Q: When you say tax free for distributions does that mean zero tax? Do state and federal income tax still apply when the Schedules K-1 appears on the personal income tax return? Thanks

A: Distributions fall outside the income tax arena. They cannot be deducted as an expense by a pass-through entity. They are not reported as taxable income by the owner or partner who receives them,

However, the owner or partner is responsible for paying federal and state income tax on his or her share of taxable income that is passed to him by the pass-through entity, e.g., by Western Star Energy, which is a Subchapter S corporation. The Schedule K-1 reports the amount of taxable income from the pass-through by the source of income, such as ordinary business income, interest income, dividend income, gain on sale of assets, and so on. The Schedule K-1 for a Subchapter S corporation also reports the dollar amount of distributions passed to the owner, which he or she uses to pay the income tax obligation on the company’s taxable income at the effective personal income rate applicable to the owner.

As noted, the distributions are tax-free. If they exceed the amount required by the owner to pay the income tax obligation on taxable business income, they serve as compensation for the owner that augments the salary and bonuses paid by his or her company and deducted as a tax-deductible expense in arriving at ordinary business income for the pass-through entity.

Course overview: Advanced UCA Cash Flow: Part II of II

Q: Under UCA cash flow calculation, distributions and loans to partners are deducted from Cash after Operations. How are contributions from partners and / or loans from partners to the company treated? Are these adjustments recorded in the same section of the UCA cash flow statement?

A: Partner or owner capital contributions and loans to the company are not consolidated with distributions and / or loans to owners nor should they be reported as an operating activity on the UCA cash flow statement. Capital contributions should, instead, be treated and classified as a financing activity intended to strengthen the company’s overall financial position. Owner loans to the company should be recorded as a related party activity since they fall outside the core operating activities and traditional third party lending used by the company. Maintaining this separation in reporting these business activities and associated cash flow impact preserves the integrity of the nature and amount of each transaction type.

Consolidating or recording capital contributions and partner or owner loans to the business as operating activities would erroneously affect Net Cash after Operations and cash flow available to service debt. The net effect would be to distort our analysis and our view of the debt capacity of the borrower.

Course overview: Advanced UCA Cash Flow: Part I of II

Q: What would you consider too aggressive of sales growth?

A: Very subjective, but anything around 15% or above will generally exert a negative cash impact on a company’s cash flow by virtue of movements in the balances of the operating balance sheet accounts such as receivables, inventory, payables, and accrued liabilities. The impact of such sales growth on the bottom line depends on the company’s ability to maintain its fundamental profitability sufficiently robust in a strong growth environment so that it can accommodate increases in financing and associated interest expense.

The cash impact of sales growth depends on the composition of the balance sheet. For example, if a company has very few receivables, inventory, payables, and accrued liabilities, it may grow at a very robust sales growth rate with little negative cash impact from changes in the balance sheet accounts. This would be especially true if the balances in the receivables and inventory accounts roughly matched the balances in the payables and accrued liabilities accounts. By the same token, if the balances in the receivables and inventory accounts vastly exceeded the balances in the payable and accrued liabilities accounts, then very modest sales growth, e.g., four or five percent, could have quite a negative cash impact from movements in the operating balance sheet accounts.

This does raise the issue of debt capacity, which is primarily driven by a company’s fundamental profitability – best measured by EBITDA% – and the level and composition of its interest-bearing debt. If sales growth contributes substantially to a company’s need for outside financing, it may soon run up against its actual debt capacity. This is an issue we address in detail in our single-topic webinar Debt Capacity and Cash Flow.

Course overview: Advanced UCA Cash Flow Part II of II

Q: We used a “long form” UCA in class. Is there a short form UCA for Western Star like I did in your pre-work? The Gain of $59,392 is showing as part of my short form Business Cash Income. I did not see the impact of this gain in the long form we walked through?

A: Your UCA Cash Flow is absolutely correct and your results match the “long form” we used in the webinar at every checkpoint from Business Cash Income to Calculated Change in Cash. We offer these thoughts regarding what might appear to be an inconsistency in handling the $59,392 Gain on Sale of Asset:

• Note first that your Modified UCA Form represents the indirect method of reporting cash flow which begins with net income. We used the direct method in presenting our “long form” CF during today’s webinar. Both are correct and both accurately track Western Star Energy 2014 cash flow.
• Note that the Net Business Income of $79,403 start point for the indirect method you chose includes the impact of the non-cash Gain on Sale of Asset. To adjust for this, it’s absolutely appropriate to subtract the Gain in arriving at Business Cash Income to eliminate the implication that it represents a positive cash flow for the business. Recall that all cash flow impact is associated with accounting for the original sales proceeds.  
• No such adjustment is needed when employing the “long form” direct method since we start with Sales. Each succeeding income statement line item is then adjusted by the amount of the change in the counterpart balance sheet account(s). The Gain is simply not introduced in the calculation of Business Cash Income and our results match.
• Note also that the calculation of Fixed Asset Spending is identical under both methods and both make appropriate use of the Gain to accurately depict the company’s 2014 FA Spend.

Course overview: Advanced UCA Cash Flow: Part I of II

   

 

Q: The financials that we were provided on Shockproof did not show distributions on the income statement. It was only on the credit refresher. This caused confusion when our group was doing the exercise.

A: Good point. Note, however, that we can compute distributions from the financial statements by reconciling the change in retained earnings.

To compute distributions by reconciling retained earnings add 2015 net profit of $538,570 to 2014 retained earnings of $1,430,723 reported on the balance sheet. The sum of these two amounts is $1,969,293, which would be the 2015 retained earnings balance IF all profit were allocated to retained earnings and not reduced by distributions to owners. However, as we see actual ending 2015 retained earnings were $1,530,917. The difference between the "what if" amount of $1,969,293 and the actual amount is $438,376 which is the amount of 2015 distributions.

Q: There were also no footnotes to the financial statements.

A: Correct. The financial statement footnotes were not provided in the financial statement excerpt for this session. If you had a complete financial statement it would include footnotes, which would is a great source of additional information but not necessarily about distribution. However, if the complete set of accrual financial statements included a FASB 95 statement of cash flows – which is customary and required document – the FASB 95 statement would explicitly state the amount of distributions.

Q: Clarification. You made a comment that interest expense was already accounted for in traditional cash flow, correct?

A: Yes. Traditional cash flow is commonly defined as net income plus non-cash charges, e.g., depreciation and amortization expenses. GAAP net income includes interest expense.

By contrast, the other cash flow proxy – EBITDA – does not include interest expense, since it is defined as earnings before interest expenses, income taxes, depreciation, and amortization.

Q: In 2015 wouldn't there have been accelerated depreciation? Why isn't depreciation expense higher?

A: It's very common for a company to use straight line depreciation for its accrual financial statements and accelerated depreciation for its business income tax returns. Straight line depreciation provides a more attractive bottom line number, which is more pleasing to lenders. Accelerated depreciation drives down taxable income, which is a primary objective of every personal and business taxpayer.

Note that a company can use one depreciation method for its accrual financial statements, which conform to GAAP, and a different one for its business income tax returns which conform to the IRS tax code; hence one of the differences in accrual income and taxable income.

Q: Shouldn't we pick up the CPLTD in 2014 as well to figure out increases in LTD in 2015?

A: We pick up 2014 CMLTD, which is due and payable in 2015, in our calculation of principal debt that would have been paid in 2015.  We deduct it from Business Cash Income to get Cash after Debt Repayment.

However, we compute new long-term debt by taking the difference between 2014 long-term debt (excluding the CMLTD since it has been paid in 2015) and compare this amount with the sum of 2015 CMLTD and 2015 Long Term Debt. The difference is the amount of new long-term debt arranged in 2015.

Course overview: Uniform Credit Analysis (UCA) Cash Flow Statement

Q: Is the cash impact for the change in inventory days a reliable calculation? It seems there are so many things a business can do impact COGS.

A: It is safe to say that a creative company and a creative accountant can manipulate the sales number, COGS, operating expenses, the A/R balance, the inventory balance, and the payable balance, which makes any equation suspect if the underlying data is suspect.

In the case of the cash impact from a change in inventory days, keep in mind that we remove non-cash charges from COGS before we compute the cash impact. Generally, the most obvious manipulation to COGS comes from the posting of non-cash charges, which can vary greatly by year depending on how they are spread between COGS and operating expenses. The other "manipulation" is the failure to apply the matching principle, which results in an artificially high inventory balance and an artificially low COGS. But that is an issue of accounting competence that becomes less likely as the quality of financial statements improves up the chain from company prepared, to compiled, to reviewed, and to audited.

Q: Please repeat the financing gap.

A: The Financing Gap, also called the Cash Conversion Cycle, is accounts receivable days plus inventory days minus account payable days. There are some variations, such as including accrued liabilities with payables, in computing accounts payable days.

The shorter the cash conversion cycle the better off is the company because it locks up cash for a relatively smaller period of time. Increases in the cash conversion cycle mean that the firm must finance itself for a longer time, which will increase the firm’s short-term financing needs and financing costs.

Financial managers will want to monitor the cash conversion cycle and take action should it begin to lengthen. Shorter cash conversion cycles mean the firm will reduce its short-term financing needs and financing costs.

Course overiew: Advanced UCA Cash Flow: Part II of II

Q: Is it correct that the UCA exercise basically changes the income statement from accrual to cash accounting?

A: Yes. The UCA cash flow statement identifies the cash amount for all revenue and expenses reported on the accrual income statement. Business Cash Income is the cash counterpart to accrual net income.

But the UCA goes further. It determines if there is sufficient cash flow to pay down long-term debt as scheduled. It identifies the amount of cash spent on fixed assets and other long- term investments. It identifies a financing requirement for the year. It identifies the sources of cash to meet the financing requirement.

If the statement is properly constructed, the calculated change in cash - the financing requirement less the financing - will equal the change in cash from the company's accrual balance sheet.

Q: On slide 51, where do you get the financing amount of $417,779?

A:  It's the sum of $285,935 of additional short-term debt and $131,844 of new long-term debt. See Slide 50 for the computation of new long- term debt.

Course overview: Uniform Credit Analysis (UCA) Cash Flow Statement

Q: What defines short-term debt vs long-term debt?

A: In general, short-term debt is payable within one year or less. Long-term debt has a repayment period in excess of one year.

Short-term debt is used to fund short-term needs or business activities that generate cash during the coming year. One example is a line of credit (LOC) to finance inventory and accounts receivable until they convert to cash (generally within a year) with draws made on a recurring basis as the line pays down. Current maturities or current portion of long-term debt (CMLTD) is that portion of long-term debt due and payable in the coming year. Despite being a component of long-term debt, the due date(s) for this portion of the total debt overrides the long-term nature of the total debt to be classified as short-term debt.

Long-term debt usually provides financing for long-term events or business activities that require more than a year to convert to cash. For example the acquisition of fixed assets with a useful life of multiple years is properly supported by long-term debt.

Q: In Step I in the Exercise, we discussed how a decrease in gross margin (GM) is a cash outflow. If accounts payable (A/P) increases in conjunction with a decrease in GM, would that increase in A/P be a source of cash rather than a cash outflow despite the GM decrease?

A: Yes. You are correct in saying that an increase in accounts payable is a source of cash.

In constructing a cash flow statement, the cash flow impact of A/P, a source of cash flow for this discussion, is integrated with the cash flow impact of Cost of Goods Sold (COGS), a use of cash since it represents production costs. The positive cash flow impact of an increase in A/P offsets the negative cash flow impact of an increase in COGS and may, on occasion, exceed it. If the increase in A/P exceeds the increase in COGS, the result of the two changes is a cash inflow.

In Step 1, we referred to a decrease in A/P days – not A/P – as a cash outflow, which may be a source of confusion. Even though A/P did increase and did represent a source of cash in 2015, A/P days decreased from 47 to 43 days, which is a use of cash since the level of A/P relative to COGS decreased.

We have two offsetting events occurring with respect to the movement in A/P in 2015. The $24,111 increase in A/P was a cash inflow in 2015. But the four-day decrease in A/P days was a cash outflow that drained $39,709 in cash from the company. That is, if Tampa Bay Leisure had maintained A/P days at 47 days in 2015, instead of paying more rapidly by four days, the ending 2015 A/P balance would have been $446,967. Since the ending A/P balance in 2015 was $407,258, the company gave up $39,709 in cash by paying four days more rapidly. Therefore, we commented that the four-day decrease in A/P days was a cash outflow.

To take a more fundamental look at your question, note that the GM is calculated by dividing Gross Profit (excluding non-cash charges) by sales. A declining GM such as we saw in Tampa Bay Leisure’s performance, indicates that the company was less efficient in managing its production costs relative to sales for the period. It’s that fundamental inefficiency that makes a decrease in the gross margin a use of cash when constructing a cash flow statement. That is, COGS, which is a use of cash, has increased relative to sales, which is a source of cash.

