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.