16,258 per the income statement for Sequoia Properties.  That amount added to the amount of depreciation accumulated over prior periods for the assets in question.  The sum of all such depreciation expense – accumulated depreciation – was $470,795 at the end of 2007.

From the Sequoia Properties financial statements, note that accumulated depreciation at the end of 2006 was $454,536.  Adding 2007 depreciation expense of $16,258 to 2006 accumulated depreciation provides us with a calculated accumulated depreciation expense of $470,794 at the end of 2007 – one dollar less than the amount recorded as 2007 accumulated depreciation.  We can attribute the difference to a rounding error.

Question: Would you mind explaining to me the underlying philosophy or theory for including Interest Income in the “Operations” section of the UCA Cash Flow Statement?  (Interest Income is added into the calculation of “Cash after Operations.”)  I am torn between whether interest income is an operating function, or an investing/treasury management function.  In other words, is generating a return on deposits/investments the company’s primary operation?

Answer: Interest income is very likely a residual event for most companies and, therefore, a miscellaneous income item that falls into a catch-all category somewhere in the operating section of the cash flow statement.  If generating interest income were the primary activity of a business, then we'd move it to the top of the cash flow statement, i.e., begin the UCA cash flow statement with interest income and match funding costs against it as our substitute account for cost of goods sold.

I would agree with you that generating interest income is not a company's primary objective, at least not for the vast majority of companies we subject to a UCA cash flow statement.  Interest income would be similar to other income in the income statement - something outside the ordinary that can't be considered as "revenue" or "sales" but does represent income and needs to be captured in the lower reaches of the operating statement.
 
Question: As taught, once a UCA Cash Flow Statement is constructed, one can draw various conclusions and make observations.  One observation you emphasized was to avoid looking at net income + depreciation expense or EBITDA for debt repayment capacity.  These always focused on absolute dollar amounts.  My financial institution is big on debt coverage ratios.  Is there a debt coverage ratio that can be generated by using, at least in part, the UCA Cash Flow Statement.  If so, what are its components (numerator and denominator)?

Answer: I've yet to find a debt service coverage ratio that uses some or all of the UCA cash flow, simply because the ratio would be so difficult to explain to the borrower.  But there is a two part approach that gets at this issue of controlling cash flow.
 
First, use a Business Profit Coverage Ratio that is defined as net income + interest expense - sum of distributions and loans to shareholders / interest expense + CMLTD (prior period).  That needs to be greater than 1.00 by a risk factor associated with the risk of converting all accrual income to cash.

Then complement this ratio with a Financing Gap Ratio, that is determined by deducting operating liabilities (payables, accruals, deferred revenue, customer deposits) from operating assets (primarily receivables and inventory), then dividing the resulting amount by sales.  That provides a percent that, if unchanged going forward, will assure that operating assets increase or decrease at the same rate as operating liabilities.  This imposed limitation on the relationship between operating assets and operating liabilities, coupled with the Business Profit restraint, will assure positive business cash flow, absent the cash impact of sales growth or decline.

A borrower can easily understand a Financing Gap ratio since it is a variation of the current ratio or a working capital/sales ratio.

Question: I appreciated your comments regarding “auto-pilot” spreading.  I previously spread financial statements by creating models within Microsoft Excel, which I preferred because it facilitated my knowing better the numbers and how they should be spread.  However, my current employer utilizes, and requires spreads produced by, one of these automated spreading software programs.  Given the mandated use of an automated spreading program, do you have any thoughts on how I can conform, yet still know well the financial position of my borrowers?  Is it just a matter of ensuring that I intelligently input the data into the automated spreading program?

Answer: I believe the software systems have a function that allows you to track the flow of an account from either the income statement or balance sheet to the cash flow statement.  As a result, you might end up searching for an account that would be incorporated in Intangible Spending (to use the Sequoia Properties/accounts payable classification example).  In addition, you can frequently insert an account and then direct its flow to the UCA cash flow statement.  I'm not certain if the account insertion features applies to all input areas or just to restricted areas.