Q: The company would not have to take the larger distribution and that would mean they have sufficient cash to repay the loan, isn't this correct?

A: Yes, this would be one of several options the company could pursue. If it reduced distributions by $39,458 (the cash flow deficit at Cash after Debt Repayment), it would have enjoyed sufficient operating cash flow to service its interest-bearing debt.

In addition, it could have tightened its receivables by $39,458 or tightened inventory by the same amount. Any of these three events would have reduced cash outflow sufficiently to allow the company to meet its debt service.

The interesting question is whether it would or could take any of these three steps. Its owners may have a great need for additional cash to fund their personal expenses and lifestyle, which could explain the heavy distributions. Or it may not be able to tighten receivables because of the bargaining power of its clients. Or it may have expanded inventory to take advantage of bargains and discounts that will show up in its gross margin.

Q: If the owner doesn't receive distributions but draws a salary (officer compensation), do we also include this salary in calculating the Owner Payout Ratio?

A: No. The owner payout is defined as the sum of a) distributions or withdrawals and b) loans to owners or partners. Salaries are not included in the owner payout. Note, however, that a Subchapter S corporation may pay salaries to owners, but a partnership, an LLC, and a sole proprietorship may not do so. That is, salaries cannot be claimed as a tax-deductible expense on the business income tax returns for partnerships, LLCs, and sole proprietorships.

Partners and owners of these organizations take their compensation in the form of distributions or withdrawals or guaranteed payments, in many instances, for partnerships and LLCs.

Finally, note that the owner payout rate – the owner payout divided by reported net income – measures the percent of reported profit taken out of a company in the form of distributions and loans to owners and partners. If that rate exceeds 1.00, then retained earnings decline and leverage increases.

Q: Did Tampa Bay Leisure have cash reserves to begin with?

A: Tampa Bay started the year with cash balances of $200,442. Since the amount of outside financing it arranged in 2015 fell short of the financing requirement by $111,780, it used up $111,780 of its existing cash balances. The company had no other cash resources or reserves, such as short-term money market funds or longer-term liquid investments.

Q: If all of the current year cash summary accounts down to and including Cash After Financing Costs are positive but Cash After Debt Amortization is negative, does this indicate an operating borrowing cause in the current year?

A: Yes, an operating borrowing cause on the basis that business cash flow should be sufficient to meet all operating cash costs, plus interest expense and scheduled debt repayment.

In some respects, scheduled debt repayment can be considered a proxy for depreciation expense in that long-term debt is, in theory at least, linked to the life of the asset it finances. Therefore if business cash flow - which excludes non-cash charges - cannot cover scheduled debt repayment, it cannot cover the replacement cost of fixed assets financed by long-term debt, which is a very real cost of doing business.

Q: Would you have lent money to the Tampa Bay Leisure?

A: Yes, indeed, I would certainly lend to Tampa Bay Leisure. The company improved its bottom line profit in 2015 while growing substantially at roughly 16%. It managed its operating cash flow very effectively. A minor $39,458 cash flow deficit at Cash after Debt Repayment is quite respectable for a company with significant growth and a relatively heavy balance sheet. With respect to the balance sheet, it did let its financing gap slip from 71 to 82 days, which drained cash from the company. I'd be curious why payable days decreased at the same time inventory days increased, but there may be a logical explanation. All other indicators are positive. The owner payout rate actually decreased, and the company's leverage ratio remains quite modest at 0.69 ... and so on.

Q: Why did the UCA webinar consider member distributions operating expenses? My team and I disagree, as distributions are not typically paid by annual cash flow alone. It can come from cash on hand built up over time, which is significant in some cases. By  assuming 100% of distributions are taken from that specific year is not entirely accurate and has a negative impact on cash flows.

In the UCA webinar, after distributions, ratios remain strong despite the significant decrease in cash. While the webinar presented the company coming up short, short term debt appropriately financed receivables and inventory build-up. And long term debt and cash actually appeared to finance fixed assets. What was left over, along with cash on hand, were distributed to members. Our thoughts as the UCA webinar weighed heavily on member distributions and the assumption of it being paid by operating income for that specific year.

A: Distributions are definitely operating expenses regardless of how and where they are recorded on the financial statements. Distributions have two objectives - to provide cash to owners and partners to pay the income tax obligation on taxable company income and to provided compensation to owners and partners. Income taxes and compensation are operating expenses and should be classified as such even though distributions are not recorded as an expense on the income statement. They are not recorded as an expense primarily because IRS regulations state that they are not tax-deductible to the company nor are they taxable revenue to the owner or partner. If they were recorded on the income statement as an expense for a pass-through company, they would have the very same impact on retained earnings as they now do as a direct reduction to retained earnings.

Note, too, that owners of a Subchapter S corporation frequently supplement their salary via distributions that exceed the amount necessary to satisfy the income tax obligation on taxable business income. Partners who are not provided guaranteed payments and sole proprietors rely solely on distributions to pay taxes and receive compensation. There are exceptions but partnerships and sole proprietorships cannot report salaries as a tax-deductible expense. Partners receive compensation either via distributions alone or in combination with guaranteed payments. Sole proprietors received their compensation exclusively via distributions (withdrawals).

The question about how distributions are paid is a separate question. They may certainly be paid out of accumulated cash balances - in whole or in part. With respect to Tampa Bay Leisure, its cash balances decreased by $111,780 in 2015. The company very likely used the $111,780 of existing cash balances to meet the $39,458 deficit at Cash after Debt Repayment and then applied the remaining $72,322 toward fixed asset purchases of $490,101. It then used a combination of additional short-term debt and new long term debt to meet the $417,779 shortfall in paying for its fixed asset purchases in 2015.

There is nothing good or bad about the deficit at Business Cash Income. The reasons for the shortfall are important, however. We point out that an obvious reason was robust compensation for the owners. In addition, we could focus on deterioration in the company's management of receivables, inventory, and payables. The financing gap increased from 71 to 82 days. If the company had maintained the financing gap at 71 days in 2015, it would have saved about $125,000 of cash. That savings would convert the $39,458 cash flow deficit at Cash after Debt Repayment to a healthy cash flow surplus of approximately $85,000. So in some respects, we get to pick our poison - owners compensation or poor balance sheet management as the cause of the cash flow shortfall at Cash after Debt Repayment. In some respects, it doesn't really matter because the company appears to have used existing cash balances to meet the shortfall. The increase in interest-bearing debt in 2015 was applied to fixed asset purchases.
 

Q: Must the income statement used in constructing a UCA cash flow statement be accrual-based?

A: The income statement used in building a UCA cash flow statement does not have to be accrual based, but it is rare for a company to keep an income statement on a cash basis. Those that do so are usually small businesses that accept only cash for the services they provide and pay all expenses in cash only.

The vast majority of companies use the accrual method of accounting to record sales as they meet all the Generally Accepted Accounting Principles (GAAP) criteria to cause statements to fairly and accurately depict all business activity for the period measured.  Generally GAAP also call on a business to apply the Matching Principle in recognizing production costs and operating expenses. GAAP causes the business to present sales and costs on the income statement in this way regardless of whether cash has exchanged hands in completing a sale or recognizing costs.  

Note that the IRS will allow companies to report income on a cash basis if, in general, their sales are less than $5 million. Note also that other severe restrictions apply in doing so. Almost invariably, the companies in question keep their books on an accrual basis, using a cash basis for income tax reporting because it may result in less tax.

All publicly traded companies must use accrual accounting.

Q: If we were to make a credit offer to Tampa Bay Leisure, how could we prevent the continued use of short-term debt to fund long-term assets?

A: An important first step might be to offer long term financing to more properly restructure the company’s borrowing and eliminate the misuse of short term borrowing, most likely the company’s line of credit. Doing so frees up the misused portion of their short term borrowing capacity and reset their cash flows.

Restructuring a company’s borrowing also sets the stage for conversation to establish more discipline around future use of a line of credit or other short term borrowing. Establishing a tight borrowing base requirement can effectively set the stage for more carefully monitored draws and provide assurance that the line of credit draws are indeed made to support only eligible inventory and receivables. To be most effective, the lender should manage the frequency of a borrower’s submission of the borrowing base to better assure current information as well as assure that the line is meeting current requirements. Another useful discipline is to ask for or generate projections based on management input to identify, as closely as possible, forthcoming borrowing causes and needs. If no short-term borrowing causes, reduce the short term line or amount available accordingly.

Q: Discuss the feasibility of using UCA cash flow-based covenant definitions.

A: The UCA cash flow statement is the most thorough and complete analysis of a business’ cash flow. This makes the UCA cash flow statement perhaps the most reliable source to define quantifiable performance-measuring covenants. Examples of quantifiable covenants that can be clearly defined using the UCA cash flow statement are a) the ability of the business to service debt with cash from operations, b) the value and impact of related party activity, or c) the value of fixed assets acquired.

It is, however, important to note that with this reliability in defining quantifiable performance, measuring covenants becomes what some users perceive to be a difficult process in constructing a UCA cash flow statement. Lenders may have difficulty fully understanding UCA cash flow-based covenants, and it’s likely that borrowers will consider use of the UCA cumbersome or simply too complex.

The key to effective covenants comes in a shared lender and borrower understanding of the intent of the covenant, how it is calculated, and the value it brings to lenders and borrowers. While UCA cash flow-based covenants may be a bit more difficult to comprehend, they are certainly the most reliable source of information related to cash flow.

Q: Why do we use the Current Portion of Long Term Debt (CPLTD) from the prior fiscal year-end and not current fiscal year-end in the UCA cash flow?

A: The CPLTD from the prior period is due and payable in the current period. The cash outflow, therefore, occurs in the current period.

The CPLTD in the current period will pay out in the next period. The cash outflow occurs a year in the future.

Therefore, in our webcast example for Tampa Bay Leisure, the 2014 CPLTD of $21,977 will be paid in 2015 and the 2015 CPLTD of $57,900 will be paid in 2016.
 
 

Q: Couldn't we look to the owner as a guarantor depending on how his or her financials look as a result of the owner taking distributions? Perhaps add a condition to the loan agreement?

A: Yes. We would almost invariably require the owner or owners to provide a continuing guarantee for the line of credit. In addition, to assure the company retains sufficient operating cash flow to properly service its interest-bearing debt, i.e., pay interest expense and repay debt as scheduled, we might require a loan covenant that would limit distributions and loans to owners to some percent of reported profit, e.g., 50%, that would assure that sufficient profit – but not cash flow – remains in the company to meet debt service.

Q: Is the Section 179 Deduction treated the same as depreciation expense?

A: It depends. For a Subchapter C corporation and sole proprietorship, the Section 179 Deduction is added to depreciation expense on the income statement in the business income tax returns (Schedule 1120 and Schedule C) and is, in effect, considered to be depreciation expense. But for a Subchapter S corporation, partnership, and limited liability company (LLC), the Section 179 Deduction is not reported on the income statement in the business income tax returns (Schedules 1120S and 1065). It is excluded from the business income tax returns in accordance with IRS instructions. Rather, the Section 179 Deduction is passed through to the owners or partners of these companies and used by them as a reduction to taxable business income that they report on Schedule E and then at Line 17 on Form 1040.

Note that the Section 179 Deduction is not allowed as an expense on the accrual financial statements for any business organization that prepares financial statements according to Generally Accepted Accounting Principles (GAAP). That is, the Section 179 Deduction is a creature of Congress that plays no role in the preparation of accrual financial statements.

Q: In what cases are there unexplained differences in UCA cash flow statement?

A: There are a vast variety of reasons that account for an unexplained difference between the calculated change in cash balances on the balance sheet and the actual change in those balances.

It is quite common to forget a minor balance sheet account, such as other receivables or other assets, in computing the UCA cash flow statement.  It is relatively easy to make a simple subtraction or addition error. It happens frequently, too, that we confuse a change in a balance sheet account for a cash inflow when it is actually a cash outflow.

In addition, an unexplained difference frequently arises because of a failure to identify and incorporate distributions in the constructing the cash flow statement. Further, there are a few computations that suffer a high error rate. For example, the computation for fixed asset spending is frequently performed incorrectly as is the computation for new long-term debt.

Q: Does the UCA cash flow statement useful in analyzing rental cash flow?

A: Yes. The UCA cash flow statement is useful, in fact, necessary, in assessing any company that prepares an income statement and balance sheet. A property management company that generates revenue primarily from rental income will record balance sheet information such as rental payment due, deposits, accrued expenses or accrued liabilities, commission due, and so on. As a result, net profit reported on the income statement may vary, and vary considerable, from Business Cash Income reported on the UCA cash flow statement.

