Q & A Global Cash Flow (May 18, 2010)
Q: Why would you not conduct a cash flow on the business first, since that is what we are financing and would impact cash flows downstream?
A. In our example, the borrower/obligor is Fresno Properties which is requesting a $3.1 million term loan to finance the acquisition of an apartment complex. Since our first recourse is to our borrower/obligor, it is important that we first analyze the financial condition and future prospects of Fresno Properties.
We do conduct a complete a financial analysis of the apartment complex (property) to determine its financial impact on Fresno Properties, but our analysis beginning point is our borrower/obligor, followed by the guarantor (if applicable) because those two entities are legally liable to the bank. The financial condition of the property is important to the transaction, but is analyzed last because its cash flow is upstreamed to Fresno Properties and not to the bank.
Q: In the first example, why wasn't depreciation & amortization expense added back on the Fresno Properties income statement, giving us a total amount of $64,181 available for debt service?
A: In the example we used Business Income which is defined as reported net income from the income statement plus the sum of a) distributions or withdrawals and b) loans to owners in the period. Distributions and loans represent cash outflows for personal income tax payments on company profit or owner compensation – or both. Since distributions, withdrawals, and shareholder loans are not recognized as expenses according to income tax regulations and guidance – and associated GAAP – they are reflected on the balance sheet and not passed through the income statement.
Business Income reclassifies these operating expenses that represent income taxes and compensation as proper operating expenses on the income statement and, therefore, we adjust reported net profit by the sum of these two operating expense amounts.
The key issue is whether there is sufficient actual or Business Income at the end of the day to pay down long-term debt as scheduled. And even though depreciation expense is a non-cash expense, it does serve as a proxy for the actual cash outflow a company provides to maintain its fixed assets. Maintaining property, plant, and equipment is a real expense, even though the measure of it in the income statement is an approximation only.
Business Income does not pretend to represent cash flow. It represents actual business income after adjustments for all “off income statement” expenses. The best cash flow statement, in turn, is the Uniform Credit Analysis (UCA) Cash Flow statement, not traditional “cash flow” defined as net income plus non-cash charges. Recall that we used the UCA cash flow statement to understand cash flow movements within and between related parties in the webcast presentation.
Q: Why would you not conduct a cash flow on the business first, since that is what we are financing and would impact cash flows downstream?
A. In our example, the borrower/obligor is Fresno Properties which is requesting a $3.1 million term loan to finance the acquisition of an apartment complex. Since our first recourse is to our borrower/obligor, it is important that we first analyze the financial condition and future prospects of Fresno Properties.
We do conduct a complete a financial analysis of the apartment complex (property) to determine its financial impact on Fresno Properties, but our analysis beginning point is our borrower/obligor, followed by the guarantor (if applicable) because those two entities are legally liable to the bank. The financial condition of the property is important to the transaction, but is analyzed last because its cash flow is upstreamed to Fresno Properties and not to the bank.
Q: In the first example, why wasn't depreciation & amortization expense added back on the Fresno Properties income statement, giving us a total amount of $64,181 available for debt service?
A: In the example we used Business Income which is defined as reported net income from the income statement plus the sum of a) distributions or withdrawals and b) loans to owners in the period. Distributions and loans represent cash outflows for personal income tax payments on company profit or owner compensation – or both. Since distributions, withdrawals, and shareholder loans are not recognized as expenses according to income tax regulations and guidance – and associated GAAP – they are reflected on the balance sheet and not passed through the income statement.
Business Income reclassifies these operating expenses that represent income taxes and compensation as proper operating expenses on the income statement and, therefore, we adjust reported net profit by the sum of these two operating expense amounts.
The key issue is whether there is sufficient actual or Business Income at the end of the day to pay down long-term debt as scheduled. And even though depreciation expense is a non-cash expense, it does serve as a proxy for the actual cash outflow a company provides to maintain its fixed assets. Maintaining property, plant, and equipment is a real expense, even though the measure of it in the income statement is an approximation only.
Business Income does not pretend to represent cash flow. It represents actual business income after adjustments for all “off income statement” expenses. The best cash flow statement, in turn, is the Uniform Credit Analysis (UCA) Cash Flow statement, not traditional “cash flow” defined as net income plus non-cash charges. Recall that we used the UCA cash flow statement to understand cash flow movements within and between related parties in the webcast presentation.