Instructor Blog

Q: I do not understand the math on Slide 26. $1,899,801 – $1,703,921 = $195,880 and not $166,505.

A: Since our focus was on the questionable depreciation expense of $16,258, we did include a negative $29,375 of miscellaneous expenses – Interest Income of $6,694, Other Income of $3,036, and Other Expenses of $39,105 – in displaying the Net Income number of $166,505. If we increase Total Expenses of $1,703,921 by $29,375, the result will match Net Income of $166,505. Please see Page 3 in the financial statements to confirm these amounts.

Q: In underwriting for an approval, I have seen Depreciation and Interest expense actually added back in for spreads. Is our company doing it wrong?

A: It is necessary to add back Depreciation and Interest expense to Net Income in computing traditional "cash flow" available to service debt, which many lenders use as a reference in reaching a credit decision. In Session 3, we address this issue in depth in comparing traditional "cash flow" to the UCA cash flow statement and the use of both in arriving at a credit decision.

Q: We don’t have slide 33.

A: Slide 33 is a hidden slide that reinforces the solutions to Poll Question 3. All the information about solutions to Poll Question 3 are included in the written explanations to the Poll Questions, which are available in the follow-up email and also available if you click the quiz link within your account.

Course overview: Analytical Decision Tree and the Credit Write-Up

Q: The ratio calculation for Total Coverage, Inc. does not include prepaid expenses even though this line item is noted in the borrower’s balance sheet. Meanwhile, the ratio calculation for Sacramento Distributors, Inc. does include prepaid expenses as reflected in the borrower’s balance sheet. Please see snips provided below.

Can you please explain to me why we would input Sacramento’s prepaid expenses into the ratio calculation, but not input this line item for Total Coverage, Inc.? I do not believe that this difference is explained in the session or materials. If I am mistaken on this, can you please direct me to the section in the materials that explains this situation?

A: Regarding the Financing Gap ratio operating accounts, this issue was addressed in Session 7, albeit very briefly, on the last bullets on Slides 43 and 44. On Slide 43, we covered one of the key considerations in establishing a Financing Gap ratio as a covenant to protect cash flows is to determine the identity and inclusion of relevant operating balance sheet accounts which will vary by company and industry. In our example we have a flooring contractor, Total Coverage Inc. and a beverage distributor, Sacramento Distributors. Operating deposits are commonly taken by flooring contractors when large flooring contracts are secured. The balance in this account is material relative to the Financing Gap. Although Total Coverage Inc. also has prepaid expenses on their balance sheet, these have steadily declined over the three year period and at roughly $23,000 in 2019 projection are immaterial relative to the Financial Gap. On the other hand, Sacramento Distributors as a distributor has a higher level of prepaid expenses, but , unlike a contractor, they have no operating deposits.
 
On slide 44, we reviewed the Balance Sheet operating accounts that we identified to include for Total Coverage Inc. in their Financing Gap ratio. As you noted, these accounts do not include prepaid expenses. The last bullet on Slide 44 titled Options addresses this issue. Depending on the industry and the company, it may be important to include prepaid expense in the Financing Gap ratio. However, as summarized in the last sub-bullet on Slide 44, the emphasis is on consistency from year to year.
 
Again, to repeat a key point, the relevant operating accounts vary by company and industry, and the operating accounts that are included in the ratio equation needs to be consistent from year to year to have a meaningful measurement year over year. The Financing Gap ratio Invariably needs to include accounts receivable, inventory , accounts payable and any other accounts that have a material impact on the cash flow of the company.

Course overview: Identifying and Mitigating Repayment Risks

Q: Basically, this question scenario shouldn't have happened then, right? Since you are saying they shouldn't increase the value.

A: Keep in mind that a company cannot adjust historic cost upward. It can only adjust it downward according to the Conservatism Principle.

If an estimate suggests market value is greater than historic cost, there is no change to the historic cost value recorded on the balance sheet. But if an estimate, or appraisal, finds the market value less than recorded historic cost, then the historic cost amount on the balance sheet is decreased accordingly.

The key point is that the Conservatism Principle limits a change in recorded historic cost to a reduction in that recorded cost. It prohibits an increase in the recorded historic cost. If historic cost is adjusted, the adjustment can only be a decrease in recorded value.

Q: How do we make sure we receive the post-session Review Quiz the day after each session?

A: Please login to your account to access the quiz. For a credentials reminder, please click the Account button in the upper right corner of our homepage, click the Forgot password option, enter your email address in the email field and click "Send it to me".

Course overview: Critical Accounting Principles and Assumptions and More Debits and Credits

 

Q: The math on Slide 24 for 2019 AP calculation doesn’t seem to add up?

A: The math seems okay. ($396,382) / ($1,109,202) = 0.35735749. (0.35735749) x $1,899,801 = $678,908. $678,908 minus $2,367,035 (the 2018 A/P balance) = $1,688,127, which is the amount of the balance that would be paid down in 2019 – a cash outflow.

Q: With this accrual reduction analysis you are showing us, how do these cash flow projections differ from the Schedule K-1 tax return analysis we performed prior? Like, if we use the tax returns income, what's this cash flow for?

A: We used Schedule K-1 information previously to help estimate Schumacher's personal cash flow surplus or deficit. And as we determined, his personal liquid assets were the better source of possible cash support in a crisis than any flawed estimate of personal cash flow available to help service debt.

In this Session, we completed projected cash flow statements, which are based upon accrual financial statements and not on business income tax returns, to estimate the projected cash flow available from each company to meet its debt service as well as the combined or global cash flow from a) all companies and from b) Fritz Schumacher to meet the collective debt service for all companies. Business income tax returns play no role in this projection process.

Accrual financial statements were also the source of information for the historical business cash flows we completed in previous Sessions for our borrower, Sequoia Properties, to assess the borrower cash flow before the Shadelands Glen apartment acquisition.

Course overview: Management Assessment, Competitive Forces, and Projected Performance

Q: Can you review the Form 4797 again? Specifically, how 335k is cash and 35k is not.

A: The property that provided the $35,158 taxable long-term gain was owned by Lafayette Partners. Larry Crevin owns 60% of the partnership as his Schedule K-1 (Form 1065) indicates. His pro-rate share of gain on sale was $35,148. This is non-cash to Larry Crevin as the statement "From K-1" indicates on Form 4797 at Line 2 in Part I.

The other $24,518 taxable long-term gain reported on Form 4797 represents the gain on rental real estate owned and sold by Larry Crevin. The sale was for $335,000 – see Line 20 on Form 4797. Those sale proceeds ($335,000) were all cash to Larry Crevin as the sole owner. The book value of the property was $310,482 as Line 23 on Form 4797 reports. Therefore, the taxable gain on the sale was $24,518.

Q: What would be the covenant to maintain personal investments in liquid assets?

A: A covenant to retain sufficient liquidity as a secondary source of repayment would a) require a personal guarantee and b) require the guarantor / owner to maintain a minimum dollar amount invested in liquid assets that could be converted to cash within a specified time frame, e.g., 72 hours, 7 days, 10 days. In addition, the covenant would require timely bank or brokerage statements to assure effective monitoring by the lender.

In Larry Crevin’s case, the covenant could read something like this:

“Personal guarantee of Larry Crevin plus owner to maintain at least $1,000,000 (one million dollars) of personal assets invested in liquid assets that could be converted to cash within 72 hours. Guarantor to provide quarterly bank and / or brokerage statements within 30 days of each quarter-end to confirm maintenance of $1,000,000 in liquid assets.”
Covenants are a topic of session 7 in this series.

Course overview: Guarantor Analysis and the Second Way Out

Q: Where does amortization expense go?

A: An amortization expense is an operating expense on the income statement. It represents the decrease in an Intangible Asset such as distribution rights, which a company pays for that last over a number of years. Intangible Assets lose value year by year. That loss in value is expressed as an amortization expense on the income statement.

Q: Did you say that Accrued liabilities was an expense?