Q: Why don't we see UCA CF more with public companies?

A: Publicly listed company must include a comprehensive cash flow statement – a FASB 95 Direct or Indirect Statement of Cash Flows – as part of its audited financial statements. The FASB 95 cash flow statement differs from the UCA cash flow statement in several ways. Specifically, the FASB 95 cash flow statement classifies distributions as a financing activity while the UCA cash flow statement classifies distributions as an operating activity. In addition, the FASB 95 cash flow statement does not provide a summary account indicating if operating cash flow was sufficient to meet all interest-bearing debt service. The UCA cash flow statement does so with its Cash after Debt Repayment summary account.

The UCA cash flow statement was developed by lenders and not by the accounting profession. Consequently, it focus on the issues critical to a lender in assessing a) the sources of cash to meet interest-bearing debt service, b) the borrowing causes, c) the financing requirement, and d) the sources of cash to meet a financing requirement. Because of classification and formatting deficiencies, the FASB 95 Statement of Cash Flow does not adequately address these four issues.

Q: Where are the distributions of $438,376 hidden in the balance sheet?

A: By definition, distributions are considered an adjustment to the company’s retained earnings or partners’ capital accounts presented in the balance sheet. Another spot that readily presents the amount of distributions for the period is the Cash Flows from Financing Activities section of a FASB 95 Statement of Cash Flows that presents a separate line item for distributions to shareholders or partners.

In the absence of these two sources of information regarding the amount of distributions for the period, you can compute them by reconciling the change in retained earnings. The underlying rationale rests on the fact that income statement net profits are posted to the balance sheet line item, retained earnings, to align the two statements. Since distributions and withdrawals are literally treated as a distribution of retained earnings per GAAP, reconciling retained earnings from one period to the next easily surfaces the amount of distributions.

Here’s the methodology for reconciling retained earnings using the Tampa Bay Leisure, Inc. 2015 financial statements:
 

2014 Prior Year End Retained Earnings	$1,430,723
+/- 2015 Current Year Net Profit	538,570
= 2015 Expected Current Year Retained Earnings	1,969,293
+/- 2015 Actual Current Year Retained Earnings	(1,530,917)
= 2015 Distributions – Expected less Actual Current Year Retained Earnings	$438,376

 

Q: Please explain the difference between free cash flow and UCA cash flow.

A: Given standard definitions of free cash flow, it would be roughly comparable to UCA Cash after Debt Repayment less Fixed Asset Spending.  Presumably, Free Cash Flow is cash available to distribute to shareholders or to use for acquisitions after accounting for all operating cash needs and debt service.  But the definition of free cash flow can vary considerably. And one issue is how working capital is defined in arriving at a free cash flow estimate.

Q: Please repeat the calculation for Poll Question 3.

A: Poll Question 3 is as follows:
“If there had been no change in EBITDA% in 2014, the cash inflow from the change in A/R days would have exceeded the cash outflow from the changes in inventory days and accounts payable days by:

• $201,173.
• $352,329.
• $365,034.

$352,329 is the correct response. Our focus on the cash inflow from the change in A/R days and how it relates to the cash outflow from the changes in inventory days and A/P days gives us an opportunity to assess the A/R change as a cash flow source to support or offset the inventory and accounts payables changes in 2014.

The calculations are as follows:

A $493,627 cash inflow from the 2.9 day reduction in A/R days minus a $12,705 cash outflow from the one day increase in inventory days minus a $128,593 cash outflow from the eight day decrease in A/P days = $352,329 or $493,627 – $12,705 – $128,593 = $352,329

Q: Please repeat the calculation for Poll Question 2.

A: Poll Question 2 is as follows:

“If there had been no change in inventory days and A/P days in 2014, the cash inflow from the change in A/R days would have exceeded the cash outflow from the change in EBITDA% by:

• $72,580.
• $188,468
• $201,173.”

$201,173 is the correct response. By eliminating the cash flow impact of the change in inventory days and A/P days, we can now assess the effectiveness of the cash inflow created by the A/R days change in offsetting the cash outflow created by the change in EBITDA%.

The calculations are as follows:

A $493,627 cash inflow from the 2.9 day reduction in A/R days minus a $292,454 cash outflow from the 0.47% reduction in EBITDA% = $201,173 or $493,627 – 292,454 = $201,173.

Q: Please explain further how accrual-defined revenue, expenses, and profits are estimates of cash events. Please walk through an example. For instance, how does a sale hit the books (journal entries)?  

A: Let’s assume the example of a sale for $1,000 as you suggest. A company consummates a $1,000 sale by meeting all the requirements laid down by Generally Accepted Accounting Principles (GAAP) and grants their customer 30 day terms. The company records the sale as a $1,000 credit to Sales and records the amount due it from the customer as a $1,000 debit to accounts receivable (A/R). No cash changed hands at the time of sale. The company simultaneously submits an invoice to the client for payment of the $1,000 in 30 days. The net result is to increases A/R by $1,000 and increases revenue or sales by $1,000 with no exchange of cash.

At this point the revenue is non-cash since the client has not yet paid and the sale stands as an estimate of a $1,000 cash flow to be realized when the client pays. When the client does pay, the company credits (decreases) A/R by $1,000 and debits (increases) cash by $1,000. Only at this point is there a cash inflow.

In most cases, the sale is recognized and the cash is ultimately received during the same accounting period. For those situations in which the cash flows to the selling company takes place in a subsequent accounting period, recognized revenues and cash flow are totally different for each of the periods impacted by the series of transactions.

We therefore base our observation that revenues, expenses, and profits are estimates of cash events on the timing differences between recognizing a sale or expense (for which the business is granted terms and pays in a period other than the one in which the expense is recognized according to GAAP) and the point at which cash actually flows to complete the transaction.  

Q: In looking at my figures, it appears that the amounts listed on the Modified and on the Long Form UCA Cash Flow Worksheet for distributions do not match. Why the discrepancy?

A: The Modified UCA Cash Flow Worksheet presents $438,376 paid out as distributions during 2015 as a separate line item and cash outflow. The change in Due from Shareholders (Loans to Owners) is displayed separately on the next line as a $25,000 cash inflow since that account balance was reduced by $25,000 during 2015. The combined impact is a cash outflow of $413,376. Keep in mind that it is highly likely the $25,000 change in Due from Shareholders was the result of converting $25,000 of the balance in this account to distributions – a non-cash event that took place by virtue of simple accounting entries. Therefore, the actual amount of the cash distribution was the net of the two amounts noted above or $413,376.

The Long Form UCA Cash Flow Worksheet simply combines these two line items as a single entry and presents only the net cash outflow of $413,376.

The net impact is identical, just reported in contrasting ways.

Q: Would you please answer Extra Poll Question 2?

“Extra Poll Question 2: Since Cash after Debt Amortization was a negative $39,458, Tampa Bay Leisure could not contribute cash toward the purchase of fixed assets in 2015 but was compelled, instead, to use some of its net profit of $538,570 to do so.
Agree or Disagree?”

A: We disagree with this question because profits are not actual cash flow, but are instead simply an estimate of potential cash flow to the company reporting the profit.

The negative $39,458 Cash after Debt Repayment means that all cash from operations during 2015 was consumed in operating the company and servicing debt leaving no cash from operations to support Fixed Asset Spending for the year. To fully meet the cash demands of these components of the Financing Requirement, the company was forced to rely on third party / outside sources of cash – not profits which are not cash – to finance all cash requirements (fixed asset spending) that follow Cash after Debt Repayment on the UCA cash flow statement.

Q: Why would sales growth be a cash outflow and not a cash inflow?

A: It is true that sales growth could be considered a quality cash inflow as long as a company does not give up profit margin to gain sales.

However, sales growth also creates a cash outflow in the sense that operating assets (inventory, accounts receivable, and prepaid expenses) almost always grow faster than operating liabilities (accounts payable and accrued liabilities). This increase in working capital is a cash outflow, which usually exceeds the positive cash impact from increased profits.

Q: Couldn't you make the case that the business owners, tax liability not included, can adjust their distributions in the future so that debt can be paid? In other words, wouldn't the distributions be discretionary?

A: No, not really. Owners frequently minimize salary and take additional compensation in the form of distributions. If the lender limits distributions via a loan covenant, the owners would tend to increase salary such that their total compensation remains unchanged.

In addition, the sum of salary, distributions, and loans to owners is usually driven by lifestyles, including personal debt obligations. Nothing is more difficult to change, or downsize, than an established lifestyle. The most prudent approach to this issue is to assume that distributions are not discretionary and cannot be adjusted – unless proven otherwise.

 

Q: How do I get current maturities of long-term debt (CMLTD) of $21,977 paid by Tampa Bay Leisure in 2015?

A: The current maturities of long-term debt payable during any selected year is the amount reported as CMLTD at the prior year end. CMLTD are considered to be a current liability and are payable during the coming period.  

In the case of Tampa Bay Leisure, Inc. 2014 year end CMLTD was $21,977 and by definition is expected to be paid during 2015, the following period.

Q: How did you come up with $438,376 in distributions paid to the company’s shareholder during 2015?

A: Distributions paid to owners or partners of a “tax pass-through” business entity are not reported on the income statement or balance sheet for the period. Distributions are instead derived from a full reconciliation of the company’s retained earnings account for the period. That reconciliation MIGHT appear in the footnotes or as a separate statement.
Here’s the formula to employ if a retained earnings reconciliation is not presented:

• Prior YE Retained Earnings + Current Year Net Profit – Actual Current YE Retained Earnings = Distributions

Applying the formula to Tampa Bay Leisure, Inc.:

• $1,430,723 [2014 YE RE] + $538,570 [2015 Net Profit] – $1,530,917 [2015 YE RE] = $438,376

Q: Please explain why the $438,376 in 2015 distributions does not equate to the 0.77 Owner Payout Rate reported as a Business Driver Performance indicator cited in the webcast and the Exercise document.

A: The Owner Payout Rate is defined as the sum of Distributions and the cash flow impact of the change in Due from Shareholder (the loans to owners account) divided by net profit for the period.

Applying the formula to Tampa Bay Leisure, Inc. for the year 2015, we derive the following calculation:

• $438,376 [Distributions] – $25,000 [change in Due from Shareholder] = $413,376
• $413,376 [Owner Payout] / $538,570 [2015 Net Profit] = 0.77 [2015 Owner Payout Rate]

Note that Distributions represent a cash outflow from the company. The change in Tampa Bay Leisure, Inc. “Due from Shareholder” was a $25,000 reduction in that asset account. An asset account that declines is a cash inflow and we accordingly subtract that change from the Distribution to arrive at the net Owner Payout for 2015. 

Q: Can you please mention again why the change in “Due from Shareholder” is not included in the Related Party Cash Flow section of the UCA Long Form CF Statement? See reference on Slide 49.

A: We consider Loans to Shareholders and Distributions as cash payments to owners that represent taxes on earnings generated by the company or as compensation to owners. Since both are in effect operating events we include the change in Due from Shareholders alongside Distributions in the array of accounts that sum to Business Cash Income.

Q: What is the difference between the Direct and Indirect Cash Flow vs. the UCA Cash Flow?

A: The UCA CF Statement can be presented in both a Direct or an Indirect format.

The Direct UCA cash flow statement follows the accrual income statement sequence beginning with sales and identifies the actual cash amount for every accrual income statement line item by adjusting each I/S line item by the net change in the counterpart balance sheet account. The direct UCA cash flow statement, in effect, “starts at the top” with sales and works its way down the income statement.

The Indirect UCA cash flow statement begins with traditional "cash flow" (net income plus non-cash charges) and then adjusts this measure for a) distributions, b) loans to owners, c) changes in operating asset accounts, and d) changes in operating liability accounts. The indirect UCA Cash Flow Statement, in effect, “starts at the bottom” of the income statement with net income and works its way up. Both statements produce the same number at Business Cash Income.

FASB 95 also presents direct and indirect statements following the sequence already described that serve a very different purpose. FASB 95 is intended to simply identify company cash flow and, unlike the UCA CF Statement, is not intended to be readily used to determine a company‘s ability to service debt. The FASB 95 statement is further driven by considerable differences in classification guidelines, a key one being the fact that FASB 95 classifies distribution as financing rather than as an operating event.

Q: When would the line “Due to Officers/Stockholders” in the Related Parties Cash Flow section be used?

A: Change in Due to Officers/Stockholders represents new loans made by officers or stockholder to the company during the period. This type of loan is considered to be a related party transaction in that it is generally made with the full intention of being repaid as quickly as possible. This type of loan is also often a loan of “last resort” in that the company may well be experiencing financial stress and has been turned down by traditional lenders making owners the only remaining loan source.

