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July 2022 Comments
In this issue:
Pitfalls in Analyzing Partnerships and Limited Liability Companies
In the previous edition of Comments we reviewed the difficulties in properly assessing pass-through entities and, specifically, in properly assessing the Subchapter S corporation. As you may recall, there are two assessment issues we need to properly resolve:
Therefore, net profit margins are overstated and traditional "cash flow" - net income plus non-cash charges - is overstated.
Therefore, operating expenses and SG&A% are understated while EBITDA% is overstated when distributions exceed the cash amount required to satisfy the company income tax obligation.
As we concluded previously, the solution to the first problem is to adjust reported net income on the accrual statement by the amount of distributions. By doing so, the full amount of expenses for income taxes and compensation is captured on the income statement. The net profit margin is now correct, and traditional "cash flow" is now correct.
And as we concluded previously, the solution to the second problem is more complex. It requires us to estimate the income tax component and the compensation component within the distribution amount. To do so, we need access to the personal income tax returns of the owners or partners, which allows us to identify the effective tax rate for each owner or partner and apply that rate to the taxable income passed to the owner or partner. In addition, we need access to the pass-through's business income tax returns, which provide information about taxable income and clearly identifies distributions. However, keep in mind that Schedule C does not report information about a sole proprietor's withdrawals.
The task of identifying partner compensation from a partnership or LLC faces an additional wrinkle. Partnerships and LLCs do not pay salaries to their partners or members since salaries are not a tax-deductible expense, given IRS regulations. There is a partial way around this impediment, which is for the partnership or LLC to establish and pay a guaranteed payment to specific partners or members. Guaranteed payments are a tax-deductible expense. Therefore, for those partnerships or LLCs that provide guaranteed payments, some of the partner or member compensation is captured in the total for operating expenses on the accrual income statement. If distributions provide no more than the cash needed by partners or members to pay the income tax obligation on their company's taxable income, SG&A% and EBITDA% would be accurate and require no adjustment.
So, we're back to estimating the cash distributions necessary to pay the income tax obligation As an illustration, let's assume a partnership reports a) guaranteed payments of $375,000 at Line 4C on Schedule K, b) distributions of $225,644 at Line 19A on Schedule K, and c) $331,289 of taxable income at Line 9 on Schedule M-1 for 2021. The general partner, as a proxy for the three partners in the partnership, reports 2021 taxable income of $207,030 at Line 15 and total tax of $61,667 at Line 24 on Form 1040. Therefore, the effective tax rate is 29.79% or (($61,667) / ($207,030)) = 29.79%.
Given this information, partners will require $98,691, or (($331,289) x (0.2979)), in cash distributions to meet the federal income tax obligation on the partnership's taxable income passed to them for payment. $225,644 of cash distributions exceeds the amount required for federal income tax payments by $126,953. Apart from further income tax payments, if any, required by state taxing authorities, the partners in this example received $501,953 in compensation for 2021 - $375,000 in guaranteed payments and $126,953 in cash distributions.
To get SG&A% and EBTDA% roughly right, we need to add $126,953 to operating expenses as additional officer compensation. SG&A% will increase accordingly, and EBITDA% will decrease accordingly.
Note the information requirements necessary to properly assess this and other pass-through entities:
As we noted previously, few if any software systems capture the income tax and compensation components of distributions. This is a manual process. Some lenders may consider it worth the effort, and some may not. But proper bottom line profit-after-tax is within easy reach by simply spreading distributions as operating expenses.
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A Thriving Industry May Signal Tough Times Ahead
Michael Corkery reports in a recent New York Times article, that business is booming for the liquidators who buy returned and unused merchandise from major U.S. retailers and re-sell it online to the highest bidders at dramatic discounts.
Yet while one industry is booming in today's U.S. economy, this industry's client base seems to be signaling that recession is a very distinct possibility. The past two years of heavy consumer spending, fueled by pent-up demand and federal relief checks, may have hit the wall.
Two problems have plagued many retailers over the past year - a very high rate of returned online purchases and surplus inventory of discretionary merchandise that buyers now bypass in conserving cash for basics such as food and fuel in the face of inflation.
In 2021, online shoppers returned almost 20% of their purchases, up from 10.6% in 2020 and roughly four times the return rate in 2019. For a variety of reasons, retailers dispose of returned merchandise and surplus inventory quickly and quietly. They write-off returned merchandise, sell it to liquidators, or donate as much as possible to charitable organizations. They turn to liquidators to absorb much of the excess inventory at rock bottom prices. In any event, the dual impact of returns and stale inventory hit the bottom line. But retailers generally decide to cut their losses early, rid themselves of returns and stale inventory, and use the shelf space that opens up to stock more of the lower margin basics that have now gained consumer favor.
