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.