There are several contrasts to be drawn between “Due to” and “Due from” Stockholder loans. “Due from” loans made by the company to owners can often be characterized as an “advance distribution” intended to make cash available for payment of taxes due from the owner on company earnings or as additional compensation. As such, there is often no intent or capacity for the owner to repay the loan. As a consequence, the “Due from” loans are often converted to a distribution and never repaid in cash.

Q: Net profit of $538,570 is after interest expense was subtracted. Correct?

A: Yes. Interest expense of $38,839 was the last item subtracted from Operating Profit in arriving at Net Profit in the amount of $538,570 for Tampa Bay Leisure in 2007.

Please note that this acknowledgement can give us a false sense of security regarding Tampa Bay Leisure’s ability to service its debt. If we define cash flow using either Traditional Cash Flow (Net Profit + Depreciation Expense) or EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) as a cash flow proxy, we’ll incorrectly come to the conclusion that Tampa Bay paid interest expense and repaid long-term debt as scheduled with cash from operations. We know this conclusion is incorrect based on our thorough construction of the UCA Cash Flow Statement that reveals that Tampa Bay, in reality, fell short of generating enough Business Cash Income (-$17,481) to cover all 2007 interest expense and scheduled long-term debt repayment.

Q: On Slide 53 (Tampa Bay Leisure’s Traditional Cash Flow), I am not seeing the source for the payment of zero dollars of long term debt in 2006. I see CMLTD on Tampa Bay Leisure’s balance sheet of $21,977 in 2006 and $59,700 in 2007. Can you help me find this figure?

A: Look to the company’s 2005 YE balance sheet for the CMLTD payable in 2006 displayed in Slide 53. CMLTD is a current liability and is payable in the next 12 months as defined by GAAP. 2005 CMLTD is reported as 000 meaning that Tampa Bay Leisure has no required principle debt payments falling due in 2006. By extension, the $21,977 CMLTD reported at YE 2006 is payable in 2007 and the $59,700 CMLTD reported at YE 2007 is actually payable in 2008.   

Q: How would we classify discharge of debt due to a bankruptcy on UCA cash flow?

A: A bankruptcy court’s discharge of debt would not trigger a change in the manner by which we integrate a reduction of debt in constructing a UCA Cash Flow Statement. We would look to the CMLTD as defined on the post-discharge balance sheet to determine the amount of debt to be serviced in the following period. We would also use the same formulas in calculating the net change in both short term and long term debt as a source of funding to support a financing requirement.

We must also note that it is critical for us to know that it was a bankruptcy discharge that drove a reduction in debt for the period. This qualitative understanding of what might otherwise be considered a routine cash flow activity must be part of our considerations in arriving at a new credit decision or managing an active loan portfolio.  

Q: I'm interested in learning where these would be reflected in a UCA Cash Flow Statement:

1. Cumulative effect of accounting change that reduces net income
2. Cumulative effect of accounting change that increases net income
3. Equity earnings of unconsolidated subsidiary/affiliate
4. Equity losses of unconsolidated subsidiary/affiliate
5. Cash distributions from unconsolidated subsidiary
6. Cash injections from unconsolidated subsidiary
7. Write-down or write-off of assets (nonrecurring)

A: These are very appropriate issues and certainly quite relevant to most large Subchapter C corporations.

1.  Cumulative effect of accounting change that reduces net income

If the company has prepared its financial statements in accordance with FASB 154, issued in 2005, there is really nothing to do.  The current statement should reflect the accounting change as applied in that year, which means that the resulting UCA cash flow statement will accurately reflect the impact of the change on the operational area affected, e.g., cost of goods sold adjusted downward because of a change from LIFO to FIFO.  The cumulative impact is reflected in retained earnings - an increase in net income, for example - and the appropriate balance sheet account or accounts.  In this instance, the inventory account would be adjusted upward, assuming the accounting change resulted in lower COGS and, therefore, a higher remaining inventory balance.  However, if the financial statements are prepared such that the cumulative change is presented as an extraordinary item in the income statement - which was the common practice before FASB 154 - the issue is then one of identifying the revenue or expense account and adjusting it by the amount of the cumulative change reported on the income statement.  Again, if the change impacted COGS, then a positive amount - increase in inventory, decrease in COGS, and increase in net income - for the cumulative change should be used to adjust downward reported COGS.  But, it really isn't necessary to do so, so long as the cumulative change is reported in the Miscellaneous section of the UCA cash flow statement, which comes before Business Cash Income.  That is, one way or another, we will pick up the impact and it will be reflected in the operating section of the UCA cash flow statement.

To recap, if the financial statements are prepared according to FASB 154, there is really nothing to do since retained earnings will reflect the cumulative change via a prior net income adjustment and the current balance sheet we work with will incorporate the offsetting accounting entries.  If the financial statements are not prepared according to FASB 154 but, rather, show a cumulative change in the present income statement, our bottom line UCA Business Cash Income will be the same whether we classify the cumulative change as an extraordinary item or adjust the appropriate revenue or expense account.

2.  Cumulative effect of accounting change that increases net income

The reverse of the above.

3.  Equity earnings of unconsolidated subsidiary/affiliate

If there are no distributions from the unconsolidated subsidiary/affiliate, the cash impact from equity in earnings is zero.  Under the equity method of accounting, the parent company writes up its investment by the amount of its equity in earnings.  In constructing the UCA cash flow statement, we reverse the entries, i.e., we remove equity in earnings from revenue since it is a non-cash amount and we reduce the ending balance of the investment account by the amount of equity in earnings - zero cash inflow from equity in earnings and zero cash outflow for long-term investments.  However, if the unconsolidated subsidiary/affiliate up-streams distributions to the parent, we will see a decrease in the ending investment account balance from what we anticipated it to be by the amount of the distribution.  For example, if equity in earnings were $10,000, the beginning investment balance $200,000, and distributions from the subsidiary/affiliate $5,000, the ending investment balance would be $200,000 + $10,000 - $5,000 = $205,000.  Once we back out the impact of non-cash equity in earnings, the adjusted investment account balance drops to $195,000.  This $5,000 decrease in an asset account over the period signals a $5,000 cash inflow to the parent, which we would expect to see captured at some point on the FASB 95 statement of cash flows - perhaps buried in Cash Used in Investing Activities.  The cash inflow, once identified, is classified similar to dividend income as miscellaneous cash income that feeds into Business Cash Income.

4.  Equity losses of unconsolidated subsidiary/affiliate

The reverse of the above.

5.  Cash distributions from unconsolidated subsidiary

Classified similar to dividend income as a miscellaneous cash inflow in the operating section of the UCA cash flow statement, which has a positive impact on Business Cash Income.  Frequently the issue is one of clearly identifying the cash distributions, which leads us back to the investment adjustments noted in Point 3 above.

6.  Cash injections from unconsolidated subsidiary

Classified as a related party transaction and not as an operating event in the UCA cash flow statement.

7.  Write-down or write-off of assets (nonrecurring)

Remove the write-down expense from the operating section of the UCA cash flow statement since it is non-cash, restore the asset in question by the amount of the write-down or write-off, and compute the change in the asset balance following the write-down restoration.  For example, if inventory were written down by $10,000, there would be a $10,000 write-down recorded on the income statement - or buried in a larger income statement account.  Remove that $10,000 expense from the expense stream and increase the ending inventory balance by $10,000.  Then compute the resulting change in the inventory balance as part of the computations that flow into cash cost of goods sold.

August 18, 2015

Q: If you include the owners as co-borrower or guarantors will this cover the shortage if, of course, there is excess personal cash flow from the owner and guarantor?

A: The owners/guarantors may be able to meet a cash flow shortfall if they have sufficient highly liquid personal assets that they can convert to cash within a very few working days. The best measure of owner/guarantor support is their "ready" cash and NOT their personal cash flow.
A personal cash flow surplus may be used for anything. What matters is the cash readily available from investor/owner assets to support company debt service in a crisis.

Q: Is this applicable with Subchapter S corporations for real estate entities?  Do the distributions also need to be deducted?

A: The UCA cash flow applies to any company with an operating balance sheet. It definitely applies to real estate entities. The operative question is not the type of industry, e.g., CRE or C&I, but, rather, whether or not changes on the balance sheet reflect cash inflows or outflows.

And, yes, distributions and loans to owners must be deducted in computing Business Cash Income on the UCA cash flow statement. Once the cash is out the door, the borrower's ability to service its interest-bearing debt is diminished by the amount of the cash outflow.

Q: Are accounts receivable, notes receivable, accounts payable and notes payable from affiliated companies also reflected as Related Party cash inflows or outflows?
 
A: We approach the issue you raise from the perspective of function and purpose. If affiliated accounts receivable, notes receivable, or accounts payable were generated in the normal course of business with an affiliate and do represent trade receivables and trade payables, then we classify them as an operating event identical to standard trade receivable and trade payables. Even if an affiliated account receivable has been converted to a note receivable we would still classify it as an operating event, given its origin.

However, if we suspect that accounts receivable, notes receivable, and accounts payable are really non-arms length events but, rather, quasi-financing events, we would classify them as related party transactions.

It can be a tough call. But issues of this sort point out clearly why the electronic spreading process cannot be a mindless exercise. Issues of this sort also underline the necessity of knowing your borrower, which many lenders fail to do.

June 23, 2015

Q: How do you determine how much of the distribution amount is for the income tax obligation?

A: If you have the accrual income statements, you can estimate the maximum income tax obligation by multiplying the accrual net profit by the sum of the maximum federal income tax amount (39.6% for 2014) and the maximum state income tax amount. Any distribution in excess of the resulting income tax obligation will be compensation. This is a very rough approximation of the income tax liability because income taxes are paid on net taxable business income and not on accrual net income.

If you have the business income tax returns you can determine the income tax obligation for Subchapter C corporations, as well as for pass through entities, by referring to the last line item of Schedule M-1. The amount reported on this line is the taxable income that must be reported, collectively, on all owners’ or partners’ personal income tax returns. Given this amount, you then estimate the amount of income taxes owners or partners must pay by applying a combined federal and state (where appropriate) income tax rate.

Q: The financials given before the class did not include distributions as a line item. I know they are not part of the income statement, but it might have been helpful to have it consistent with the slides and available for reference.

A: We were intentional in not including distributions on the income statement or in the body of the balance sheet because they are indeed not reported as a separate line item on either document as you pointed out. If presented anywhere in the statements, distributions are part of the footnotes or an incremental report reconciling retained earnings. In the case of Tampa Bay Leisure the only way of identifying the distributions was to reconcile Retained Earnings. We elected to save the participants the burden of doing so during the webcast.

We consciously chose to introduce the $438,376 in distributions for 2007 when referencing the income statement sources of information for constructing the UCA CFS. Our purpose was to point out that since the payments can be characterized as taxes or additional owner compensation, it's appropriate to reference them as a "hidden" income statement item.

Q: The financial handout before the class had the financials listed in descending order, but the snapshots of the financials on the overhead were in ascending order. It was a little hard to easily move back and forth between the slides and the financials because of this.

A: Part of our purpose is to introduce webcast participants to the realities of financial analysis. As you observed, the Tampa Bay Leisure financial statements were presented in descending order moving left-to-right from 2007 to 2005.

We’ve found that software spreading systems often present the same information in reversed order as you also observed in several of the slides. Our intent in not adjusting the order presented in the slides was to indirectly make participants aware of this inconsistency. If we can cause one person to avoid the extra work associated with correcting any misinformation they may have conveyed by creating this “real-world” awareness, we’re glad to provide the extra service.

Q: On slide #28, it states that the ($17,481) business cash flow would be insufficient to cover interest expense and LTD repayment; however, interest expense was already deducted from the ($17,481) business cash flow through net income, so it’s actually double counting the interest expense.

A: In compiling the information presented on Slide 28 (Observations) our intent was to create a very narrow focus on Tampa Bay Leisure’s (TBL) failure to service all of their 2007 debt requirements (principle & interest) with cash from operations.

The company’s interest expense of $38,839 was indeed included in the calculation of the company’s 2007 $538,570 net profit. Using this net profit as a start point in constructing the Modified UCA and arriving at ($17,481) Business Cash Income (BCI), we easily see that the company was unable to service any portion of the Current Maturities of LTD in the amount of $21,977.

Our logic was to then build on this observation to express that the negative BCI indicates that the company failed to cover that much ($17,481) of their interest expense for the year as well with cash from operations. By now narrowing our focus to the company’s ability to cover interest expense, our conclusion is that although the company did cover $21,358 of their 2007 interest expense ($38,839 - $17,481) with cash from operations, they failed to cover all of their interest expense.

