Q: Where do you get taxable income of $109,704 that was noted in Poll Question 4?

A: The $109,704 comes from the business income tax returns, which we did not provide but, instead, reported that amount in Poll Question 4. Specifically, the $109,704 is reported at Line 18 on Schedule K and again at Line 8 on Schedule M-1 in the company's business income tax returns for 2018.

Course overview: Debt Capacity and Cash Flow

Q: Why do we add back interest expense on the Business Cash Flow Statement?

A: We add back interest to Business Cash Flow in the numerator of the Debt Service Coverage Ratio because in the denominator we measure Business Cash Flow against debt service. Debt service us the sum of interest expense and scheduled long-term debt repayment, which is last year’s current maturities of long-term debt.

Course overview: Debt Capacity and Cash Flow

Q: For cash flow purposes to calculate a DSCR, should you subtract cash paid for income taxes for a limited partnership?

A: A company reporting as a limited partnership or limited liability company (LLC) does not directly pay income taxes on its taxable income. Like any pass-through entity, which both are, they passe the income tax obligation to their partners or members. The pass-through entity then provides distributions to the partners or members, which they use to pay their personal income tax obligations on taxable partnership income. Cash paid for income taxes is included in distributions. Any amount of distributions in excess of the income tax obligation represents compensation for the partners or members.

Note that distributions are included in the Owner Payout for D & J Installation Contractors where Owner Payout is the sum of distributions and loans to partners.

Course overview: Debt Capacity and Cash Flow

Q: I do not know how we got $419,789 on Slide 27. Could you please go over it again?

A: 2015 debt service before any adjustments was the sum of 2015 interest expense of $272,291, plus 2014 current maturities of long-term debt of $137,498, plus 2014 current maturities of subordinated debt of $68,478,. The sum of these three amounts is $488,267. Once we prohibit the pay down of subordinated debt, we reduce $488,267 by $68,478 to arrive at $419,789.

Course overview: Debt Capacity and Cash Flow

Q: How do you calculate the debt service constant, particularly if you have multiple loans with multiple lenders?

A: There is a debt service constant for every combination of a) a specific interest rate, b) a specific amortization period, and c) the payment frequency. The associated debt constant is available via Excel formula or we provide an online worksheet.

Worksheet: Debt Service Constant

Mathematical calculation of the Debt Constant

Apply the appropriate debt service constant to each long-term loan and sum the resulting annual debt service to arrive at total borrower debt service for a period. If you're unsure of the financing terms for loans provided by other lenders and can’t locate sufficient information in the footnotes or statements to the business income tax returns, then use your best judgment.

Q: If an account receivable were charged off, would that not be reflected in the income statement? So it would be a net wash to the business cash flow?

A: An accounts receivable charge-off is reflected in the income statement if the company is using the direct charge-off method. The company reports the charge-off as an expense on its income statement and reduces its accounts receivable balance by the amount of the charge off. As a result, the change in accounts receivable is understated by the amount of the charge-off – a non-cash event that reduces the balance in the present period – and cash revenue is overstated by the amount of the charge-off. Recall that cash revenue is the sum of accrual revenue and the change in accounts receivable, net. In this case, net and gross accounts receivable are the same thing.

However, cash operating expenses are “overstated” by the amount of the non-cash charge-off since they are computed as the sum of accrual operating expenses and the changes in accrued liabilities and prepaid expenses.

The two events wash out precisely in compiling the UCA cash flow statement, i.e., cash from sales is overstated by the amount of the charge-off while cash operating expenses is also overstated by the amount of the charge-off.

If a company is using the allowance method, the charge-off does not appear in the income statement. Rather gross accounts receivable on the balance sheet is reduced by the amount of the charge off. The offsetting entry reduces the allowance for doubtful accounts by the same amount. As a result, the net accounts receivable balance is not changed by the charge off. Cash revenue for the period remains as the sum of accrual revenue plus the change in accounts receivable, net.

As always, the quality of financial information is highly important to the debt capacity estimate since all revenue must be reported, bad debt expenses must closely match actual write-offs, and all expenses must be reported.