A: Accrued liabilities are a liability. They represent expenses that the company has not yet paid. For example, a consultant sends an invoice to a company for services performed. If the company does not pay the invoice immediately in cash, the company reports it as an accrued liability that is due to be paid in the near future.

Q: I am confused. You said that Fixed assets were on the income statement...

A: Fixed assets are reported as an asset on the balance sheet. They capture hard assets such as equipment and real estate and soft assets such as loan fees or territory distribution rights. Frequently fixed assets apply to hard assets and such things as distribution rights are classified as Intangible Assets.

Q: What is the income tax expense again?

A: The income tax expense is the amount of income tax a company owes on the profit it generates. The amount of the income tax expenses depends on the applicable income tax rate and the amount of the company's profit.

Q: Office supplies are an expense on the income statement, but the physical office building would be a long-term asset, correct?

A: Absolutely correct. Office supplies are an expense on the income statement while a physical office building would be reported as a long-term, or fixed, asset.

Q: Can you show us the slide with the account titles and amounts please? (Slide 58, 59, 60?)

A: All the slides except the poll solutions are included in the PowerPoint slides available through a link in your confirmation email. You will receive a link to the written solutions to the Poll Questions within 24 hours of the session’s end.

Course overview: Financial Statement Structure and Composition

Q: How do we calculate the owner’s income tax obligation that is displayed on Slide 15?

A: In general, we calculate the maximum personal income tax obligation for an owner or partner of a pass-through entity by multiplying the maximum combined federal and state personal income tax rates by the company’s profit before tax on its accrual income statement. In so doing, we are invariably overestimating the actual, personal income tax obligation for two reasons. First, very few, if any, owners or partners report sufficient taxable income to be taxed at the maximum personal income tax rates  Second, accrual profit before tax is generally greater than taxable income, since taxable income is determined by IRS guidelines and is reported in the company’s business income tax returns. Taxable income is less than accrual profit before tax in all but very rare instances.

As a result, to refine our estimate of an owner’s or partner’s income tax obligation, we need the personal income tax returns of the owner or partner, which allows us to compute his or her effective tax rate. The effective tax rate – total tax on all taxable sources of income divided by adjusted gross income – is invariably less than the maximum combined personal income tax rate. Further, we need the business income tax returns, as noted above, to identify actual taxable income passed to the owner or partner. In the absence of these documents, we use accrual income statement information and maximum personal income tax rates in estimating an owner’s or partner’s income tax obligation on a company’s profit before tax.

In today’s session, recall that we limited projected distributions to the maximum combined personal federal and state income rates applied to projected profit before tax. The maximum combined personal federal and state income rates in California in 2018 was 49.3%. We assumed profit before tax would grow by the 2018 sales growth rate of 5.94%, As a result, our projected profit before tax was $238,268. At a maximum combined personal federal and state income tax rate of 49.3%, the projected income tax in 2019 was $117,466, Since we held distributions to the projected 2019 income tax obligation, we reported distributions at $117,466 in constructing our 2019 projected UCA cash flow statement.

In 2018, Total Coverage, Inc. provided distributions and loans of $319,870. However, the company’s profit before tax was $181,530. At a maximum combined personal income tax rate of 49.3%, the income tax obligation would be $89,494. Therefore, distributions and loans to owners exceeded the maximum personal income tax obligation by $230,376. In effect, the $230,376 represented additional owner compensation since it was not needed to pay income taxes on the company’s net profit. For more clarification, please refer to the Solutions for the Session 2 Exercise.

Q: Just FYI. The slides sent out to us report distributions as $105,553 rather than $117,466 on Slide 38.

A: Thank you. That is our error, and we have now posted the current version of the slide deck.

Course overview: Management Assessment, Projected Cash Flow, and the First Way Out

Q. Can you explain a little more what the "Cap Rate" is?

A: The cap rate is simply Net Operating Income (NOI) divided by a property's acquisition price. NOI represents the amount of property cash flow returned to the investor from the acquisition. The investor uses this cash flow to meet the debt service on the term financing arranged to purchase the property. The amount of NOI that remains after paying debt service on the term financing represents the return to the investor on his or her actual equity investment in the property. Generally, an investor will provide at least 20% of the acquisition price.

Investors use cap rates to compare the potential returns on various real estate properties. A cap rate may be an actual fact, or it may be an estimate. It is an actual fact if it is based on an actual NOI, but it becomes an estimate if it is based on an estimated or "stabilized" NOI. In either case, the acquisition price is an actual fact.

We explore these issues again in considerable detail in Session 6.

Q: For Poll Question 6, wouldn't the cap rate be historic since the appraiser gathered the NOI / cap rate value from data provided at the time of sale by the seller, buyer, or broker? Could the answer be, therefore, that it depends on information provided by each appraisal?

A: It appears that the NOI in every instance is derived from a cap rate provided by the buyer, seller, or broker while the sales or acquisition price is an historical fact. In every instance, there is no firm information about property NOI. It could be the NOI from the last operating period or NOI based on an average or stabilized NOI from the appraisal report. If the comments had stated explicitly that the cap rate was based on a) the last twelve months of NOI for the property at 20 Western Drive, in San Jose – $142,987 – and on b) an historical sales price of $2,080,000, then the resulting cap rate of 6.87% would indeed be based on historical information. But given the information available in the appraisal report, we cannot reasonably conclude that the derived NOI is an historical amount.

Course overview: The Appraisal Report and Approaches to Market Value
 

Q: An observation. Note that the State of GA uses a Security Deed in lieu of a Deed of Trust or Mortgage document.

A: Research of several Georgia real estate related websites confirms that Georgia uses a “Deed to Secure Debt” or Security Deed” to secure real estate debt. Under Georgia law, the lender is deeded the property in conjunction with granting a real estate loan, but in a lesser form of a deed that becomes activated if the borrower defaults in some way. In the words of Georgia courts, "a security deed, although conveying the legal title, does so for the purpose of security only."

This description indicates that a Security Deed functions in a manner similar to that of a Deed of Trust. Like a Deed of Trust, the Security Deed allows a lender to access the underlying collateral more quickly following an event of default than does a mortgage. Foreclosures under a Security Deed in Georgia, like most other States, are by non-judicial process, whereas in mortgage lien States, the foreclosure process tends be through the court system.

Mortgages are also used in Georgia to secure real estate transactions, but rarely so.

Course overview: Commercial Real Estate Loan Documentation

Q: Is a UCC-11 Information Request required or can a lender just conduct a UCC search on the Secretary of State website?

A: A UCC-11 Information Request is not required, and a lender can conduct a personal search of the Secretary of State (SOS) website for existing filings on record for a borrower. By foregoing a UCC-11 conducted by the SOS office and conducting an individual search, a lender is sacrificing any credibility associated with a search conducted by the Secretary’s office.

When faced with this choice, the lender must weigh the merits of a SOS office search vs. the value of a search conducted by the lending institution at the SOS site. The choice then becomes an underwriting business decision determined by the institution’s policy guidelines, the skill of the lender (or lender’s designate) in navigating the SOS site, and the scale of the risk involved.   

An additional thought in considering this choice is the cost associated with either option. For example, one Secretary of State website reports: "UCC records can be researched for free from this site, or the UCC Section will perform a UCC Search by written request on a UCC-11 Information Request form for a $38 fee."

Course overview: Commercial Loan Documentation

Q: Please go through the formulas for calculating the value of those columns dependent on data presented in other columns of the Work in Progress report.

A: The computations for the values reported under the various column headings are as follows:

• Earned Revenues = Actual Cost to Date + Gross Profit Amount.
• (Over)/Under Billings = Earned Revenues – Billings to Date.
• Percent Complete = Actual Cost to Date / Total Cost Anticipated.
• Gross Profit Percent = Gross Profit Amount / Earned Revenue.
• Gross Profit Amount = Earned Revenues – Actual Cost to Date

Course overview: Understanding and Analyzing Contractor Financial Statements: Part II of II

Q: With respect to the equity line item on the UCA cash flow statement, why isn’t there a year-over-year change if the owner converted their loan to equity?

