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- 5/2022
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May 2022 Comments
In this issue:
Pitfalls in Analyzing Pass-Through Entities
As a reminder, a pass-through entity is a business organization that passes the obligation to pay federal and state income taxes on the taxable income it generates to its owners or partners. There are three such entities - a Subchapter S corporation, a partnership or limited liability company (LLC), and a sole proprietorship.
In general, it seems fair to say that there are several reasons why pass-through entities are more difficult to analyze in reaching a credit decision than the standard Subchapter C corporation.
First, pass-through entities are more difficult to analyze because the income statement - either an accrual or business income tax return income statement - does not include an income tax expense account. Net income reported for a pass-through entity is, in fact, income before tax and not final, bottom line income that includes the income tax expense. Consequently, all performance ratios and cash flow statements using this net income amount are incorrect.
However, the problem of identifying the proper income tax expense for a pass-through entity and correcting the errors in performance ratios and cash flow statements seems easily resolved by identifying the dollar amount of distributions and withdrawals passed from the business to the owners or partners. In other words, a pass-through entity not only passes its income tax obligation to owners or partners but it passes cash to these same owners or partners in the form of distributions and withdrawals so they can make the required income tax payments. Therefore, reported net income on a pass-through entity's income statement reduced by distributions or withdrawals should provide the proper profit after tax value and allow correct computation of performance ratios and cash flow statements.
Second, pass-through entities are more difficult to analyze because distributions and withdrawals serve more than one purpose. They provide cash for owner or partner payment of business income taxes and for owner or partner compensation. Therefore, the lender now faces the problem of correctly identifying the amount of owner or partner compensation included in distributions or withdrawals if it wants to estimate operating expenses, SG&A% (operating expenses as a percent of sales), EBITDA, and EBITDA%.
The most pragmatic approach may be to estimate the required income tax payment on a pass-through entity's taxable income and then measure this estimate against the distributions or withdrawals provided to the owner or partner. Any difference between the two serves as an estimate of compensation and would be added to reported operating expenses. However, this raises the question of the appropriate state and federal personal income tax rate to apply to taxable pass-through income. The lender could use the maximum personal income tax rates that apply at both the federal and state in question, or it could use the effective income tax rate from the owner's or partner's personal income tax returns. (The effective rate is the amount recorded for income tax due divided by taxable income on Form 1040.) Yet note that this latter approach gets messy if there is more than one owner or partner, since multiple owners or partners are likely in different marginal income tax brackets.
Third, pass-through entities are more difficult to analyze in reaching a credit decision because most spreading software systems were designed around the Subchapter C corporation and not around pass-through entities. For example, it would be rare to encounter a spreading software system that included a data-entry prompt for the split between a pass-through entity's a) income tax expense and b) owner or partner compensation in the amount recorded for distributions or withdrawals. Consequently, if the lender wants to make these adjustments, it must find work-arounds that do not have unintended ripple effects and consequences.
In subsequent issues of Comments, we address these and similar issues for each of the pass-through entities - beginning with the Subchapter S corporation - since variations in IRS tax regulations for each of the pass-through entities create additional analytical problems.
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A Case for Cautious Optimism
First quarter GDP in the U.S. decreased by 1.5% on an annual basis. First quarter GDP in most of the industrialized world followed suit. If second quarter GDP is again negative, the U.S. will be officially in a recession.
The Economist, in a recent assessment, concludes that the second quarter may not turn out as badly as the conventional wisdom seems to think. It concedes that numerous headwinds are battering the U.S. consumer, whose spending accounts for roughly two-thirds of GDP, which means that as the consumer goes, so goes the U.S. economy.
With respect to the headwinds, inflation continues to eat away at disposable income, which has failed to keep pace with inflation. The prospects for greater inflation are ominous, given the impact on fuel and food prices from the war in Ukraine and the supply chain impact from further lockdowns in China. In addition, the Federal Reserve is steadily raising interest rates to slow demand and combat inflation. The stock markets have suffered their worst month in recent memory. Consumer confidence in the U.S. is at a 10-year low. The federal stimulus checks have come to an end.
Even so there are glimmers of hope. U.S. consumers have rapidly shifted buying preferences from goods to services. Such a shift should soften demand for goods and result in a slow down in prices, even in spite of continued supply chain problems. The negative impact from less spending on goods may be fully offset by more spending on services. Restaurant and bar revenues are up significantly. Hotel occupancy is generally above pre-pandemic levels. Airlines are packed once again. Consumers are running up credit card debt and drawing down personal savings.
But there remain several wild cards whose impact on the U.S. and global economy are unknowable. One is the impact of the war in Ukraine on fuel and food prices. A second is the impact on supply chain problems from the present China lockdown. A third is the impact from the Federal Reserve's decisions on interest rates. And, lingering in the background, is the impact of the present surge in the virus.
Such uncertainty suggests lenders batten down the hatches, if they haven't done so already, by closely tracking borrower performance, examining the cash value of loan guarantees, and assuring that collateral is properly documented and perfected. Some optimism may be warranted about escaping a recession, but precaution should carry the day.
