Global Cash Flow Questions and Answers
In the Question and Answer segment of Webcast on Global Cash Flow on September 25th, 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.
Katy asks ...
Q. If the guarantor of the borrowing company has 40 or more other
companies, is there a good way to narrow them down before performing
an analysis?
A. Not necessarily. To narrow down in any way requires enough initial information to make a judgment about which of the companies are worth a second look and which are not. We are stuck, in effect, with acquiring and reviewing all the necessary information. But such a review may lead quickly to the companies and events that are critical to further assessment.
Katy asks ...
Q. Is it not necessary to get the tax returns for all related companies?
A. It may not always be necessary but it is always an excellent idea to ask for and obtain all the business income tax returns. If you do so, you likely have the information you need early on in any analysis and will not have to burden the borrower with additional requests.
Katy asks ...
Q. If one of the related parties is the guarantor's trust, how do you know the cash inflows and outflows coming from the trust?
A. You have to ask the trustees or the trust executor or administrator. The business income tax returns – Form 1041 – do not provide the necessary information. Schedule E on the personal income tax returns will list estate income, but that income may not be cash to the individual.
Leslie asks ...
Q. What is the debt service capacity for these entities?
A. You can estimate that with fairly precise accuracy by using our Debt Capacity Worksheet. If you are an Organization member, log on and click “Commercial Loans” under “Worksheets” in the left panel. Then select the Debt Capacity link. That brings you to the Debt Capacity Worksheet. Using the financial statement information we provided for the Webcast, enter data in the worksheet using the Data Input link for guidance. You might be quite surprised at the results.
Wes asks ...
Q. Should a client own several different entities, each with different financial year-ends, can we use internally prepared financial statements for a particular year-end such as December 31 as a reasonably reliable way to calculate global cash flow?
A. If you feel comfortable that your internal estimates are roughly accurate, I’d do so. However, keep in mind that the borrower does have the ability to provide you with a full set of statements for any financial year-end you choose. The balance sheet is simple. The borrower might have to make a few income tax adjustments for a Subchapter C corporation if it were attempting to provide a full year income statement that differed from the stated financial year-end. But the results should be a very good approximation to actual events. For non-Subchapter C corporations, in which the company does not compile a year-end tax obligation, the process of providing full year income statements is far simpler.
Jason asks ...
Q. Are there any rules of thumb to follow in trying to reconcile company prepared, interim financials with previous year tax returns?
A. There is a real danger in attempting to use interim statements in virtually any way. If you had a six-month interim, for example, there would be a temptation to annualize it and compare it to the prior year’s income tax returns. But the six-month statement may include seasonality that will abate in the final six months. Therefore, the comparison or reconciliation would have no meaning and could be quite misleading.
Further, interim statements frequently omit key amounts and values. Depreciation expense and accumulated depreciation may not be current. The borrower may forget to accrue interest expense, so the interest expense amount is understated. Further, revenues are frequently overstated and expenses understated since some goods or services booked as revenue may not have been delivered and all expenses may not be properly recorded. Tread very carefully with interim statements.
Anonymous
Q. Loans from shareholders be hidden in the statement of owners’ equity and if so how would you determine that?
A. If they were hidden, the company or accountant would need to classify a loan from a shareholder as a capital injection, which is faulty or fraudulent accounting. If the company or accountant did so, there would be no way to detect it. The balance sheet would not reflect an increase in Due to Shareholders. It would reflect an increase in Paid in Capital. However, the cash impact would be identical regardless of classification. A loan from shareholders or a capital injection from shareholders represents a cash inflow.
Debra asks ...
Q. What is the difference between M-1 depreciation on corporate tax
returns and depreciation reported on the front page of Form 1120?
A. M1 is designed to reconcile book income with tax income. At Line 5a on Schedule M-1, the taxpayer lists any amounts of depreciation recorded on the accrual financial statements that were not recorded on the business income tax returns. That would occur if depreciation expense for the year recorded on the accrual financial statements were greater than the depreciation expense recorded on the business income tax returns.
Note that Line 8a on Schedule M-1 provides for the amount of depreciation recorded on the business income tax returns that was not recorded on the accrual financial statements.
Depending on the amount of depreciation expense recorded on both the accrual financial statements and on the business income tax returns, the taxpayer will usually provide an amount at Line 5a or at Line 8a – but not on both lines.
The reason that depreciation expense may be different for financial statements and business income tax returns reflects the fact that businesses usually accelerate depreciation expense for income tax purposes, which drives down taxable profit, but straight-line depreciation expense for financial statement purposes, which provides a lesser amount of depreciation expense and, therefore, greater accrual profit.
Tim asks ...
Q. Should we determine and take the amount of interest expense between related parties into the cash flow?
A. Yes indeed. You could add a line below each of the related companies in the Global Cash Flow Worksheets and record the amount of interest income or interest expense per related company. If the data is good and valid, the sum of interest income and interest expense will be zero, since interest income for one related company is interest expense for another related company.
Tim asks ...
Q. Your presentation is confusing on Sequoia when you discuss the large cash demands in 2008. In the UCA cash flow you show all the obligations as an increase in long-term debt. Shouldn't some of that be in increases to short term debt?
A. You’re right. Some of that increase should be in short-term debt and it actually was. But it wasn’t short-term interest bearing debt. It was short-term supplier credit. Note the increase in accounts payable from the UCA cash flow statement was $1,970,653 and the increase in accrued liabilities was $421,706 – a total increase of $2,392,359. That was, in effect, the short-term debt increase. The problem for Sequoia is that these trade creditors will put immense pressure on the company to pay those outstanding amounts in 2008. That will force Sequoia to seek replacement financing in the form of either short-term or long-term interest bearing debt – or to tap into the cash generated by one or more of its related companies. Either way, it will likely be very difficult to find the replacement financing.
Tim asks ...
Q. So the increase in LTD includes the increase in the CPLTD?
A. Not quite. The increase in 2007 long-term debt is calculated by measuring 2007 long-term debt – the current maturities + the remaining amount classified as long-term debt – against the 2006 long-term debt, which does not include 2006 current maturities. In the UCA cash flow statement, we account for the 2006 current maturities immediately following Net Cash Income. Therefore, the amount of new long-term debt in 2007 is the increase in 2006 long-term debt, i.e., 2007 current maturities (which is long-term debt reclassified as current liabilities since it is due to be paid down in the next operating period) + 2007 long-term debt measured against 2006 long-term debt.
Karen asks ...
Q. What would we be missing using EBITDA instead of the UCA cash flow?
A. You would be missing the cash flow absorbed or released by balance sheet events, which could be massive. EBITDA is an accrual income statement concept. It is a very rough proxy for actual cash flow available to pay for income taxes and debt service. We can determine actual cash flow by integrating the income statement with the balance sheet. In most instances, actual cash flow is vastly different from EBITDA. It may be more than EBITDA or it may be less – and usually it differs by a considerable margin. To be safe, stick with the UCA cash flow statement. It illustrates the actual cash position of a borrower. EBITDA is simply a guess based on incomplete information.
Todd asks ...
Q. Do you have the Excel files for today's Global Cash Flow seminar available, i.e., the ones that are contained within the slides?
A. We don’t have underlying Excel files for the UCA cash flow statements. We generated those statements from proprietary software – Shockproof! Analytics – that we use for analysis. Organization members have access to that software.