A: There is no cash inflow or outflow from a change in equity on the 2018 UCA cash flow statement, since the $4,112,432 increase in equity recorded on the balance sheet in 2018 was a conversion of debt to equity, which is a non-cash event. Hence, nothing is recorded at the Increase/(Decrease) in Equity line on the UCA cash flow statement.

The cash impact of the equity infusion occurred when the loans were made to the company. The conversion process removed $4,112,432 of loans from the liabilities section of the balance sheet and reclassified that amount as equity. New long-term debt in 2018 is then the difference between the ending 2018 balance for long-term debt and the 2017 balances reduced by $4,112,432.

Had this amount of equity been a true cash injection in 2018, then the cash flow impact of that injection would have been reflected on the UCA cash flow.

Course overview: Ratios, Borrower Cash Flow, and the First Way Out

Q: With respect to Poll Question 2 and Job Number 3983, I don’t see over-billings of $47,071.

A: The question might be a bit misleading. The over-billings for Job Number 3983 at the end of 2018 was $13,994 as the Contract Status report indicates. That amount was part of several other over-billings that summed to $47,071 and was listed at the bottom of the “(Over) / Under Billings” column on the Contract Status report. It is also the amount reported on the company’s balance sheet – $47,071 – as the balance for Cost and Profits in Excess of Billings for 2018, an asset account.

If Southwest Contractors had reported under-billings for Job Number 3983 of $253,139 instead of $263,139, the additional $10,000 of under-billings for the job would increase by $10,000 to $23,994, and the total amount for under-billings on the Contract Status report and on the company’s balance sheet would increase by $10,000 to $57,071.

Course overview: Understanding and Analyzing Contractor Financial Statements: Part I of II

Q: On Slide 19, where can we find if owners are taking out more distributions than their tax obligation?

A: There is no entry on the financial statements that indicates the amount of income tax due on taxable partnership profit. To determine if distributions exceed the amount of cash needed by the two partners to pay the income tax obligation on taxable partnership income, we need the following:

1. The taxable partnership income, which is identified at a single line on the partnership's business income tax returns (Form 1065). Taxable income usually differs from accrual income because the income tax returns are prepared according to IRS regulations and the accrual income statement is prepared according to Generally Accepted Accounting Principles (GAAP).
   
   The objective of the accountant preparing tax returns is to drive down taxable income to minimize the tax liability of the client by applying the most favorable provisions in the IRS tax regulations. The objective of the accountant preparing financial statements, on the other hand, is to assure that the accrual income statement is prepared according to GAAP.
2. The effective personal income tax rate for both partners, which we compute from their individual income tax returns – from their Form 1040. Once we have their effective personal income tax rates, we multiply that rate against their share of taxable partnership income as reported on their Form 1040.

For example, if the effective tax rates (taxable income divided by total tax) for both Schumacher and Castillo were 32.53% and taxable partnership income for each partner was $54,106, the two partners would need $17,601 in cash distributions to meet the income tax obligation on taxable partnership income. Yet Sequoia Properties provided $86,346 of cash distributions to them, which means that distributions exceeded the amount needed for income tax payments by $86,346 - $17,601 = $68,745.

As a side note, while the pass through taxable income was the same for both partners, Sequoia Properties did not provide an equal amount of distributions to both Schumacher and Castillo in 2018. The full $86,346 went to Schumacher, which would reflect a provision in the partnership agreement about the allocation of distributions. Only Schumacher received compensation in the form of distributions, i.e., the amount of distributions which exceeded the tax liability.

Course overview: Analytical Decision Tree and the Credit Write-Up

Q: Was the accurate answer for Poll Question #2 the first choice? You had started to say the answer was the second choice (general partner) but the slide differed from that.

A: The correct answer is the first choice of those offered, i.e., the income tax obligation passes to the partners in a partnership but stays with the Subchapter C corporation. Usually, the income tax obligation is pro-rated among the partners on the basis of relative ownership – Choice #1 – but it may also be determined by specific provisions in the partnership agreement that differ from relative ownership.

Specific provisions could indicate the General Partner is solely responsible for all income tax obligations, and only then would Choice #2 be correct.

Course overview: The Credit Write-Up and the CRE Analytical Process

Q: Should we use our forensic accountant in the situation where tax returns are poorly prepared?

A: From a taxpayer’s perspective, Schedule K and the associated Schedules K-1 are critical schedules to identify taxable income.

Schedule L and Schedule M-1 (as well as Schedule M-2) are intellectually interesting, nice to have, but may be considered irrelevant for the most part by the accountant.

As a result, at times Schedule L and Schedule M-1 may be poorly prepared where accrual net income on Schedule M-1 does not match accrual net income in the financial statements. Or reconciliation of taxable income to book income is incomplete or inaccurate. Or Schedule L does not match the accrual balance sheet in the financial statements.

The bottom line is that it is not always possible to create accrual income statements from tax returns.

With credits where this may occur, the first approach is to have a conversation with your customer and the accountant to determine why the tax return was not completed correctly according to the Tax Code.

If the accountant will not cooperate, the solution to this issue may simply be for the customer to change accountants going forward.

It certainly would not be necessary initially to bring in a forensic accountant unless there was evidence of fraud taking place.

Course overview: Schedule M-1 and the Accrual Income Statement

Q: Do we not consider the Schedule A when evaluating the personal tax return (if used)?

A: Yes. There is information on Schedule A that is very useful in evaluating the personal income tax returns and the individual’s spending patterns. Schedule A presents information such as real estate taxes paid, charitable contributions made, the amount of tax-deductible mortgage interest paid in a period, and several other expenditures. This information is valuable in validating declarations made in the personal financial statement and during client interviews. 

As a possible matter of interest, we explore these issues in depth in Session 4 of our eight session college series on Using Federal Tax Returns for Ratios and Cash Flow Analysis. In that Session, we use the personal income tax returns, and additional information, to construct a personal cash flow statement.

Course overview: Minimum Financial Data for Assessing Borrower Risk

Q: How do we calculate the "Cash Flow" Coverage Ratio?

A: The Cash Flow Coverage Ratio is calculated by dividing traditional "cash flow" of $221,628 for Total Coverage in 2018 by the amount of scheduled long term debt repayment of $33,687 payable in 2018. The $33,687 long term debt payable is the sum of Current Maturities of LTD of $10,003 and Current Maturities of Capital Leases of $23,684.

The Coverage Ratio, therefore, is (($221,628) / ($33,687)), which is coverage of 6.58 times the scheduled debt repayment amount.

Keep in mind that the Current Maturities are the prior year Current Maturities listed as of year-end 2017 and are due and payable in 2018.

Q: You have mentioned over this series that distributions paid to “pass-through” business owners are non-taxable. Wouldn't the individual have to pay tax on any amount above and beyond the S Corp's tax obligation?

A: No. The owner’s tax obligation for a “pass-through” entity’s earnings is based on the company's taxable income passed to them as reported on a Schedule K-1. Examples of possible earning types passed on to an owner are a) ordinary business profit, b) interest income earned by the company, c) gains on sale of company assets, and so on. Pass-through entities like a Subchapter S Corporation pay no income tax, but they do file an information only tax return. All income tax on the company’s taxable income is paid by the owners on a pro-rata basis according to their share of ownership.

Distributions are how the company passes cash to the owners to pay taxes on their respective share of taxable company profit they are now obligated to pay. Per IRS regulatory guidance, distributions are not taxable to the receiving owner(s). Worthy of note is the fact that distributions are not a tax-deductible expense for the company. Distributions are, in effect, outside of the tax arena.

Of further note is the fact that if owners ever deplete their net worth in the company (referred to as the owner's "basis") by taking cumulative distributions that exceed their "basis", the owner must pay a long-term capital gains tax on the excess amount. This happens rarely.