Our final conclusion as expressed on Slide 28 is intended to convey that Tampa Bay Leisure did not generate enough cash flow from operations to fully service their 2007 principle & interest payments with cash from operations.

Q: My question has to do with subtracting depreciation as a capital expenditure in the bottom of the analysis just below Cash after Debt Service. We know that above in the SG & A area we are adding depreciation back into the total as a reduction to SG & A as it was a non-cash charge, then in the capital expenditures investment section we are removing it. Is this because of the contra-nature of depreciation or the fact that there was an expenditure originally made and we’re trying to account for the accumulated depreciation or?

So the question is then: why is accounted for in cap ex in the investment section of the UCA as a putative cash outlay?  What’s the logic?

A: Below is a review of the generic methodology for computing fixed asset spending - or CAPX - and then an attempt to illustrate how it works in practice in compiling a UCA cash flow statement.

1. Begin with the change in net PP&E.  If the net change is positive, we consider it a cash outflow.  If it is negative, we consider it a cash inflow.
2. Adjust the net change by depreciation expense for the year, which we consider a cash outflow.
3. Adjust the first two amounts by a gain on sale, if any, which we consider a cash inflow.
4. Or adjust the first two amounts by a loss on sale,if any, which we consider a cash outflow.

The sum of the three amounts - the first two in addition to either a gain or a loss on sale - is net cash spending for CAPX.  However, if there were a gain or loss on sale of asset, we would make a further adjustment if the seller took back a note from the buyer, which would increase net cash spending on CAPX.

The depreciation expense adjustment re-establishes the PP&E balance for the current year to the balance in the account before it was written down by the application of depreciation expense.  Assuming no gains or losses, we go from last year's net PP&E balance to this year's PP&E balance prior to the application of this year's depreciation expense. The difference between the two balances is CAPX for the year - or net cash spending on CAPX.  If there were a gain or loss in the year, a gain would reduce the CAPX amount while a loss would add to the CAPX amount.

For example, assume gross PP&E in the prior year is $10,000 and accumulated depreciation expense is $5,000.  In the current year, gross PP&E remains at $10,000 (no fixed asset spending or CAPX), depreciation expense is $500, and accumulated deprecation increases to $5,500.  The change in net PP&E is a negative $500, which we consider a cash inflow since an asset account decreased.  Yet we need to adjust the net change by a cash "outflow" of $500 representing the depreciation expense for the year.  The result is zero dollars for CAPX.  (We could have reached the same conclusion in this example by comparing gross PP&E for the two years.)

February 24, 2015

Q: Why or why not would you consider the change in notes receivable, accounts receivable (current and noncurrent) in calculating Business Cash Income?

A: It depends on the nature of the events that gave rise to the notes and accounts receivable. If Western Star Energy loans money to the various parties and books the loans as notes or accounts receivable, such transactions fall outside their primary operating activities as a petroleum products distributor. This activity is classified as a related party event because such advances are made only to businesses with whom they are contracted. However, if the original transactions were trade-related, i.e., represented the unpaid portion of products sold, then the associated notes and accounts receivable would be classified as an operating event and included in the Business Cash Income calculation.

The overriding consideration in classifying these items is to determine the nature of the underlying transaction. If a business event directly related to the company’s primary operation drives the receivables then it would be appropriate to include them as an operating activity in determining Business Cash Income. If not, they should be considered a related party or other activity and reported as such. In this case, Western Star Energy is not in the business of originating loans causing us to consider them as a related party activity since they lend only to entities with whom they are contracted.

Q: With respect to Question 10, there appears to be a problem in that the actual A/P day in 2007 was 14.1 while the question refers to 14.9 days.

A: Question 10 is as follows:

“If Western Star Energy had been forced to reduce A/P days from 14.9 days to 13.3 days in 2007, Cash after Debt Repayment would have approximated:

• A positive $122,000.
• A negative $135,000.
• A negative $231,000.”

The intent of the question is to bring out the impact of further reducing A/P days in 2007 in comparison to the company’s actual performance in 2006. A/P days moved from 14.9 days in 2006 to 14.1 days in 2007. Our task is to identify the impact of an additional 0 .8 day reduction to 13.3 days in 2007 on Cash after Debt Repayment.

The calculations are as follows:

1. Calculate one day of COGS for 2007: ($59,021,207) / (365) = $161,702.
2. Calculate cash flow impact of additional 0.8 day reduction in 2007: ($161,702) x (0.8) = $129,362, which is a cash outflow of this amount.
3. Calculate revised Cash after Debt Repayment: ($6,095) – ($129,362) = ($135,457)

With respect to Step 3 above, recall that 2007 Cash after Debt Repayment was a negative $6,095. A further cash outflow of $129,362 increases the deficit to $135,457.

February 17, 2015

Q: Just a note. The distributions figure needed to complete the exercise is not included in the financial statement provided in the materials.

A: You are correct. There is no distribution number with the financial statements. This is often the case with company prepared or compiled financial statements, which do not normally include either a cash flow analysis or a net worth reconciliation where distributions are calculated.

However, you can identify the distributions for Tampa Bay Leisure by adding 2006 retained earnings of $1,430,723 and 2007 net profit of $538,570, which yields $1,969,293. Then measure this amount against 2007 retained earnings of $1,530,917. The $438,376 difference represents 2007 distributions.

August 26, 2014

Q: Any concerns or comment about new long-term debt exceeding fixed asset purchases?

A: Long term debt did indeed increase by $852,334 during 2007, a year in which Western Star Energy experienced fixed asset spending of only $779,660.

As we consider the appropriateness of the 2007 new debt structure, it’s important to note that 2007 is the third straight year of significant sales growth. Just as this long term / sustained sales growth drives the 2007 fixed asset expansion we observed, it also drives a permanent increase in Western Star’s core trading assets, inventory and receivables needed to support the higher sales levels.

A portion of this year’s new long term debt appears to have been used to reduce the company’s reliance on their line of credit (short term debt) apparently being used to finance the long term growth we see. This strategy seems to be an effective one and will reduce some of the stress Western Star Energy may have been encountering in the funding mismatch now corrected.

An additional consideration in this conversation may well be related to the acquisition price of the fixed assets purchased vs. the year-end depreciated valuation of the assets. It’s also possible that since we don’t know exactly what type of assets were acquired our view may be further distorted by markdowns driven by market vs. book value considerations.     

Bottom line is that long term debt is used appropriately when it meets long term funding requirements. 

Q: In the cash impact from changes in sales computations, why isn't the gross profit margin held constant to calculate the change in inventory and accounts payable balances? If we are isolating the sales growth (or decline), it seems like keeping the COGS % at the prior year level would be a more accurate way to calculate these changes. This would keep any movement in the gross profit margin from skewing the cash impact calculation from changes in revenues.

A: It is certainly possible to maintain the gross margin and, therefore, COGS%, at the prior period value when estimating the cash impact from sales on inventory balances. If we did so, then all balance sheet accounts would grow by the sales growth rate, and, in effect, life would be a bit easier – at least for the cash impact of sale growth computation.

If we followed this approach, we would then need to revise the methodology for computing the cash impact from changes in inventory days and accounts payable days. Instead of measuring inventory against COGS, we would be compelled to measure inventory against sales. We would need to do so since we must be able to explain the full change in the inventory balance. The same change in methodology would apply to accounts payable days.

For example, if we were to hold the gross margin constant, 2007 COGS would be $58,706,542 for Western Star Energy and 2007 inventory measured against this COGS would be $514,619. Note, too, that the inventory balance in this example would grow precisely as the sales growth rate. Given a sales-driven inventory balance of $514,619, our change in inventory based solely on sales growth would be $514,619 – $469,073 = $45,546 and not $48,305 as the Cash Impact Worksheet illustrates.

Now comes the difficult part. We know that the increase in the inventory balance was $61,010, a cash outflow. To account for the remaining $15,464, we need to measure inventory against sales and not against COGS. If we do so, the expected inventory balance in 2007 would be (($469,073) / ($56,389,722)) x ($61,865,087) = $514,619. We measure that against the actual 2007 inventory balance of $530,083. The difference is $15,464 – the cash outflow caused by the very slight upward movement in inventory days (but inventory days measured against sales and not against COGS). The sum of $45,546 and $15,464 is $61,010, precisely the change in the inventory balance but now broken into two slightly different amounts.

Given this alternative approach, which will get us to the same objective of identifying the cash impact from sales and from management action, we opted to choose the different route. In so doing, we froze all prior year relationships as traditionally measured and allowed only sales to change. The implications are that sales, COGS, operating expenses, and accounts receivable all grow in lock step with the sales growth rate. However, since it is industry practice to measure inventory and accounts payables against COGS, those two balance sheet accounts will grow at the same rate as COGS in order to maintain their prior year relationship to COGS. However, if COGS happened to grow at the sales growth rate, i.e., if the gross margin did not change, then all balance sheet accounts would grow at the sales growth rate.

In effect, it is a trade-off. Do we want to be purists about the sales growth rate or do we want to abide by industry standards in measuring inventory and accounts payable days? We opted for the latter primarily because we want to highlight the importance of management’s control over the operating balance sheet assets and liabilities.

With respect to skewing under this approach, keep in mind that we freeze the gross margin and SG&A% in computing the cash impact on EBITDA from sales growth alone and then from any change in EBITDA%. With respect to the relative cash impact from sales growth on inventory and accounts payable, our computations will differ if we retain the historic relationship between inventory and COGS and account payable and COGS or decide to allow both balance sheet accounts to grow by the sales growth rate. But, either way, the associated cash impact from movements in inventory days and accounts payable days will adjust precisely to the amount necessary to explain the change in the respective balance sheet accounts.

Q: I was unclear on the answer to Poll Question #6. The instructor asked for the isolated cash impact due to the change in EBITDA% but then gave the answer as the total change in EBITDA dollars for the period. This was inconsistent with the way Poll Questions #7 & #8 were answered.

A: You are correct. The 47 basis points change in EBITDA % from 2006 to 2007 did indeed result in a cash outflow of $292,454 in 2007. When this impact is combined with the $55,257 cash inflow driven by the 9.71% increase in sales, the net result is a cash outflow of $237,197.

We stated the answer incorrectly, and we thank you for bringing this to our attention.

August 19, 2014

Q: If a company is organized as a Subchapter S corporation or limited liability company (LLC), will distributions show up in the changes in retained earnings year-over-year?

A: Distributions will indeed show up in changes in net worth, since they decrease retained earnings or partners' capital. But you may have to reconcile the change in retained earnings or partners' capital to identify the amount of distributions.

In some cases, financial statements may include a reconciliation of net worth as well as a statement of cash flows, and distributions can be found in either of those calculations.

Q: Can you please go over fixed asset spending on why we add depreciation for 2007 but not for 2006?

A: In order to determine 2007 fixed asset spending, one must start with 2006 net fixed assets and then measure it against the 2007 net fixed asset balance before reducing that balance by a non-cash event called depreciation. The difference between 2007 fixed assets before applying 2007 depreciation expense and the starting point – 2006 net fixed assets – represent fixed asset spending in 2007.

The 2006 depreciation expense is used to calculate 2006 fixed asset spending in the manner described above for 2007 fixed asset spending.

Q: Do you guys still make the Cash Impact Worksheet calculator available on your website?

A: Yes, for members, once you login to your account, please click the Software / Commercial Loans menu option and four worksheet links will appear on the next page: EBITDA Adjustment, Net Income Adjustment, Cash Flow Snapshot, and Cash Impact.

March 12, 2014
Q: Where would realized and unrealized gains fall?  Investing or operating activities?

A: Realized gains on investments would be included on the income statement in an “Other Income” or similar account in arriving at Profit before Taxes.  “Other Income” is used in the Operating Section of the UCA Cash Flow.

If unrealized gains were related to financial investments, they would be pulled out of “Other Income” in the operating section and then used to compute actual cash and equivalent balances.

Q: Where would interest income (or dividends) from marketable securities show up on the UCA cash flow statement?

A: Interest or dividends received show up in the operating section of UCA cash flow, usually as other income or interest and dividend income.

Q: If a company sells an asset that they have held for more than one year and have a loss from the sale, where would you find the sale price opposed to the loss?  Wouldn't you want to know that sale price as it relates to actual "cash in" for the period?

A: Information about the sales price of assets sold during a period rarely, if ever, show up in the financial statements, although they are provided in detail in the business income tax returns.  However, in computing fixed asset spending on the UCA cash flow statement from balance sheet and income statement information, we compute net fixed asset spending rather than gross fixed asset spending less the proceeds from the sale of existing fixed assets.  Consequently, we need only three pieces of information – the change in net fixed assets (from the balance sheet), the total amount of depreciation expense (from the income statement), and the total gain or loss on sale of assets (from the income statement).  Given that information, we can compute the cash inflow or outflow from the combination of fixed asset purchases and sales in the period.

