UCA Cash Flow Questions and Answers (March 25, 2010)
Q: How do we know if it is a non-cash distribution to the owners? Can we see it somewhere on the 1120S tax return?
A: Distributions to the owner of a Subchapter S corporation are reported on the accrual financial statement in the reconciliation of net worth section, in Section M-2 on the business income tax returns (Form 1120S and Form 1065), and on the appropriate Schedule K-1.
A distribution could be non-cash if the company converted a prior loan to the owner to a distribution by a set of simple accounting entries. In addition, a distribution could be non-cash if the company distributed real property or other non-cash assets to the owner in lieu of cash. The only way to be certain that distributions are all cash or part non-cash is to ask the customer or the accountant.
Q: What if a company had a 179 depreciation expense on the tax return?
A: In accordance with GAAP, a company may use one depreciation methodology (say straight line depreciation) on the accrual financial statements and a different method (say accelerated depreciation, which includes Section 179 depreciation) on the tax return. The estimate of fixed asset spending is not impacted by the depreciation method. That is, regardless of the depreciation method used, the resulting estimate of fixed asset spending will be the same.
For example, assume a company purchases a fixed asset for $25,000 and applies five year straight line depreciation, resulting in a depreciation expense of $5,000 in the first year and a net book value for the asset of $20,000 at year end. Now assume the same company purchases the same fixed asset for $25,000 and applies an accelerated depreciation methodology that results in first year depreciation of $12,500. The resulting net book value of the asset is $12,500 at year end. Obviously, the company spent $25,000 on fixed assets, regardless of the depreciation methodology it uses.
The standard computation formula – ending net book value of the asset increased by depreciation expense for the year less last period’s ending net book value – provides the same answer in either instance, i.e., (($20,000 + $5,000) – (000)) = $25,000 and (($12,500 + $12,500) – (000)) = $25,000.
Q: EBITDA repayment analysis generally subtracts P&I payments from “traditional” historical cash flow. Can we use the UCA in a similar manner based on historical or only on a forecast basis?
A. On an historical basis, the UCA cash flow clearly shows whether a company met its debt service from business cash flow. If Cash after Debt Repayment is a positive amount, the company generated sufficient cash flow from business operations to meet all cash operating expenses, pay interest expense, and repay long-term debt as scheduled. If Cash after Debt Repayment is negative, it did not do so. The cash source of debt service – partially or totally – was likely additional outside debt.
Because the UCA cash flow statement is difficult to understand, particularly for most borrowers, we can use two simpler concepts and 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:
The second is the Financing Gap Ratio, which is defined as follows:
Business owners can readily understand these two measures, which is always a major consideration in establishing covenants or performance standards.
Q: How do we know if it is a non-cash distribution to the owners? Can we see it somewhere on the 1120S tax return?
A: Distributions to the owner of a Subchapter S corporation are reported on the accrual financial statement in the reconciliation of net worth section, in Section M-2 on the business income tax returns (Form 1120S and Form 1065), and on the appropriate Schedule K-1.
A distribution could be non-cash if the company converted a prior loan to the owner to a distribution by a set of simple accounting entries. In addition, a distribution could be non-cash if the company distributed real property or other non-cash assets to the owner in lieu of cash. The only way to be certain that distributions are all cash or part non-cash is to ask the customer or the accountant.
Q: What if a company had a 179 depreciation expense on the tax return?
A: In accordance with GAAP, a company may use one depreciation methodology (say straight line depreciation) on the accrual financial statements and a different method (say accelerated depreciation, which includes Section 179 depreciation) on the tax return. The estimate of fixed asset spending is not impacted by the depreciation method. That is, regardless of the depreciation method used, the resulting estimate of fixed asset spending will be the same.
For example, assume a company purchases a fixed asset for $25,000 and applies five year straight line depreciation, resulting in a depreciation expense of $5,000 in the first year and a net book value for the asset of $20,000 at year end. Now assume the same company purchases the same fixed asset for $25,000 and applies an accelerated depreciation methodology that results in first year depreciation of $12,500. The resulting net book value of the asset is $12,500 at year end. Obviously, the company spent $25,000 on fixed assets, regardless of the depreciation methodology it uses.
The standard computation formula – ending net book value of the asset increased by depreciation expense for the year less last period’s ending net book value – provides the same answer in either instance, i.e., (($20,000 + $5,000) – (000)) = $25,000 and (($12,500 + $12,500) – (000)) = $25,000.
Q: EBITDA repayment analysis generally subtracts P&I payments from “traditional” historical cash flow. Can we use the UCA in a similar manner based on historical or only on a forecast basis?
A. On an historical basis, the UCA cash flow clearly shows whether a company met its debt service from business cash flow. If Cash after Debt Repayment is a positive amount, the company generated sufficient cash flow from business operations to meet all cash operating expenses, pay interest expense, and repay long-term debt as scheduled. If Cash after Debt Repayment is negative, it did not do so. The cash source of debt service – partially or totally – was likely additional outside debt.
Because the UCA cash flow statement is difficult to understand, particularly for most borrowers, we can use two simpler concepts and 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 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)]
Business owners can readily understand these two measures, which is always a major consideration in establishing covenants or performance standards.