Course overview: Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success

Q: Where can I get the Excel spreadsheet for the debt service constant calculation?

A: The Excel model for the debt constant is online now, accessible via this link.

Q: Have you ever been asked to do appraisal management or appraisal review seminars?  Trying to get a couple of new analysts trained up for that task.

A: We offer two courses that cover Commercial Real Estate appraisal review for purposes of a lending decision. Below are links to descriptions for both courses, one self-guided and the second live (or recorded).

1- Credit College sessions (105 minute sessions, live or recorded)

session 4. The Appraisal Report and Approaches to Market Value
session 5. The Income Capitalization Approach and the Cap Rate  
session 6. Underwriting Standards, Actual vs. Stabilized NOI, and Breakeven Analysis

2- Income Producing Properties (self-guided, self-paced, 12-16 hours)

Course overview: Commercial Real Estate

Q: When you say tax free for distributions does that mean zero tax? Do state and federal income tax still apply when the Schedules K-1 appears on the personal income tax return? Thanks

A: Distributions fall outside the income tax arena. They cannot be deducted as an expense by a pass-through entity. They are not reported as taxable income by the owner or partner who receives them,

However, the owner or partner is responsible for paying federal and state income tax on his or her share of taxable income that is passed to him by the pass-through entity, e.g., by Western Star Energy, which is a Subchapter S corporation. The Schedule K-1 reports the amount of taxable income from the pass-through by the source of income, such as ordinary business income, interest income, dividend income, gain on sale of assets, and so on. The Schedule K-1 for a Subchapter S corporation also reports the dollar amount of distributions passed to the owner, which he or she uses to pay the income tax obligation on the company’s taxable income at the effective personal income rate applicable to the owner.

As noted, the distributions are tax-free. If they exceed the amount required by the owner to pay the income tax obligation on taxable business income, they serve as compensation for the owner that augments the salary and bonuses paid by his or her company and deducted as a tax-deductible expense in arriving at ordinary business income for the pass-through entity.

Course overview: Advanced UCA Cash Flow: Part II of II

Q: What is the best way to build a covenant around cash flow since borrowers don't prepare a UCA cash flow statement?

A: We suggest you use two covenants – a Financing Gap Ratio and a Business Profit Coverage Ratio – to assure that, if honored, the borrower will generate sufficient operating cash flow to service its interest bearing debt. If it honors both covenants and is still unable to meet debt service from operating cash flow, it means that profitable sales growth explains the deficit in operating cash flow and not any deterioration in balance sheet management or lack of sufficient profit remaining in the business to service debt.

The attached Credit Refresher on Covenants and the First Way Out explains the Financing Gap Ratio and Business Profit Coverage Ratio in detail. As you’ll note, both are simple concepts that are easy to understand. Briefly, the Financing Gap Ratio is the difference between operating assets, such as receivables, inventory, and payables and operating liabilities, such as payables and accrued expenses, divided by sales. If the ratio increases from one year to the next, it means that the Financing Gap has increased, which triggers a cash outflow from poor or deteriorating balance sheet management. And vice versa, if the Financing Gap Ratio decreases, it means that the company has reduced its Financing Gap by, for example, tightening control of accounts receivable days – a cash inflow.

Business Profit is Net Profit reduced by the sum of distributions and loans to owners or partners. The Business Profit Coverage Ratio is Business Profit plus interest expense divided by interest expenses and scheduled long-term debt repayment. So long as the Business Profit Coverage Ratio is greater than 1.00, it means that the borrower has sufficient profit (not cash flow) remaining in the business to properly service its debt.

Therefore, as the Credit Refresher points out, if a borrower honors both last year’s Financing Gap Ratio and a Business Profit Coverage Ratio of 1.00 or greater, it will generate sufficient operating cash flow to service its debt. The borrower has no need to understand UCA cash flow in order to achieve sufficient operating cash flow so long as it honors both covenants. As we noted above, sales growth could still cause insufficient operating cash flow if these two covenants were honored, but most lenders readily welcome providing financing to support profitable sales growth. An operating cash flow deficit in such circumstances is a positive event and a financing opportunity.

As a point of information, Shockproof! Training will conduct “Covenant Use in Controlling Cash Outflows” on August 10, 2022. This webinar addresses the use and application of the Financing Gap Ratio and the Business Profit Coverage Ratio in detail.

Q2:How do we best determine future cash flow if we don't receive projections?

A: The most practical approach is to use the last actual values for all the Business Drivers – sales growth, gross margin, SG&A%, A/R days, Inventory Days, A/P days, the Owner Payout Rate, and Fixed Asset Spending as % of Sales – as the default set of projection variables. If there is a compelling reason to change any of the last actual values based on your knowledge of the client and its marketplace, make the necessary adjustments and then run projections forward for one year.

This will provide a very rough estimate of cash flow from operations and fixed asset spending. You could then discuss your projections with the client and determine where and how its view of next year differs from the rough estimate you provided.

Course overview: Description and Analysis in the Credit Write-Up

Q: On slide 41, how is it decided how it is split up between cash and due from shareholders? Is it always assumed that the debit to distributions can be split as a credit to cash and credit to due from shareholders in any way?

A: When a company issues distributions to an owner or partner, it is usually a cash distribution unless noted otherwise.

In this case, Sierra Products decided to convert, which means to reclassify, $92,469 of loans to its owner to distributions. It had made loans to its owner earlier in the year, likely as an advanced distribution, and decided to convert $92,469 of these prior loans to distributions. Cash changed hands at the time the loan or loans were made, but no cash changes hands when some amount of a prior loan is reclassified as a distribution.

The accounting entries are a) a credit entry of $92,469 to Due from Shareholders, which decreases this asset balance by $92,469, and b) a $92,469 debit entry to Distributions, a contra liability account, which deceases Retained Earnings by $92,469.

In addition, Sierra Products distributed $107,531 of cash to the owner. To record this event, the company a) posted a $107,531 credit entry to Cash, which decreases the balance by that amount and b) posted a $107,531 debit debit to Distributions, which increases this contra account balance by $107,531 and, therefore, decreases Retained Earnings by $107,531.

To simplify matters, we show in Session 4 a single $200,000 debit entry to Distributions rather than two separate debit entries that sum to $200,000.

As a result of these entries, Due from Shareholders decreased by $92,469, Cash decreased by $107,531 and Retained Earnings decreased by $200,000. The total decrease in assets of $200,000 is matched exactly by the total decrease in liabilities and net worth of $200,000.

As an alternative, Sierra Products could have made a $200,000 cash distribution to its owner and left the Due from Shareholders balance untouched. If it had done so, it would post a $200,000 credit entry to Cash and a $200,000 debit entry to Distributions, which would have decreased Retained Earnings and Net Worth by $200,000.

Q: If it is not specified whether a sale/purchase is made with cash or credit, do we assume a mix, just cash, or just credit? i.e credit entry to sales results in debits to cash AND A/R?

A: The quiz question should provide the possibilities of offsetting entries. For example, a sale could be a cash sale or a credit sale or some combination of the two. In this instance, there are three possibilities - a single debit entry to Cash if it is a cash sale, a single debit entry to Accounts Receivable if it is a credit sale, a debit entry to Cash and another debit entry to Accounts Receivable that sum to the amount of the sale if the sale is a combination of cash and credit, i.e., the buyer paid some cash and received an invoice for the remaining amount due to be paid by him or her.

Course overview: Recording Transactions and Creating the Balance Sheet and Income Statement

Q: Can you explain slide 31 in further detail?

A: There are two methods for recording accounts receivable. One, the preferred method, is to record accounts receivable at the face value of the invoice using the historic cost principle, and then adjust that balance by the company's estimate of the dollar amount of the accounts receivable that will turn into bad debts. This estimate is recorded as the Allowance for Doubtful Accounts. So, if we see this account on the balance sheet, we can expect to find bad debt expense on the income statement. But frequently the bad debt expense is buried in a larger account and may be difficult to identify.

