Subprime lending is confined to residential mortgages, right? Right. But, on second thought, don’t be too sure, because the very same credit standards that sunk the housing market rushed across the border into commercial lending with great gusto. 

What would a subprime business loan look like? On the surface, it may look like any other business loan. It’s the underlying credit standards that require examination and assessment. For example, a business loan based on one or more of the following credit standards may be a disguised subprime business loan, particularly for a Subchapter S corporation, a partnership, a limited liability company, or a sole proprietorship:

Only a true cash flow statement, such as the Uniform Credit Analysis or UCA cash flow statement, can confirm borrowing causes and estimate likely cash sources of repayment. 

Global cash flow, in turn, suffers from a fatal assumption, i.e., that cash distributions, withdrawals, and owner loans will be immediately available to provide support for required debt service on business loans. Yet without continuously current guarantor financial information, it’s impossible to assess the likely cash support from a guarantor.

Without a guarantee, the lender is down to business cash flow and the cash value of collateral in liquidation as repayment sources. With no collateral, the lender is down to business cash flow alone as the single cash source of repayment. And cash flow is not net income + depreciation. Nor is it EBITDA.  

Virtually every lender does it differently but, at the end of the day, it seems there are four issues that must be addressed in every credit write-up:

In addressing these four issues, there as few as two and as many as eight business drivers that require careful analysis and assessment:

For an income producing property, debt service depends on how well the owner or manager generates rental revenue and controls operating expenses – just two of the eight business drivers. For a manufacturing business, on the other hand, debt service frequently depends on how well management controls all of the eight business drivers.

 

And how do we best measure management’s success or failure? We do so by application of two simple measures. First, we determine if the business is profitable enough, after accounting for all expenses and all “hidden” compensation in the form of distributions and loans to owners, to repay long-term debt as scheduled. Second, we determine if a business generates sufficient cash flow from business operations, absent the cash impact of sales growth, to repay long-term debt as scheduled.

 

And with respect to our second measure, we use and apply the Uniform Credit Analysis (UCA) cash flow statement and not traditional cash flow, i.e., net income plus depreciation. The former generally provides the answers we seek. The latter frequently obscures those same answers.