If there are no sales of fixed assets during the period and, therefore, no reported gains or losses, we can more easily compute fixed asset spending by computing the change in gross fixed assets.  However, if there are sales during the period, then we need to resort to the computations noted above.

Q: My question is concerning Agricultural Lines of Credit or Agricultural Term Notes (of which we do a lot). These entities are usually Sole Proprietors, Family owned corporation, Family owned LLC or Family owned S Corps and are for the most part cash basis.  How do you see the UCA Cash Flow working for this type of business? There is usually not a CPA prepared Balance Sheet for any of the entities and Income/Expenses are taken off of a Schedule F.
 
A: An excellent question and one that has no really good answer, especially for sole proprietorships.

If the farm operation reports on a cash basis and uses Parts I and II on Schedule F, increase Net Farm Profit at Line 34 by a) the amount of depreciation expense at Line 14, b) the amount of interest expense at Lines 21a and 21b, and c) the amount of withdrawals or distributions. The resulting estimate is business cash flow available to service interest-bearing debt.

The problem here, of course, is that distributions or withdrawals are not captured on Schedule F or elsewhere on the personal income tax returns, which means you will need to contact the borrower or the accountant (assuming there is no set of accrual financial statements available). In addition, you will need to contact the borrower or accountant to identify the amount of scheduled debt repayment if the borrower has long-term lines of credit from other lenders.

From this point on, it is still difficult to complete a UCA cash flow statement since you need the purchase and sales prices of fixed assets, which may not be readily available. But if you get this far, you will at least have good idea if the farm operation threw off enough cash to service its interest-bearing debt.

If the farm operation reports on an accrual basis and uses Part III, then you can really do nothing without the accrual financial statements, as you noted.

For farm operations that report using Form 1065 and Form 1120S, you should have enough information in those business income tax returns to create and accrual income statement - even if the information is captured on a cash basis - and then construct performance ratios and an approximate UCA cash flow statement. I should mention, however, that Schedule L and Schedule M-1 are frequently poorly, if not incorrectly, prepared, since they are clean-up schedules, in effect, which are not used to determine taxable income.

Centrec Consulting provides a software program that converts cash-based agriculture information to accrual financial statements. You're probably familiar with them. If not, they may be able to help.

November 26, 2013

Q: Where did the pre depreciation write-down of $698,643 come from?

A:It is the sum of 2007 net fixed assets (net means after 2007 depreciation expense is added to 2006 accumulated depreciation) plus 2007 depreciation expense.

By adding $127,582 of 2007 depreciation expense to 2007 net fixed assets of $571,061, we compute the 2007 fixed asset balance prior to application of 2007 depreciation expense as $698,643.  (We refer to this amount as the 2007 pre depreciation write-down balance.)

Next we subtract 2006 net fixed assets of $208,542 from the calculated 2007 pre depreciation write-down of $696,643 to get 2007 fixed asset spending of $490,101.

Q: Back to the net fixed asset spending calculation.  Why wasn't the 2006 net fixed asset figure of $208,542 not also adjusted for 2006 depreciation expense similar to the 2007 adjustment to net fixed assets for 2007 depreciation expense?

A: We leave 2006 net fixed assets alone since we want to measure how much that balance increases in 2007 prior to any non-cash downward adjustment for depreciation expense. We would only increase 2006 net fixed assets by 2006 depreciation expense if we were computing 2006 fixed asset spending.  Then we would measure that adjusted balance against 2005 net fixed assets.

Q: Can't they also use accounts payable as a source of cash by extending terms or paying more slowly?

A: Certainly a company can attempt to stretch its payables, but it may encounter problems if it stretches too much, e.g., the suppliers may put them on a “cash on delivery” (COD) basiswhich may, in turn, trigger a true cash flow crisis.  A company must proceed with caution in stretching accounts payable to conserve cash.

Q: How do you reconcile net worth?

A: Begin with last year's net worth and add this year's profit and any capital contributions you can identify. Then measure the result against this year's actual net worth. If the "what if" amount exceeds the actual amount, the difference likely represents distributions made to owners this year.

Q: I am having a discussion with my colleagues about when it would not be appropriate to use the UCA analysis.  Which situations or industries that you do not find that UCA is not appropriate.

A: In my opinion, the only time to forgo use of a UCA cash flow statement is assessing a company that has no balance sheet.  If there are no operating asset accounts, such as receivables and inventory, and no operating liability accounts, such as payables and accruals, then reported net income (decreased by the amount of distributions and loans to owners) would be equal to business cash income (or net cash income depending on the UCA version you use) on the UCA cash flow statement.  Further, if there is no balance sheet, then you don't have to worry about computing fixed asset or intangible spending.

The above situation may exist, but I have yet to run across a borrower that basically has no balance sheet. That means, in turn, that the UCA cash flow statement is appropriate - I would say mandatory - in every situation.  It is the only analytical tool that allows you to a) identify the cash sources of debt service, b) identify the borrowing causes, c) identify the financing requirement for the period, and d) identify the sources of cash to meet the financing requirement.  These are critical issues for every credit.  The cash flow proxies such as traditional "cash flow" and EBITDA do none of the above.  They use only income statement information.

Borrower size doesn't matter either.  In fact, I would argue that the smaller credits require as thorough an analysis, which means a full and complete application of UCA cash flow, as do larger credits.  Small doesn't mean simple.  Further, with the smaller credits, the lender is usually the single source of support so if the lender gets the analysis wrong, there is generally no greater fool around to bail it out.

August 20, 2013

Q: Can you repeat the relationship between cost of goods sold and accounts payable?

A: The relationship, or linkage, is routed through the relationship between inventory and accounts payable.  As a company purchases inventory, it usually finances some or all of the purchase via trade credit in the form of accounts payable.  When the inventory, in turn, is either processed or resold, it moves from the balance sheet to the income statement as an element in cost of goods sold. Consequently, accounts payable play a role, indirect as it may be, in the final determination of cost of goods sold since accounts payable support inventory purchases, which ultimately end up as cost of goods sold.

The UCA cash flow statement acknowledges these relationships.  Cash Production Costs in the UCA cash flow statement is the combination of a) accrual cost of goods sold after removal of depreciation expense, b) the change in inventory balances, and c) the change in accounts payable balances.  If there is no change in inventory and accounts payable balances, Cash Production Costs reduces to accrual cost of goods sold absent depreciation expense.  However, if the inventory balance increases (a cash outflow) more than the accounts payable balance increases (a cash inflow), Cash Production Costs will exceed accrual cost of goods sold absent depreciation expense.  And vice versa.  A company’s management of inventory days and accounts payable days, therefore, plays a critical role in determining Cash Production Costs.

Accounts payable emerge in the normal course of doing business just as accounts receivable emerge in the normal course of doing business.  Neither represents outside financing as such but, rather, reflects customary business operations.

June 20, 2013

Q: On Slide 43 what is the pre-depreciation write down of $1,810,558? Where does that come from?

The general formula for Fixed Asset Spending is the change in in net fixed assets, adjusted by depreciation expense as well as by the gain or loss on the sale of assets.

In the case of Western Star Energy the change in net fixed assets from 2006 to 2007 was a cash outflow of $683,371 (2007 net fixed assets $1,654,877 minus 2006 net fixed assets $971,506) adjusted by 2007 depreciation expense of $155,681, which gives us fixed asset spending before the gain on the sale of assets of $859,052. We then must adjust this number by the 2007 gain on the sale of assets of $59,392, leaving us with 2007 fixed asset spending total of $799,660.

Another approach to fixed asset spending would be to take the 2007 net fixed assets of $1,654,877 and add back the 2007 depreciation expense of $155,681, giving us a pre-deprecation write down of $1,810,558 (we must remember that beginning fixed assets in 2007 was $1,810,558). The 2007 pre-depreciation write down of $1,810,558 minus the 2006 net fixed assets of $971,506 gives us fixed asset spending of $859,052 before the 2007 gain on the sale of assets of $59,392. Adjusting $859,052 by the 2007 gain on the sale of assets gives us 2007 fixed asset spending of $799,660.

These methods are just two different ways of calculating fixed asset spending.

Q: Would you expand on Poll Question 3 in which the cash outflow from a one-day decrease in accounts payable days more than offsets the cash inflow from a three-day decrease in accounts receivable days?

A:Poll Question 3 is as follows:

• The decrease in accounts payable days between 2006 and 2007 resulted in a cash outflow that more than offset the cash inflow from the decrease in accounts receivable days between 2006 and 2007.  Agree or Disagree?

The answer to this poll question is “disagree”.

The computations leading to this conclusion are as follows:  

• Change impact from change in A/R Days = (A/R at 24 Days) – (2007 A/R)

($3,685,375) / ($56,389,722) x ($61,865,087) – $3,549,593
$4,043,220 – $3,549,593 = $493,627

 

• Change impact from change in A/P Days = (2007 A/P) – (A/P at 15 Days)

$2,279,358 – ($2,183,134) / ($53,510,724) x ($59,021,207)
$2,279,358 – $2,407,951 = ($128,593)

The three-day decrease in accounts receivable days provided $493,627 of cash to the company while the one-day decrease in accounts payable days drained $128,593 of cash from the company.  For more detail and explanation please see Page 10 in the solutions for the webcast exercise.

   
 

Q: One of the struggles we face, as a community bank financing a lot of small businesses, many of which are sole proprietors, is that we don’t have consistent year end financials where balance sheet and income statement dates match up. We also seldom have accrual derived income statements and many times are using income tax returns that are on a cash basis. How do we make use of the UCA analysis under those limitations?

A: We have a couple of webcast the focus on business income tax returns and how to use them for ratio and UCA cash flow analysis.  They may possibly help.

But the issue of getting financial statements that are least in balance is a tough one.  I recall years ago talking to a U.K. bank that was heavily in very small business lending.  They received virtually no current financial information from small borrowers, so they became asset based lenders, i.e., they based their credit decisions on the value of the collateral.  However, that turned out to be a poor approach which led them to attempt to anticipate borrower problems by tracking movements in their checking accounts -  a still unresolved issue.

If I were to become a collateral lender in the absence of current or decent financial statements, I think I would require the owner's bank, broker, and financial advisory statements on a monthly basis and decide whether the owner (and, presumably, the guarantor) had enough ready cash to service debt or liquidate interest-bearing debt obligations.  But in my heart of hearts, I would never embrace that approach with any enthusiasm.

Back to decent financial statements.  If a borrower can't produce such statements, it certainly raises an issue about his or her ability to understand the company's current and prospective financial and cash position. Absent such statements, I'd be very reluctant to extend credit.

March 13, 2013
Q: Isn't accrued interest receivable an asset?

A: Yes, accrued interest expense is an asset. I mistakenly referred to the line item as accrued interest expense.

As we note on Slide 34 in the presentation slides, accrued interest receivable is the balance sheet counterpart account to interest income on the income statement. In the case of Western Star Energy, 2007 interest income on the income statement was $1,867.  There was a further interest income cash inflow in that year of $796, reflected by the decrease in the accrued interest receivable balance from $1,855 in 2006 to $1,059 in 2007.

Q: My team just completed the Advanced UCA webinar and were wondering if there was a spreadsheet in the Shockproof library that we can use to calculate the cash impact of sales growth on the various financial statement categories?  We also use an Excel financial spreadsheet and I'm wondering if there's also something better in the library that we could or should be using.

A: Yes, for members we provide a Cash Impact Worksheet which allows you to quickly estimate and separate the cash impact of sales growth or decline on accounts receivable, inventory, and accounts payable from the cash impact of changes in the company’s management of receivables, inventory, and payable.  To access the Cash Impact Worksheet, please log on to the Shockproof! Training website, click on "Software" and then on "Commercial Loans".

Q: Will you be sharing the Power Point presentations with all of us?
A: The slide deck is available within the email we sent with the webcast materials.

 

February 19, 2013

Q:  In your opinion is there any revenue size cutoff where traditional cash flow (global with the owner) would be preferable over UCA cash flow analysis?

A:  There is no revenue size that determines the use of traditional cash flow (net income plus non-cash charges).

The critical assumption underlying this debt service coverage ratio (net income plus non-cash charges divided by the current portion of long term debt) is that accrual profit is, or shortly will be, converted fully to cash.  Net income plus non-cash charges is not cash flow.  Rather it is a proxy for business cash flow, which may or may not materialize as a company collects its receivables, uses its inventory, and pays its accrued expenses. Further, this debt service coverage ratio does not include two significant streams of owner compensation – distributions and loans to owners or shareholders – which could materially reduce the amount of business “cash flow” available to service interest-bearing debt.
 