The other method is the direct write-off method. Under this method, the company reports accounts receivable using the historic cost principle and only adjusts that balance when it recognizes a bad debt. It recognizes a bad debt by reporting a bad debt expense on the income statement, which, again, may be buried in a larger expense account and difficult to identify.

With respect to Due from Related Parties and Preliminary Site Costs, the point here is to search for them on the balance sheet and be aware, if they exist, that they are frequently written down or written off. Loans to Related Parties are frequently forgiven and, therefore, written off. The same applies to Preliminary Site Costs on those occasions where the company decides that the project in question will likely be unprofitable. Therefore, it makes sense to cut the losses, close down the project, and write off the amount reported on the balance sheet.

And because any bad debt or write off reduces net income, reduces net worth, and increases leverage, companies are reluctant to write down or write off completely such assets as accounts receivable, due to related party, and costs incurred in developing a project.

Course overview: Critical Accounting Principles and Assumptions and More Debits and Credits

Q: What is the difference between depreciation expense on Schedule 1120s and on the accrual income statements?

A: For Sandover Contractors, the amount of depreciation expense reported at Line 14 on Schedule 1120S is $154,070. The amount reported on the accrual income statement is $178,007.

Depreciation expense on the business income tax returns usually differs from depreciation on the accrual income statement since a) a company may use a different method for computing depreciation expense on its tax returns than it used in reporting on an accrual basis, and b) a company reports depreciation expense on its tax returns only on those fixed assets not used to compute the Section 179 Deduction.

Keep in mind that the objective in preparing tax returns is to minimize taxable revenue. Therefore, companies will use whatever methods that allow them to maximize depreciation expense and the Section 179 deduction in order to drive down taxable revenue for the company and for its owners or partners.

Course overview: The Section 179 Deduction

Q: Will different entities list their balance assets and liabilities in an order other than most to least liquid assets or most urgent liability to those payable in the more distant future based on the personal business philosophy of management? Say they want to pay APs before Notes Payable for instance.

A: The generally accepted format used in the accounting profession for listing the array of accounts on the income statement and balance sheet is determined by the nature of the accounts presented rather than the sequence in which assets are liquidated or liabilities are paid at the preference of the company. The sequence may vary from time to time at the discretion of the accountant, but, as a general rule, the GAAP-driven array is widely recognized and applied.

In the case of company-prepared financial statements, it becomes more likely that there will be some variation in the order accounts are displayed. In the case of compiled, reviewed, or audited statements, however, expect to see the standard GAAP array since it is the accountant, and not the company, who prepares the financial statements.

As an additional note, be aware that the names of the accounts may vary from company to company to better describe the company’s particular business activities. This is likely to be more common on the income statement than on the balance sheet since revenue and expense accounts reflect specific types of activities.

Course overview: Understanding Financial Statements and Business Organizations

Q: How can you tell when a municipality's pension liability is getting too large for them to handle? Are there red flags or a rule of thumb?

A: There is no given "Rule of Thumb." However, a practical approach is to review the municipality’s enterprise-wide Statement of Activities over the past two or three years and determine if the Change in Net Assets is deteriorating, stable, or improving.

There is a continuing concern about the extent of municipalities’ unfunded pension liabilities and whether they are sufficiently large and threatening to cause severe debt service problems. GASB 68 and GASB 71 attempted to clarify the computation and presentation of unfunded pension liabilities, but there is considerable controversy about the proper discount rate to use for future pension obligations and the proper rate of return to use on investment of pension assets. As a result, think tanks, such as the Brookings Institution, have suggested that the best approach to assessing the severity of pension obligations is an assessment of a municipality’s income statement – or Statement of Activities – over time to determine its prospects for covering all costs, including annual pension expense and debt service.

The key to any practical assessment is use of the enterprise-wide financial statements for a municipality, which are reported on an accrual basis according to GAAP. The use of fund accounting statements requires numerous adjustments to approximate a cash flow statement that allows assessment of a municipality’s ability to meet all operating costs, as well as pay its debt service as scheduled.

Q: We have bonds where we have a pledge of dedicated tax revenues. The bond resolution indicates that P&I payments are payable prior to the payment of any operating expenses. Our analysts are looking at the debt service in relation to the specific dedicated tax revenues (prior to operating expenses). We have a school district that had decreases in net assets every year and almost no real liquidity. Given the bond terms, how realistic is this situation? How much confidence should the dedicated tax and priority over operating expenses provide?

A: A few comments and questions to consider.

If the school district has diminishing operating cash flow, that should be of concern.

The bond's payment priority appears to be a subordination clause. Whether the district honors the clause will only be apparent after the fact.

If all bond interest charges are met without delay, that is good news. However, does the district have a short term credit line and is it using it more as time passes? If so it may be relying on short term debt to service long term debt.

Are there any funds transfers to the school district from other funds and business operations controlled by the associated municipality? (Assuming the school district is not a stand alone entity.)

Finally, all of the above is further complicated since the financial data is usually stale by the time it's public.

Course overview: Fund Accounting and Municipality Analysis: Part I of II

Q: Is a Schedule K the closest to a standard company income statement we can find in a tax return?

A: Schedule 1120S, the first page on the business income tax returns for a Subchapter S corporation, is the closet to a standard profit and loss statement. And Schedule 1065, the first page on the business income tax returns for a partnership or LLC, is the closet to a standard profit and loss statement. Schedule K captures summary, but not detailed, information such as taxable business income but not the taxable revenue and tax-deductible expenses that sum to taxable income. Schedule K also includes information that is not included on Schedules 1120S and 1065, such as interest income and tax deductible contributions.

Q: What do you mean the Schedule L should be on a GAAP basis? Could you explain that in a little more detail please?

A: The IRS states that the Schedule L balance sheet must match the company's books and records. Since companies keep their balance sheet on an accrual basis according to GAAP, Schedule L is reported according to GAAP. As a result, taxable income never reconciles with the change in net worth reported on Schedule L since taxable income invariably differs from accrual income. And Schedule L net worth changes from period to period as a result of capital contributions, accrual (NOT tax) net income or loss, and distributions or withdrawals to owners or partners.

Q: On the Poll Question 4, is the answer Line 30 on Schedule 1120?

A: Yes. The Taxable Income for a Subchapter C corporation is reported at Line 30 on the 2018 Schedule 1120. The amount of income tax due from the Subchapter C corporation is reported at Line 35 after deducting all tax payments during the year and any applicable tax credits. If the payments and credits exceed the Taxable Income at Line 30, the Overpayment is reported at Line 36.

Course overview: Business Income Tax Returns

Q: I recently completed the webinar on Spreading Financial Statements. Could you provide a copy the UCA Cash Flow for D & J Installation Contractors that supports the "Net Cash After Operations" numbers on slide 10?

A: Yes, please click here for the 2018 UCA Cash Flow for D & J Installation Contractors, Inc. along with a few notes on the second page.

Course overview: Spreading Financial Statements

Q: What are Direct Levies as were included in the Appraisal Expense Analysis and displayed in Slide 39?

A: Direct Levies are property tax assessed directly to the owner of taxable property beyond “normal” property taxes. A direct levy may represent delinquent property taxes to include late charges and other fees. Such a Direct Levy may come as a result of the taxing local governmental entity having recorded a “tax lien” or other claim on the property to satisfy the delinquent taxes.

A Direct Levy may also represent incremental property tax assessed to property owners for governmental actions that bring value to the property. A Direct Levy of this type can come because of repaving or widening a street or building a sidewalk. The amount of a Direct Levy is in excess of property tax charged by a local government as routinely determined by applying the tax rate to the assessed value of the property.

In either instance, note that a Direct Levy is an incremental billing and is associated with property taxes.

Course overview: Commercial Real Estate

Q: In Property, Plant, and Equipment, what types of business assets fall under the "Plant" descriptor?

