Global Cash Flow Questions and Answers III
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
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