However, if Net Cash Income on the Uniform Credit Analysis (UCA) cash flow statement is positive, it clearly indicates that the company generated sufficient cash flow from its business operations to pay all cash operating expenses and cash interest expense, certainly a desirable event for both lender and borrower.  Although negative Net Cash Income means the company likely used outside sources of cash to pay some cash operating expenses and cash interest expense, that event may not be undesirable if sales growth alone explains the reasons for the cash deficit.  Conversely, positive Net Cash Income may provide misleading favorable signals about borrower risk if it results from significant sales decline that masks collapsing profitability.

Accordingly, the determining factor as to when traditional cash flow may be a reasonable approximation of operational cash flow is when there are no significant changes in operating assets and liabilities and not revenue size of a company.

Q:Is there a reason change in A/P shows up under intangible spending on the power point slide #46 rather than under operations of the cashflow statement?

A: Normally accounts payable and inventory are the balance sheet counterpart accounts to cost of goods sold on the income statement. However, in the case of Sequoia Properties, there is no inventory or cost of goods sold because the company is a real estate developer.

Accordingly, for Sequoia Properties, accounts payable are related to unpaid site preparation costs (roads, water, sewer, and other development costs) which, in turn, are classified as an asset called intangible spending.

Question & Answer UC Cash Flow Statement Webcast November 6, 2012

Q: Typically, debt service covenants have been tied to net profit plus non cash add-backs less distributions to determine coverage of debt.  Should the covenant be tied to operating cash flow for those companies with accrual basis statements?

A: There are two covenants that work in tandem to address both the profitability and cash flow issues.

The first covenant is a variation of the standard debt service covenant in which reported net profit, reduced by the sum of distributions and loans to owners but increased by interest expense, is divided by the sum of interest expense and scheduled long-term debt repayment and set at some minimum level.   The intent is to constrain profit remaining in the business – after accounting for cash outflows from distributions and loans to owners – to an amount sufficient to cover interest-bearing debt service.  The covenant addresses only profit and not cash flow.

The companion covenant is a financial gap ratio maximum that addresses balance sheet cash flows.  It is computed as the difference between all operating asset accounts, e.g., accounts receivable and inventory, and all operating liability accounts, e.g., accounts payable and accrued expenses, divided by sales.  If a business maintains the financing gap ratio going forward, it means that there is no net movement in turnover ratios, e.g., no net movement in the sum of accounts receivable days and inventory days less accounts payable days.  Therefore, if a company grows while maintaining its financial gap ratio, the only cash outflow associated with changes in operating asset and liability accounts is attributed to growth and not to management’s control of those key turnover ratios.

These two covenants taken together, if honored, assure sufficient profitability and cash flow – absent the cash impact of sales growth or decline – to properly service interest-bearing debt.

On the other hand, it is certainly possible to establish a debt service covenant based on the UCA cash flow statement.  For example, we could devise a covenant in which UCA business cash flow must be sufficient to meet the sum of interest expense and scheduled long-term debt repayment.  The practical problem with such a covenant is the difficulty in explaining it properly to a borrower so that it becomes an effective covenant.  Borrowers do not generate UCA cash flow statements as a standard financial report. Therefore, the learning curve in introducing and applying a UCA-based covenant might prove somewhat insurmountable.

Q: Please help to explain why high sales growth absorbs cash.
 
A: In a high sales growth scenario, the cash throw off from additional EBITDA and from additional accounts payable/accrued liabilities generally falls short of the cash run-off from the increase in accounts receivable and inventory.
 
But there are certainly situations in which high sales growth throws off cash. For example, if EBITDA% is very robust and operating liabilities (accounts payable and accrued liabilities) exceed operating assets (accounts receivable and inventory), then high sales growth will throw off cash.  In general, however, the operating assets exceed the operating liabilities, which is the critical force that drives cash flow.

Question & Answer, Advanced Cash Flow, August 29, 2012

Q: Why did Western Star Energy management decide to pay down short term debt in 2006?

A: Without speaking to management, we are not certain why Western Star Energy paid down short term debt in 2006.

One of the most common reasons that a company pays down short term debt with long term debt is they may have temporarily used their $1,500,000 line of credit to finance capital expenditures during the year.
The lender may have reviewed this use of the line of credit and agreed to term out the amount used for long term purposes.

In a real world scenario, the lender would, of course, be in communication with the borrower during the year to ensure that the line of credit was used as intended.

Questions & Answers, Advanced Cash Flow, June 7, 2012

Q: In your opinion, was Western Star profitable in 2007?

A: According to GAAP, Western Star was profitable but, analytically, it was unprofitable. Its reported net income of $79,403 was more than eliminated by $93,323 in distributions. Further, it loaned $32,713 to its shareholder, which is another form of unreported compensation. Therefore, it had an actual business loss in 2007 of $46,633.

Q: Would sales neutral business cash income be calculated differently if revenue declines?

A: There is no difference in calculating cash impact from a sales decline.  The same general methodology applies.

For example, if accounts receivable declined as sales declined, we can calculate what the associated accounts receivable balance “should be” with the sales decline and then measure it against the actual accounts receivable balance.  The result reveals whether the company is collecting accounts receivable more or less rapidly and quantifies the resulting cash impact.

Apply the same methodology to inventory, accounts payable, and EBITDA and you arrive at the total for the Cash Impact of the Sales Decline.

You will be able to easily determine Sales Neutral Business Cash Income by removing the total Cash Impact of the Sales Decline from the actual Business Cash Income.

Try it.  Find a company with declining sales, apply the cash impact methodology, and you'll see the process works well.

Finally, many credit analysis software programs automate and reflect this methodology on either a Cash Impact report or Cash Management report.

Questions and Answers, UCA Cash Flow, May 15, 2012

Q:  Most of the tax returns and company prepared statements do not include or provide the current portion of long term debt. More times than not, I do not have this information and cannot get it. How to I figure that amount or do I not include it in my spreads?

A:  Accrual statements do exist since they are the basis for the information-only business income tax returns, so do not give up asking your customer and his or her accountant for them. However, absent that information, you might try dividing the amount of long-term debt by five years for any amount that appears to be for equipment financing or by fifteen years if it is real estate financing in order to arrive at a reasonable guess for the current portion of long-term debt.

Q:  How do you like the data to be presented within a credit memo?  Is there a coverage ratio or do you just talk about the major changes in cash flow, if cash flow from operations can cover CPLTD and how other items are funded?

A:  There is no simple coverage ratio, but there are two covenants that work in tandem to assure sufficient business cash flow to service interest-bearing debt absent the cash impact of sales growth.  

The first is Business Profit Coverage, which is defined as follows:

• [reported net income – (distributions + loans to owners) + interest expense] / [interest expense + current maturities long-term debt] > 1.00

The greater the risk that not all reported profit will be converted to cash, the greater the factor above 1.00, e.g., 1.25.

The second is the Financing Gap Ratio, which is defined as follows:

• [operating assets (last historical period) – operating liabilities (last historical period)] / [sales (last historical period)]

As a reminder, operating assets are generally receivables, inventory, and prepaid expenses.  Operating liabilities are accounts payable, accrued expenses and accrued liability and, on occasion, operating deposits and deferred revenue.  However, operating liabilities never include short-term interest bearing debt or current maturities of long-term debt.

If the Business Profit Coverage is met and if the Financing Gap Ratio does not increase, a company will have sufficient business cash flow, absent the cash impact of sales growth, to fully service its interest-bearing debt.  If the Financing Gap Ratio is honored and the company grows, the growth will drain cash because operating assets, e.g., receivables and inventory, invariably exceed operating liabilities, e.g., payables and accruals.  But no further cash will escape the company caused by an increase in receivable days, for example, or by a decrease in accounts payable days.  

Business owners can readily understand these two measures, which is always a major consideration in establishing covenants or performance standards.

Q:  Why are preliminary site costs considered intangible assets?

A:  In the case of Sequoia Properties, the accountant classified preliminary site preparation costs as intangibles until the project(s) are complete, presumably because they are neither fish nor fowl, so to speak.  They represent a work in process which may or may not be completed.  Further, they include soft costs such as surveying and engineering costs in addition to the cost of grading and preparing the properties for subsequent construction.  A different accountant may decide on a different classification.  

From our perspective, the key point is to identify the cash amount of these costs as well as determine if this cash amount is an operating or investment expense.  We decided it was definitely an investment expense, which determined our classification of both these “intangible” assets and associated accounts payables.  The latter classification, in particular, has a profound impact on Business Cash Income.

Q: I’d like to ask a question regarding Inventory’s role in the Cash from Trading (or from “Production Costs”) section. We’re performing a loan review where the amount of inventory shown on the financials has declined each year. As such, the UCA format treats this as a positive cash adjustment. It’s been speculated that he may be downshifting this particular product line (i.e. not re-ordering as much as prior years), and the concern is that the adjustment may not really be cash related. Is this plausible? It just seems odd in light of typically viewing inventory as a “use” of cash (i.e. negative cash adjustment).

A: A decrease in inventory is, if fact, a source of cash.  For example, if a company has a beginning inventory balance of $100, purchases $1,000 of inventory during the year, and then has an ending inventory balance of $50, its COGS is $1,050 or beginning inventory plus purchases less ending inventory.  Yet it only purchased $1,000 of inventory during the year, which is the actual cash outflow.  Cash Production Costs in this instance would be COGS adjusted by the change in the inventory balance, or ($1,050) + $50 = ($1,000).  In other words, a decrease in inventory is a cash inflow in constructing the UCA cash flow statement...or in constructing any cash flow statement that incorporates changes in balance sheet accounts.

Questions & Answers, UCA Cash Flow Analysis, February 21, 2012

Q: When computing fixed asset spending, how do you know how much the pre depreciation write down is?

A: With respect to the pre-depreciation write-down amount, we know that fixed asset, net, was $571,061 at the end of 2007 by reference to the company’s balance sheet.  That balance is after the depreciation write-down of $127,582.  The $127,582 of 2007 depreciation expense is the sum of $110,505 of depreciation expense allocated to cost of goods sold and $17,077 of depreciation expense allocated to operating expenses.  Therefore, the balance in the fixed asset, net, account before the depreciation write-down was $571,061 + $127,582 = $698,643.
  
To compute fixed asset spending for the period, we then measure the pre-depreciation write-down of $698,643 against the 2006 fixed asset, net, balance of $208,542, which is our starting point in the computation process.  The difference between those two balances is $490,101, which is fixed asset spending for the period.

Had there been a gain or loss on sale of assets in 2007, we would have used the following general approach in computing 2007 fixed asset spending:

• Net Fixed Assets _{(beginning balance)} – (Net Fixed Assets _{(ending balance)} – Depreciation Expense) + Gain on Sale of Assets – Loss on Sales of Assets = Fixed Asset Spending, net or
• Change in Net Fixed Assets – Depreciation Expense + Gain on Sale of Assets – Loss on Sales of Assets = Fixed Asset Spending, net
  

There will be either a gain on sale or a loss on sale but not both.

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 as a further negative amount, we increase the cash outflow, i.e., we increase the change in an asset account.  A gain on sale decreases the cash outflow, while a loss on sale adds to the cash outflow.

In the Tampa Bay Leisure example, the change in 2007 net fixed assets was an increase of $362,519 ($208,542 minus $571,061), a use of cash.  The depreciation expense of ($127,582) increased that negative amount to a total of 2007 fixed asset spending in the amount of ($490,101).  We need make no further adjustment since there was neither a gain on sale of assets nor a loss on sale of assets.

Q: The slides do not match Exhibit III in the Credit Refresher. Exhibit III doesn't show the change in due from shareholder. It lists related party transactions of $25,000.
 
A: The related party account is the Due from Shareholders account mentioned in the Credit Refresher on page 3 in the right column.

In the webcast, we refined our classification approach and matched the change in the Due from Shareholders account with distributions, since we consider both distributions and loans to owners as very similar events. That is, they provide cash to the owners for a) payment of income taxes on company profit and b) additional compensation if the sum of distributions and loans to owners exceeds the amount required to satisfy the personal income tax obligation.

Very frequently, loans to owners are advance distributions, i.e., a cash outflow to the owner that is booked initially as a loan and subsequently converted, in whole or in part, to a distribution via a set of very simple accounting entries.  In this instance, it is very likely that Tampa Bay Leisure posted a $25,000 credit entry to Due to Shareholders and an offsetting $25,000 entry to Distributions some time in 2007.  The result is a decrease in the Due from Shareholders account by $25,000 and an increase in Distributions by $25,000.  Yet no cash is associated with this transaction. 