A: Property, Plant, and Equipment describes specific fixed, tangible assets owned by the company for production of revenues over multiple years as determined by the estimated useful life of those assets. The dividing line between "Property" and "Plant" is unclear and the two together capture all property and property-related assets that are used in the production of the products or services brought to market by the company. "Plant" assets could extend beyond fixed assets located at the main place from which a company conducts business to include storage facilities for equipment held off premises or furniture and fixtures, or other similar extensions.

Q: So Accumulated Depreciation is an account in itself and unique in its classification?

A: Yes. A unique account with a narrow and very specific purpose in reporting the financial status of the company measured. As noted in the presentation and preparatory materials, Accumulated Depreciation is a contra asset account. As such the account balance reflects the total depreciation expense claimed on all depreciable assets now owned since those assets were acquired. As a contra account, the accumulated balance is subtracted from Gross Property, Plant, and Equipment, or Gross Fixed Assets, to determine Net Property, Plant, and Equipment or Net Fixed Assets.

Course overview: Double Entry Accounting, the Accounting Equation, and Debits and Credits

Q: Is there a rule of thumb for when to incorporate a related entity that is not wholly-owned into the global cashflow? If a related business (not a borrower or guarantor) is 30%, 50%, 66% owned by guarantors (or any other percentage), are there guidelines as to the best way to handle both cashflow and debt from that entity in determining the global cashflow?

A: There are two fundamental considerations in selecting the parties for computing global cash flow - control and commitment.

With respect to control, the lender must identify the party that controls the borrower as well as identify all other business organizations controlled by this party.

With respect to commitment, the lender must be assured that the controlling party is committed to using its own financial resources in support of the borrower's debt service.

To see how this plays out, recall the proposed Shadelands Glen apartment complex acquisition by Sequoia Properties from the Credit College Course on Commercial Real Estate Underwriting. Sequoia Properties is a general partnership with two partners. Each partner - Fritz Schumacher and Luis Castillo - has a 50% ownership share of the partnership.

The first step in the global cash flow compilation process is to identity which of the two partners controls the partnership's finances since they have equal ownership. The Credit Narrative identifies Schumacher as the managing general partner, the one who controls the company and its finances. The Statement of Changes in Partners' Capital reports that partnership net income is split evenly but that Schumacher receives the distributions and provides the partnership capital. Given this information, it is clear that Schumacher is the controlling party. This, in turn, requires us to identify all other business organizations controlled by Schumacher since such organizations are included in the global cash flow computations. The Credit Narrative reports three additional business organizations fall into this category.

The guidance to draw from these set of events is that control of a business organization is generally determined by ownership of 50% or greater. But 50% ownership is no assurance of control as evident by the role Luis Castillo plays in the partnership with an equivalent 50% ownership. Had we mistakenly identified him as the controlling party, the resulting global cash flow would be quite different and quite incorrect.

The second step in the global cash flow computation process is to determine if the controlling party is committed to repayment of the underlying loan used by the borrower to acquire the property. That commitment takes the form of a personal and continuing guarantee. If the controlling party provides such a guarantee, then its financial support is included in the global cash flow computation. In this instance, the Credit Narrative reports that Fritz Schumacher guarantees the proposed $3,450,000 term loan.

In the absence of such a guarantee, there is far less assurance that the controlling party will use its financial resources to support the loan in question should the borrower encounter cash flow problems or face bankruptcy at some point over the loan repayment period. There are far too many instances in which controlling parties, which have not provided a continuing guarantee, simply walk away from a failed transaction and leave the property in the hands of the lender. From the controlling party's point of view, it is less costly to give up the property than provide a guarantee that might cost it far more if the controlling party were compelled to honor the guarantee in a crisis.

Therefore, exclude the controlling party from the global cash flow computations if it does not provide a continuing guarantee.

Q: If someone has 15 businesses owned 50%, would 50% of the cashflow and debt for each be applied to the global cashflow? 100? Does it depend on majority ownership?

A: With respect to the percentage of business cash flow and business debt for related business organizations that should be included in the global cash flow computations, use the full amount of business cash flow available and the full amount of business debt in the computations. The controlling party has access to the full amount of business cash flow, which it controls and must apply in meeting the full amount of debt service on the related party's outstanding debt. To use any lesser amount of either may underestimate the related party's ability to service its debt from its own business cash flow or it may not identify the additional cash flow support required by the related party to properly meet its full debt service.

Q: We have a lot of people who overlap in ownership of related businesses as well. If 3 guarantors own 75% of a related entity (not a borrower or guarantor), should that be included at 100% ownership? 75% of cashflow and debt?

A: If the three guarantors are, indeed, the controlling party, they determine the use of 100% of the company's business cash flow. Within the group, there is likely a partnership agreement or ownership agreement that identifies one of the group as the financial decision maker.

Course overview: Global Cash Flow

Q: Were 2016 numbers provided? The cardiology medical group is only 2017 and 2018.

A: You're right. We included only the 2017 and 2018 financial statements in the interest of cutting down on the size of the case materials when we updated the webinar and webinar materials several months ago. If you would like the financial statements for 2016 and 2015, we would be happy to send them to you.

Course overview: Assessing Medical Practices



 

Q: So Preliminary Site Costs depicted on the Fresno Properties balance sheet are considered an asset. Correct?

A: Yes. The title implies that the site(s) are not yet fully developed, and that this preliminary work will be followed by actual construction and completion of the site(s). When development is completed, these initial costs become a component of the total costs of the new, fully developed fixed asset, which is reported on the balance sheet as a long-term asset. This expectation further reinforces classifying this activity as an asset account.

Course overview: Financial Statement Structure and Composition

 

Q: How do we get a copy of the excel model of the debt service constant?

A: The Excel model for the debt constant is online now, accessible via this link.

Course overview: Underwriting Standards, Actual vs. Stabilized NOI, and Breakeven Analysis

Q: Please help explain cash taxes, interest, dividends vs accrued taxes, interest expense, and dividends for the purpose of cash flow?

A: A company can recognize income taxes as an expense on its income statement but delay payment in cash. If it did so, it would record an amount for Income Tax Payable on its balance sheet, usually included in a more general account such as Accrued Liabilities. For example, if a company recorded $25,000 for income tax expense for 2021 and paid $20,000 of that amount during 2021, it would record $5,000 of income tax due and payable on its balance sheet. As a result, its accrual income tax expense for the year would exceed its actual cash income tax expense for 2021 by $5,000.

The same logic and process applies to interest expense. The accrual amount for a year may be the same, more, or less than the actual cash amount paid for interest expense. For example, if a company paid $10,000 of interest expense due from 2020 in early 2021 and then recorded accrued interest expense of $50,000 for 2021 and paid that full amount by the end of 2021, its cash interest expense would be $60,000 while its accrual interest expenses would be $50,000. In this instance, cash interest expense exceeds accrual interest expense by $10,000 for 2021.

With respect to dividends, they are usually paid out fully in cash, so the cash and accrual amounts match. But once again, a company could declare $100,000 in dividends and accrue some or all of that amount. If it declared $100,000 of dividends on December 31 but paid out that amount in January 2022, accrual dividends would exceed 2021 cash dividends by $100,000.

Please note that the difference between cash and accrual amounts generally becomes much more pronounced for sales, COGs, and operating expenses. Differences can and frequently exist for a great many of the accrual revenue and expense accounts.

Course overview: Business Income Tax Returns and Cash Flow Analysis

Q: An appraiser uses stabilized NOI to determine property value. However, the actual rent roll could show 50% vacancy and some delinquent tenants, which does not get factored into the determination of the current value. So, the current property condition does not play as a big a role as the stabilized future condition of the property in determining value. Is this correct?

A: Absolutely right. "Stabilized" values are "what if" values in a yet to be achieved optimal marketplace and is certainty not what exists today. "Stabilized" values may become fact in the future, but lenders need to focus on the here and now in underwriting a loan and defining the current property cash flow.

