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.