Further, if this did indeed occur, 2007 distributions of $438,376 included a $25,000 non-cash amount.  By adding loans to owners for the period – a “repayment” of $25,000 – to the recorded distributions for the period – $438,376 – we get the actual cash amount of distributions for 2007, which was $413,376.  As a result, our initial estimate of Net Cash Income improves from a negative $42,481 to a less negative $17,481.

None of our cash flow conclusions change as a result of this classification adjustment.  Tampa Bay Leisure still failed to meet its 2007 debt service from business cash flow.

Questions & Answers, UCA Cash Flow, October 4, 2011

Q: Are operating expenses on the income statement. paid in cash or have they been reserved (i.e. reflected as an increase in accrued expenses on the balance sheet) to finance asset growth?

A: Operating expenses on the income statement could be cash or could be an amount not yet paid for – accrued expenses in effect. Yet, by using cash flow analysis to adjust operating expenses on the income statement with the change in accrued expenses on the balance sheet, we get the cash impact of operating expenses for the period.

Q: Negative Net Cash after Operations (NCAO) isn't necessarily bad if it was a result of cash used to finance sales growth, correct? As long as everything else is in place (i.e. turnover days)

A: You are correct. If negative Net Cash after Operations is caused by profitable and sustainable sales growth, then operating assets (accounts receivable and inventory) will grow faster than operating liabilities (notes payable and accounts payable). We like financing profitable sales growth as long as the company manages its balance sheet well, i.e. keeps the turnover days constant and in check.

Q:  If loans to owners are like distributions and therefore really operating expenses, then do we then net owner contributions to the company (loans from owners) against the loans to owners?

A: It is fairly common to find a Due from Shareholders account on the asset side of a borrower’s balance sheet and then a Due to Shareholders account on the liability side of the same balance sheet. Further, the balances in both accounts normally change from period to period.  Depending on the direction and magnitude of the changes, the shareholders or owners either put cash into the company or take cash from it on a net basis.  Consequently, it seems simplest to collect the changes in one location on the cash flow statement and designate that line item as either a) a cash inflow to the company, which decreases its financing requirement, or b) a cash outflow from the company, which adds to its financing requirement.

But it is not so simple.  There are two separate accounts because the cash flows into and out of these accounts take place for very different reasons.

• If an owner borrowers from his or her company – which increases the balance in the Due from Shareholders account – it is invariably to a) use the cash as an advance distribution to pay personal income taxes on company profit or b)  to use the cash for compensation – or both.
• If an owner lends money to his or her company – which increases the balance in the Due to Shareholders account – it is usually to provide emergency financing in the absence of necessary financing from outside third parties.
  

We could argue, of course, that a loan by an owner to his or her company rightfully offsets and reduces, in theory if not in fact, the amounts he or she has borrowed from the company.  For example, assume a $100,000 balance in the Due from Shareholders account at the time an owner provides a loan to the company in the amount of $100,000, which increases the balance in the Due to Shareholders account by $100,000.  Shouldn’t we simply assume the $100,000 cash inflow was intended to eliminate the loan – even though the $100,000 balance remains in the Due from Shareholders account?

The answer is no.  If the owner had wanted to eliminate his or her loan from the company with a $100,000 payment to the company, he or she would have specified that the $100,000 was for the purpose of repaying the loan.  The balance in the Due from Shareholders account would have been eliminated by the cash inflow from the owner.  But the owner obviously had no intention of repaying the loan. Furthermore, by designating the $100,000 cash inflow to the company as a loan and not as a capital injection, the owner very definitely intends to be repaid the full $100,000 when the company has the cash resources to do so.

There are some further complications in interpreting movements in the Due from Shareholders and Due to Shareholders accounts.  If the balance in the Due from Shareholders account decreases, we quite naturally assume that the owner has repaid some or all of the money he or she has borrowed from the company.

But the facts may be very different.  If the company in question is a Subchapter S corporation, partnership, limited liability company, or sole proprietorship, the reduction in the Due from Shareholders account may simply reflect the conversion of a loan to a distribution or withdrawal via a set of offsetting accounting entries,.  That is, the owner borrows from the company during the year either to make quarterly income tax payments on company profit or to increase his or her effective compensation.  At the end of the year, the internal bookkeeper or outside accountant decides to convert some or all of the loan balance to a distribution or withdrawal with a credit entry to Due from Shareholders, which decreases that account balance, and an offsetting debit entry to Distributions or Withdrawals, which decreases retained earnings or proprietor’s capital.

The reduction in the Due from Shareholders balance does not reflect a cash repayment of some or all of the outstanding loan balance.  Quite the contrary.  Cash went out of the company to the owner when he or she borrowed the money initially that increased the balance in the Due from Shareholder account.  The subsequent reduction in the Due from Shareholders account reflected a non-cash event that converted some or all of the loan balance to a distribution or withdrawal.

For a Subchapter C corporation, a reduction in the Due from Shareholders balance will not reflect the conversion of loans to distributions, but it frequently reflects the conversion from loans to an owner to additional salary to that same owner.  In the conversion process, the company will provide the owner with the additional cash necessary to meet the tax withholding requirements on the newly provided “salary”.

Loans to owners and distributions or withdrawals, on the one hand, represent either income tax expense or compensation or both.  Regardless of how we classify these events in accordance with accounting conventions, they are operating expenses for the company and need to be recognized as operating expenses, which effectively decrease reported profit and decrease debt service resources.

Loans from owners, on the other hand, represents financing and, usually, emergency financing.  Such loans are not offsets or reductions to loans to owners but a very separate event with a very different objective.

Consequently, it is critical in assessing the risk profile and the debt service prospects of a borrower that we fully acknowledge the fundamental difference between these two categories of cash flows.  One is an operating event, which belongs in the expense stream on the income statement and in the operating section of the cash flow statement.  The other is a financing event, which does not touch the income statement but, rather, belongs on the balance sheet and in the financing section of the cash flow statement.

Questions & Answers, UCA Cash Flow, May 19, 2011

Q: Is it recommended/possible to apply the UCA cash flow statement to tax return information obtained from the customer?

A: Yes, it is possible to construct a UCA cash flow statement from business income tax return information under the same terms and conditions that apply to constructing a UCA cash flow statement from accrual financial statements, i.e., an income statement and a beginning and ending balance sheet.  In this instance, we need two consecutive income tax returns.

There are some very pronounced difficulties that usually arise in using only income tax information.  For example, some expenses are excluded from the business income tax returns and some revenue may be either allowed or disallowed, since business income tax returns are prepared in accordance with tax regulations and not in accordance with GAAP.  As a result, we’re compelled to rely on information in Schedule M-1 in the business income tax returns, which provides a reconciliation of book and tax revenue and expenses.  That information becomes critical in assuring that we’ve captured all expenses and properly captured and classified all revenue and income amounts.

In addition, we may encounter problems in identifying current maturities of long-term debt from Schedule L.  It is unclear if the amounts reported as current debt obligations are short-term debt, or current maturities of long-term debt, or some combination of the two.  Frequently, the accountant will provide a separate statement that clarifies the content of the account.

Further, Schedule L on Form 1120S for Subchapter S corporations captures loan to and loans from shareholders, which is an essential piece of information in properly computing Business Cash Income on the UCA cash flow statement.  However, Schedule L on Form 1065 for partnerships and limited liability companies does not require that information. As a result, in constructing a UCA cash flow statement from Form 1065 information, we may miss a major operating expense amount in the form of loans to partners – unless there is an associated statement that specifically details loans to and loans from partners.

In the final analysis, it is always much safer and usually much easier to ask for and use the underlying accrual financial statements in constructing the UCA cash flow statement.  Keep in mind that the accrual financial statements certainly exist and are used by the borrower daily, since the business income tax returns are prepared from information in the accrual financial statements.

Q: What is the difference between the UCA Cash flow statement and a global cash flow analysis?

A: A UCA cash flow statement focuses on a single operating entity, for the most part, unless the underlying financial statements are consolidated financial statements that include an array of companies owned in whole or in part by a parent company.  The objective of the UCA cash flow statement is to a) identify all borrowing causes, b) identify the cash sources of interest-bearing debt service, c) identify the financial requirement or surplus for the operating period, and d) identify the sources of cash to meet the financing requirement, if one exists.

The objective of global cash flow analysis is to determine if a company or borrower can possibly benefit from related party cash support or be adversely impacted by related party cash demands on the company or borrower.  The UCA cash flow statement is the single most effective analytical vehicle for identifying the likely cash support from other related parties – including owners - or likely cash drain imposed on the subject company from other related parties – including owners.  At the end of the day, however, the possible cash support from related companies or the possible cash support from owners depends on the liquid assets on the balance sheets of these related parties.  By the same token, the possible cash support that a subject company can provide to related parties, including owners, depends on liquid assets on its balance sheet.

A key in conducting global cash flow analysis is to avoid consolidating UCA cash flow statements.  That process will greatly impede our ability to identify the cash cows among any array of related parties as well as identify the problem companies or related parties within such a group of related parties.

Q: What is EBITDA?

A: EBITDA is earnings before interest, taxes, depreciation, and amortization frequently considered a proxy for cash flow available to service debt. 

It is only a valid proxy for cash flow if the following conditions apply.

• The operating balance sheet accounts, e.g., the receivables, inventory, and payables, do not change from period to period.
• The company does not issue distributions or loans to owners.
  

These conditions rarely apply.  Therefore, EBITDA is rarely a valid proxy for actual cash flow available to service interest-bearing debt.

Questions & Answers, Advanced Cash Flow Webcast, April, 28, 2011

Q: Based on analysis, do you think Western Star Energy runs a profitable business? As you see they have a bank LOC of $915M; if you had the chance, would you want to take on that debt?

A: The important question to ask is 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 has sufficient business profit, 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.

Business profit is computed as follows: net income plus depreciation minus the sum of distributions and loans to owners. 2007 business profit for Western Star Energy was $109,048 (net profit of $79,403 plus depreciation expense of $155,681 minus distributions and loans to owners of $126,036). Since 2007 current maturities of long term debt was $289,755, Western Star was not sufficiently profitable on an accrual basis in 2007.

As we saw from the UCA cash flow calculations that we completed during the webcast , business cash income of  $283,660 was also insufficient to service $289,755 in current maturities of long term debt.

As a result, Western Star Energy was unable to service long term debt as scheduled on either an accrual or a cash flow basis in 2007, although on a cash flow basis it was only marginally unable to do so.

That being said, we need to meet with the customer to determine if we were correct in our assessment of related party income (a portion of that income may be considered operational income), if we can limit the sum of distributions and loans to owners to the income tax liability in the future, if operational ratios (A/R, Inv, and A/P days) can be maintained, and, most importantly, if there are valid (and correctable) reasons for the decline in profitability.

If our credit analysis leads us to believe financial improvement (and control) will occur in the near future, we may very well continue our relationship with Western Star Energy including a renewal of their Line of Credit.  

Q: What is the value of EBITDA vs. cash from operations in a growing company?

A: EBITDA is an accrual measure of operational profit not including interest, taxes, or depreciation, and, as such, it does not take into account any cash impact from a company’s balance sheet. It is used to measure a company’s accrual operational profitability.

It is frequently considered a proxy for cash flow available to service debt.  Whether this cash flow proxy is valid depends on whether a company is a) required to use cash for replacement of property, plant, and equipment, b) can collect all outstanding receivables, c) can fully use all inventory, e) has identified and can pay all accrued expenses, and f) did not distribute cash to owners in the form of distributions, withdrawals, and loans that exceeded the maximum implied personal income tax on company profit.  If the latter occurred, EBITDA needs to be adjusted downward by the amount of the excess cash payments to owners.

Concerning UCA cash flow, if Net Cash Income on the Uniform Credit Analysis (UCA) cash flow statement is positive, it clearly indicates that the company generated sufficient cash flow from its business operations to pay all cash operating expenses and cash interest expense, certainly a desirable event for both lender and borrower.  Although negative Net Cash Income means the company likely used outside sources of cash to pay some cash operating expenses and cash interest expense, that event may not be undesirable if sales growth alone explains the reasons for the cash deficit.  Conversely, positive Net Cash Income may provide misleading favorable signals about borrower risk if it results from significant sales decline that masks collapsing profitability.

Note that the UCA cash flow format does not classify loans to shareholders as compensation but, rather, as a related party transaction.  Related party transactions in the UCA format are considered outside of operating cash flow.  Consequently, cash outflows in the form of loans to shareholders do not impact the operating section of the UCA cash flow statement, which means that Net Cash Income may be overstated by the amount of loans to shareholders in any one period.