Keep in mind, too, that the appraiser is following standard practice to “level out” naturally occurring market ups and downs in establishing stabilized values. Note also that appraisers have no skin in the game, other than their professional reputation. The lender must accordingly exercise great caution that the cash flow numbers used match reality as closely as possible in determining if the property can support the debt to acquire it.

Q: Where can you find the Baa bond rate?

A: A quick Google search will provide numerous sources of current and historic bond rates. The Federal Reserve Bank of St. Louis is a good source of information about this issue.

Q: Would rent controlled units imply a higher cap rate for a property due to potential loss of income in charging below market level rents?

A: A very good point. Yes. Rent controlled properties are likely more risky because of the inability of the landlord to raise rents in response to increased operating costs. As a result, it is quite common to see rent controlled properties physically deteriorate because the owner defers the unrecoverable maintenance and repairs. The postponed upkeep may well lead to further decreases in rental income and NOI. Even with no increase in the cap rate, the property’s value as determined by NOI divided by the cap rate would fall as NOI decreases.

Q: Is there a website/directory where we as lenders can compare different appraisers?

A: I know of no such website but one may certainly exist. I've always found it helpful to ask other lenders and other commercial real estate professionals about their opinions of appraisers. Those opinions can vary widely and the buyer of appraisal services (the lender, in effect) needs to beware.

Note also that your organization may have established a vetted list of approved appraisers.

Course overview: The Income Capitalization Approach and the Cap Rate

Q: Question on M-2 which may not apply. Are distributions on Schedules K-1s always noted as distributions or withdrawals on Schedule M-2?

A: Yes. In general, distributions reported on Schedule K in the business income tax returns are reported on Schedule M-2. However, it is not uncommon to find distributions reported on Schedule M-2 limited to the amount of taxable revenue for the year, which may be less than distributions for the year. Consequently, it is always prudent to identify distributions for a Subchapter S Corporation or for a Partnership by reference to Schedules K-1. If there is more than one owner or partner, the amounts reported on the individual Schedules K-1 will add up to the total amount of distributions reported on Schedule K in the business income tax returns.

Q: How did you arrive at $31,101 in Depreciation? If I take the depreciation of $197,289 from the 1065 tax return less the depreciation of $172,911 under depreciation on the cash flow statement and "other costs" then I come up with $24,378.

A: The $31,101 is the difference between $197,289 reported on the tax return at Line 16c and depreciation expense reported in Footnote 1 on the financial statement as $166,188. The difference between depreciation expenses of $197,289 reported on the tax return and $166,188 reported on the accrual financial statement is $31,101.

Other Costs of $172,911 on the accrual income statement match the $172,911 of Depreciation and Amortization of $172,911 reported on the Statement of Cash Flows. This implies a 2018 amortization expense of $6,723 that is not specifically identified in the accrual financial statements. Note that Schedule L in the business tax returns shows a $6,723 accumulated depreciation amount at Line 12b, which is likely amortization expense for the single year 2018.

Course overview: Schedule M-1 and the Accrual Income Statement

Q: I have come across several CPA-prepared statements where a comment was included that basically said, "we have not included some financial information because it might change your mind about the company." I would take that as a huge red flag. Is that common practice?

A: This is not a common practice but one that is very welcome and reflects highly on the CPA. Such a comment is indeed a red flag and needs to be thoroughly pursued by the lender or potential lender.

On occasion such a comment may be no more serious than a contested issue about classifying accounts that would impact a ratio calculation. But in other instances, such a comment might point to contested issues between the borrower and the accountant that raise questions about the viability of the business itself.

Course overview: Non-Financial Red Flags and Performance Implications

Q: Will Mr. Schumacher need to pay taxes on any portion of the base or excess distributions he received in 2018? Would any portion be included in the “passthrough” taxable income?

A: No and No. Distributions from “passthrough” entities in any amount are tax-free to the receiving owner or partner. Even when the distribution exceeds the estimated taxes due, owners like Mr. Schumacher do not report any portion of the distributions as taxable income on their 1040.

Further, the distributions from any of the “passthrough” entities cannot be reported as a tax-deductible expense for the paying business entity in preparing their business information-only income tax returns. Distribution, in effect, fall outside the tax arena. Schumacher is taxed only on the taxable income generated by the each of the passthrough entities in which he has an ownership stake. Owners do not report the cash distributions from those organizations as taxable income, as we noted above.

There can be an exception to this general rule. If accumulated distributions are greater than a partner's or owner’s "basis" in the Partnership, LLC or Subchapter S corporation, the amount in excess of the “basis” is taxed as a long-term capital gain. Note that “basis” for partners in a partnership is generally defined as each partner’s pro-rata accrual net worth in the partnership plus each partner’s “share” of partnership liability obligations. This exception occurs infrequently.

Q: What about the $4,112,432 capital contributions reported on Sequoia's 2018 Schedule K-1 as part of the Partner’s capital account analysis? Is it considered a cash inflow or outflow?

A: Neither. During 2018 Mr. Schumacher converted $4,112,432 of personal loans he made to Sequoia to a capital contribution as described in Note 4 on page 10 of Sequoia’s financial statements. Since the cash inflow to Sequoia occurred earlier when the long-term loan was originated, the conversion to equity is a non-cash event in 2018. In the absence of the conversion, however, the capital contribution would be a cash inflow, and the loan from Mr. Schumacher would remain on the Sequoia balance sheet as part of the Note Payable liability account.

The net effect of this capital contribution is accounted for as a $4,112,432 decrease in the long term Note Payable, which include loans from partners, and an identical increase to Partner’s Capital. From an accounting standpoint, the conversion transaction occurred before Sequoia arranged any new long-term debt and contributes to the $1,979,974 net decline in the Note Payable account. The Partners' Capital account was further increased by 2018 net profit of $166,505 and reduced by distributions of $86,346. The net effect of this combination of transactions increased 2018 year end Partners' Capital to $4,415,990.

Q: If we are consolidating Mr. Schumacher’s cash "support" with business cashflow from operations in defining Global Cash Flow, could an argument be made about the liquidity positions of each respective company as a mitigating factor?

A: Yes, indeed. We would look to the highly liquid assets – or ready cash – available from each related company controlled by Schumacher as a potential cash source available to service debt. In doing so, it is very difficult to predict which 2018 year end cash or liquid asset amounts might be available throughout 2019 to support debt service problems at Sequoia.

Each company’s cash available to support a related party would depend on the internal cash needs the companies encounter as they go through 2019. For example, only Modesto Services has significant cash balances at the end of 2018 at $350,442. That could be gone early in 2019 if the company encountered unexpected cash flow problems. On the other hand, Clovis Supply reports only $7,040 in its cash account at the end of 2018. If Clovis has a robust year in 2019, it may have excess cash resources it could lend to Sequoia for debt service support.

Bottom line? Very prudent to examine other likely ready cash resources among related companies but very risky to depend on their availability because of operating uncertainties in the forthcoming year.

Course overview: Guarantor Analysis, Global Cash Flow, and the Second Way Out

Q: Under UCA cash flow calculation, distributions and loans to partners are deducted from Cash after Operations. How are contributions from partners and / or loans from partners to the company treated? Are these adjustments recorded in the same section of the UCA cash flow statement?

A: Partner or owner capital contributions and loans to the company are not consolidated with distributions and / or loans to owners nor should they be reported as an operating activity on the UCA cash flow statement. Capital contributions should, instead, be treated and classified as a financing activity intended to strengthen the company’s overall financial position. Owner loans to the company should be recorded as a related party activity since they fall outside the core operating activities and traditional third party lending used by the company. Maintaining this separation in reporting these business activities and associated cash flow impact preserves the integrity of the nature and amount of each transaction type.

Consolidating or recording capital contributions and partner or owner loans to the business as operating activities would erroneously affect Net Cash after Operations and cash flow available to service debt. The net effect would be to distort our analysis and our view of the debt capacity of the borrower.