Q: The $2,319.94 is an annual payment, not a monthly payment.

A: You are correct. The $2,319.94 is an annual payment.

The debt service for long-term debt absorbs more Business Profit than debt service for short-term debt. For example:

$10,000 of long-term debt priced at 6.00% with 5-year amortization and equal monthly payments requires $2,319.94 of Business Profit to pay down the principal portion as well as pay the associated interest expense. To see this, divide the appropriated debt service constant of 0.231994 into available Business Profit, i.e., (($2,319.94) / (0.231994)) = $10,000.

By comparison, $10,000 of short-term priced at 6.00% requires $600 of Business Profit to meet debt service, or (($600) / (0.06)) = $10,000.

Therefore a company must use $2,319.94 of Business Profit to meet debt service on $10,000 of long-term debt while it must use only $600 of Business Profit to meet debt service on $10,000 of short-term debt.

Q: If you make the term 10 years instead of 5 years, how much debt would the $379,082 in Business Profit support?

A: At a 6.25% interest rate, 10-year amortization, and equal monthly payments, the debt constant is 0.134736. Therefore, the amount of long-term debt that $379,082 of Business Profit could support would be $2,813,517 or (($379,082) / (0.134736)) = $2,813,517.

Q: Why add back the interest expense?

A: We add back interest expense because we are looking for the amount of Net Cash Provided by Operating Activities that will service both interest expenses and principal payments as follows:

Net Cash Provided by Operating Activities of $1,538,824

• Plus interest expense of $141,004
• Less distributions of $709,446
• Equals business cash flow available to service debt of $970,382

Q: Is true cash flow the $1,538,824 on the income statement?

A: No. Any income statement amount is an accrual amount and not a cash flow amount. The $1,538,834 of Net Cash Provided by Operating Activities is a cash flow amount, but it must be adjusted by distributions and interest expense to identify true cash flow available to service debt.

As Slide 43 indicated, the true cash flow available to service debt for D & J Installation Contractors was a negative $513,193 in 2015 while the true cash flow available to service debt for Information Access, Inc. was a positive $970,382 in 2015. Only a true cash flow statement, such as the UCA cash flow statement, can be used to identify true cash flow.

Q: How do we obtain or calculate the debt service constant?

A: There is an Excel function that computes the debt service constant. If you wish, we can send it to you.

Q: In Poll Question 4, where does the taxable income of $109,704 come from?

A: The total 2015 taxable income of $109,704 for Information Access, Inc. comes from the company’s business income tax returns. We did not make those returns available for webcast participants.

However, the difference between total taxable income and accrual net profit of $112,476 is explained by a) $71,908 of travel and entertainment expenses reported as an expense on the company’s accrual income statement but disallowed as an expense on its business income tax returns and b) $74,690 of bad debt write-offs in excess of the estimated bad debt expense for the year that the company claimed on its business income tax returns but could not report as an expense on its income statement in accordance with GAAP guidance. The difference between the two amounts is $2,772, which is the difference between accrual net profit and total taxable income for 2015.

Q: Would you please explain more in detail the matching of actual events, such as bad debt write-offs against bad debt expenses? How do you verify a match or mismatch?

A: The bad debt expense itself may or may not be specifically reported on the accrual income statement. If it is relatively minor, it will likely be buried in an “Other Operating Expense” category, which adds to the problem of verifying actual write-offs with estimates – assuming we have information about actual write-offs. However, some financial statements, particularly audited or reviewed statements, will generally provide footnote information about bad debt write-offs and whether they exceeded or fell short of estimated bad debts. Yet as the quality of financial statements deteriorates, it is less and less likely that such information will be included with the financial statements. Therefore, it is usually necessary to specifically ask the company’s book keeper or accountant for the information.

However, the company’s business income tax may frequently provide the necessary information in the Schedule M-1 reconciliation process by virtue of a clarifying Statement. For example, the 2015 business income tax returns for Information Access, Inc. included a clarifying Statement to the effect that bad debt write-offs in 2015 exceeded the bad debt estimate by $74,680. In other words, the company had $74,680 less in bottom line profit in 2015 than reported as accrual net income.