The retailers' plight and the reasons for it are hardly encouraging since consumer spending determines roughly 70% of the gross domestic product (GDP) for the U.S. If the consumer is pulling back in the face of inflation and faltering confidence in the course of the U.S. economy, the U.S. is headed for tough times.
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The Last Hurrah before a Recession?
In a recent New York Times article, Peter Eavis explores the apparent conflict between recent 2nd Quarter earnings reports and the rising concern that a recession may be fairly imminent, especially given the 0.9% annual decrease in 2nd Quarter GDP following a 1.6% annual decrease in 1st Quarter GDP.
As Eavis notes, the companies reporting second quarter results were generally upbeat and fairly optimistic about the future. Further, most analysts expect future profits to increase in eight of the eleven industries represented in the S&P 500.
In reviewing the various quotes and comments cited by Eavis, it appears that the upbeat prognoses came primarily from companies that can apply pricing power, such as the petroleum industry, satisfy pent-up demand for travel, such as hotels and airlines, offer essential business tools, such as Apple and Microsoft, or provide financial services to established clientele, such as American Express.
But comments from many large U.S. corporations suggest emerging problems in other sectors of the economy. PulteGroup, a major home builder, reported a 19% increase in the average price of homes it constructs but a 23% fall off in new orders from a year ago.
As of June 30, 2022, the average 30-year mortgage rate was 5.70%. A year ago, the average was 3.00%. At 80% of the average PulteGroup home price at June 30, 2021, debt service would approximate $1,505 a month. At a 30-year rate of 5.70%, debt service increases to $2,072. With a home price increase of 19% over this time period to $531,000, the debt service on a 30-year loan at 5.70% increases further to $2,466. In a single year, a potential home buyer faced a $961 increase in monthly mortgage payments. Little wonder the residential housing market is cooling rapidly.
AT&T reported its customers were taking longer to pay by a couple of days. However, those two days translated to a $1 billion loss of current cash flow. McDonald's noted that its clients were increasingly opting for the value combinations. Ally, a major subprime auto lender, commented that slower payment problems had returned to pre-pandemic levels. Capital One reported a similar experience with the subprime sector of its lending activities.
In effect, all indicators point to current problems in the residential housing market and emerging problems in the lower income sectors of the economy, which will certainly drag down consumer spending. A key question is whether consumers in the higher income brackets will now begin to moderate spending and do so sufficiently to push the economy into recession.
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More Important than Salary and Benefits
In a recent commentary, The Economist notes that problems with company culture is the primary reason employees resign. They don't like it, and, consequently, decide to take their chances elsewhere.
According to a recent survey by the University of Pennsylvania, employees rate respectfulness, work-life balance, and morale as more important than pay. But these characteristics of company culture are very difficult to identify on the outside looking in. Their role and importance in shaping company culture is only truly apparent after a job-seeker has joined up and can observe culture in action at close range.
However, companies are changing their approach to attracting necessary talent in tight job markets. Many firms now state their position on work-life balance in appealing to a growing preference for working remotely. Others make it a point to emphasize their support for diversity. Still others rebrand themselves, in effect, by charting the progression of their corporate values as they have changed over time.
The job-seekers, in turn, rely increasingly on social media searches to identify the opinions and positions of potential bosses on various company culture issues. One study conducted jointly by the business schools at Columbia and Harvard concludes that companies whose CEOs share the spotlight in reporting quarterly earnings tend to be companies with cohesive leadership teams.
As The Economist concludes, company culture can never be fully understood until one is in the midst of it. But numerous developments underway enhance the prospects that today's job-seekers are taking less of a chance on company culture than at any time in the recent past - a true benefit for both employer and employee.
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The Essentials for Adequate Analysis
On Thursday, August 4th, Shockproof! Training conducts Minimal Financial Data for Assessing Risk, a live two-hour webinar that explores and identifies the minimum financial information required for a borrower and guarantor in order to adequately assess the four fundamental issues in every credit decision - the borrowing causes, the likely cash sources of repayment, risks to each cash source of repayment, and practical mitigants to the risks, if such mitigants exist.
At the end of the webinar, participants will be able to:
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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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.