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Implications for Inflation and Interest Rates
As David J. Lynch reports in a recent Washington Post article, the U.S. consumer dramatically shifted its purchases from goods to services in the last month. Such a shift may have a positive impact on inflation and may result in less aggressive action by the Federal Reserve in raising interest rates to combat inflation.
As an example of this shift, retail sales were roughly 9% higher in May than they were a year ago. However, bar and restaurant revenue increased by almost 20% over this same period. A year ago, there was a 15 percentage point spread, or gap, in the pre-pandemic relationship between consumer spending on goods and consumer spending on services. Today, the gap has fallen to 5 percentage points.
This shift implies good news on the inflation front since services providers, e.g., bars, restaurants, hotels, airlines, amusement parks, and so on, do not generally rely on goods subject to the more common supply chain problems. The first two years of the lockdown featured work-at-home employees and stay-at-home teachers and students. These households both spent on goods they could use at home, such as appliances, electronics, and property renovations, as well as saved for the end of the long rainy day. Federal relief checks contributed massively to both the spending on goods and the increase in personal savings.
The spending on goods at the time of severe supply chain bottlenecks drove up prices. It was the main force behind inflation that quickly gained traction. Over the past year, durable goods prices increased 14% while service prices rose 5.4%, according to the Bureau of Labor Statistics. A further rebalancing in favor of services should work to bring down the rate of inflation. Consumers are indeed using their savings and credit cards to pursue service activities they have long been denied. The savings rate has fallen dramatically, and credit card balances have increased dramatically. Neither source of cash is sustainable over the longer run, but if the hot labor market holds on as rebalancing continues, the end result could be positive for both the U.S. consumer and the U.S. economy.
And if the number of imported shipping containers is an indicator of softening pressure on the price of goods, the news on this front is encouraging, too. The number of such containers reaching the Port of Los Angeles was down for the seventh consecutive week last week, and the number of container ships waiting offshore for warehouse space to open up had fallen from the January high of 109 ships to 25 ships.
But the imponderables remain. The impact of the war in Ukraine on food and fuel prices is impossible to predict. The impact of China's present and possible future lockdowns on supply chain problems is impossible to predict. And it is impossible to predict if the Federal Reserve will read the economic tea leaves properly and adjusts interest rates just enough to tame inflation without triggering a recession. The pressure on Jerome Powell and his colleagues must be off the charts.
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Small Gestures at Work
In a recent commentary on employee morale, The Economist reviews a range of benefits and perks that companies offer employees to attract talent and minimize turnover in today's very tight labor market. Most such perks have been around for some time in one form or another and focus on publicized employee recognition for special performance. But three studies point to the additional power of the personal touch in improving employee morale and job satisfaction.
One study observed employee response to a personally signed letter of gratitude from the manager of half the members of a team that successfully completed an assigned project. The other half of the team received no such acknowledgement. A follow-up survey of all team members found that those who received personal letters felt much more valued by their employer than those who failed to receive such a letter.
Another study found that university fund raisers, who were routinely thanked personally by a superior for the number of fund-raising calls they made over a period of time, initiated measurably more calls the following month than their fund-raising colleagues who received no personal acknowledgment.
A third study found that a group at a Coca-Cola plant, who were asked to provide minor acts of kindness to a specific group of fellow workers, such as sharing treats or drinks, reported higher levels of job satisfaction at the end of the experiment. But the story continues since the recipients of the good deeds began to provide similar acts of kindness to other fellow workers.
The Economist concludes from these three studies that recognition improves morale. Nothing new here. But it adds that the positive impact of recognition is amplified greatly if expressed personally, which leads to a few rules of thumb about the personal touch:
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Addressing and Resolving the Four Essential Issues
On June 9th, Shockproof! Training conducts Analytical Focus in the Credit Write-Up, a live online webinar that runs approximately two hours, including a five-minute break and a post webinar question and answer session.
The webinar is designed for analysts and lenders interested in identifying the four essential issues that must be addressed in every credit write-up, as well as exploring the use and application of specific analytical tools, techniques, and loan covenants that effectively address these issues.
This online session explores the following topics in depth:
Please note that all single topic Webinars and each session in the Credit College Courses are recorded and available for use and review, should participants prefer the flexibility of on-demand sessions and webinars.
If you would like more information about this Webinar, about any of our other 26 single-topic Webinars, or about any of our six Credit College Courses, please call us at 1-866-237-7228 or send us an email at inquiry@shockproof.com.
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To access a 12 minute company overview, please click here.
To access a postcard PDF of our upcoming live sessions, please click here.
Please note, too, that Shockproof! Training recently incorporated a learning path function into its website that suggests single topic webinars and Credit College Courses that might be applicable for selected positions within financial institutions. The positions in question range from newly appointed credit analysts in commercial business and commercial real estate lending to experienced loan review officers, specialty lenders, and board members.