Course overview: Advanced UCA Cash Flow: Part I of II

Q: Would you repeat what you said about "Business Cash Income cannot state that cash from operations are..."

A: A negative Business Cash Income of $163,945 in 2018 indicates that after meeting all cash operating expenses, including interest expense of $59,062, Total Coverage, Inc. had a cash flow deficit of $163,945, which means that cash flow from operations was insufficient to service the debt. Instead, the company had to use either existing cash balances or additional third-party financing to cover this cash flow deficit. We can rule out existing cash balances as the primary source of cash to cover the deficit since the cash balance was only $20,339 at the beginning of the year. Total Coverage, Inc. used additional short-term debt to fund their debt service in 2018.

Q: Would one use the same last recorded value assumptions when creating projections for multiple years?

A: Yes. Begin with the last recorded value of sales growth, for example, and use it as the projected growth rate in the first projection period unless there is a compelling reason to change. If there is a compelling reason to change, use the revised projected sales growth value, which then becomes the basis for the second projection period. If there is a compelling reason to change the second projection period's sales growth rate, then do so. And on and on.

However, keep in mind that the key to any projection scenario is the first projection period, which we need to get as right as we possibly can. Projections are notoriously inaccurate and misleading, especially beyond the first projection period. The best source of information about likely projection variables, such as sales growth for the forthcoming year, is company management. If management is on top of its game, it will be very close to market events and developments. No one should have better insight into the likely course of events for the specific company in question.

Course overview: Management Assessment, Projected Cash Flow, and the First Way Out

Q: Can you discuss a Single Member LLC?

A: A Single Member Limited Liability Company has a single owner who has full control over the LLC. The LLC is a legal entity created by the state after the chartering process is completed and, as such, allows the single owner to avoid any liability for the entity's obligations unless that member guarantees that obligation. A Single Member LLC does not file federal tax returns in its own name. Rather, the Single Member reports the entity's taxable revenue as personal income on his or her Form 1040. Further, a husband and wife, if filing a joint return, may be considered a Single Member LLC.

In all other respects the single member LLC and a multi-member LLC are the same.

Q: Even with a personal guarantee, can a lender legally go after a personal guarantor's personal assets, e.g., liquidity in a bank, to cover the guarantor’s financial responsibility for a guaranteed loan?

A: Yes. Unless restricted in some way, a lender can pursue all of a guarantor’s personal assets to complete payment of a guaranteed loan.

Looking further, restrictions on this privilege may have been negotiated in originating the loan, so it depends on the precise language of the personal guarantee provided by the guarantor. As an example, the guarantee could include carve-outs that would prevent the lender from pursuing specific personal assets in seeking payment. In contrast, an unlimited guarantee is structured to allow the lender to pursue all guarantor personal assets. In the case of an unlimited guarantee, cash in a bank account or bank CDs would be subjected to attachment.

Course overview: The Credit Write-Up and the CRE Analytical Process

Q: Aren't unfunded pension obligations typically reflected on corporate financial statements as a liability?

A: Yes. You are correct. If a company reports its operations according to GAAP, it will record unfunded pension liabilities as a net liability on its balance sheet.

It would be good practice, however, to ensure that any unfunded pension obligations are included on the balance sheet for companies that have pension programs.

Course overview: Not for Profit Analysis

Q: Poll Question 4 stated Total Coverage needed less cash or less financing to buy and hold inventory in 2018 than in 2017. The answer was disagree. My question is if they are holding inventory for 15 more days in 2018 vs 2017 why would they need more cash or financing to buy inventory if they already have it on hand?

A: Poll Question 4 reads as follows:

“The change in inventory days indicates that Total Coverage, Inc. needed less cash or less financing to buy and hold inventory in 2018 than in 2017.

• Agree.
• Disagree.

The correct answer is Disagree.”

Inventory composition is constantly changing as is the value of the inventory held for sale. An underlying business assumption is that during 2018 all inventory on hand at year end 2017 was sold and replaced in the normal course of business. Total Coverage, Inc. inventory further expanded by $55,339 due to the sales increase and the increased inventory days. Both dynamics brought about an $55,319 expansion in inventory by year end 2018, i.e., 2018 inventory of $287,342 less 2017 inventory of $232,003 = $55,339.

The increase in inventory was not a surprise because the two business drivers caused inventory to increase by $55,339. The first driver was the 5.94% increase in 2018 sales that pushed a 5.94% increase in 2018 inventory to account for $13,781 of the 2018 inventory increase. The significant increase in Inventory Days from 60 days in 2017 to 75 days in 2018 caused an additional $41,558 inventory increase.

To fund the $55,339 incrementally increased investment in 2018 inventory, Total Coverage, Inc. needed to access more, not less, funding in the form of a like amount of company cash, financing, supplier credit, or additional equity investment to do so. By inspecting the 2017 and 2018 balance sheets and considering the funding options, we find that the company’s cash position increased in 2018. Short term Notes Payable to Bank, a line of credit, increased by $261,962. Trade credit in the form of Accounts Payable went down $255. We find no additional capital investment in the company.

Our conclusion is that Total Coverage, Inc. satisfied the need for more cash to support inventory, not less, by using the line of credit.

Course overview: Critical Ratios and The First Necessary Condition for Business Success

Q: Is there a limitation on the carry-over Section 179 Deduction?

A: There is no limitation on the carryover. However, it can be applied only up to the amount of Ordinary Business Income in a future period in which it is used?

Q: Do we know what the Other Income is comprised of?

A: Statement 1 to the business income tax returns reports that Other Income of $20,352 represents Referral Income.

Course overview: The Section 179 Deduction

Q: Please explain why we have two Notes Payable to Bank and Capital Lease Obligations under Liabilities. Thank you.

A: The first Notes Payable to Bank is a short-term line of credit. The second Notes Payable to Bank is a term loan that matures over multiple years. As a result, there is an annual amount due on the term loan, which is designated as Current Maturities LTD. The remaining long-term balance is reported as Notes Payable to the Bank.

Then there is the capital lease obligation, which is a form of long-term financing. As such, it, too, has an annual amount paid down against the capital lease total. Therefore, the capital lease is reported as Current Maturities Capital Leases, which are due and payable in the next year, and Capital Leases, which is the remaining long-term balance of the financing.

Course overview: Cash Flow Analysis and Borrowing Causes

Q: I was looking through the materials for today’s webinar and had a question: On schedule M-2, should the last line ($66,910) equal the capital level in Schedule L ($66,937).

A: Yes. The two amounts should be identical. There is a $27 difference because the accountant transposed the amount at Line 6 on Schedule M-2. The correct amount is $66,947 and not $66,974. When the proper amount is used, $66,910 at Line 9 on Schedule M-2 becomes $66,937, which matches the balance in the Partners' Capital Accounts of $66,937 at Line 21 on Schedule L.

Q: Regarding Poll Question 5, what does the inclusion of the net loss in the UCA cash flow statement mean? What amount is this net loss?

A: The net loss of $41,035 is the accrual net loss, which means that accrual revenue less accrual expenses, including depreciation, resulted in a negative amount of $41,035. This amount is repeated in Schedule M-1 in the business income tax returns at Line 1 on Schedule M-1. Note that, on an accrual basis, net income plus depreciation – traditional "cash flow" – is a negative $19,947, which is the sum of the first two amounts reported on the UCA cash flow statement and the starting point for constructing the statement.

Once we make adjustments for distributions, loans to partners, and changes in receivables, inventory, and payables, the company's net income on a cash basis is a negative $17,781. Therefore, it cannot service its debt from its actual cash flow.

Course overview: Cash Based Income Tax Returns

Q: Why pull cash out for distributions to stockholders if it means running out of operating cash flow?

A: Distributions are the means by which a pass-through company provides cash to its owners to pay the income obligation on the company’s taxable income. Recall that the owners of a pass-through company, and not the company itself, are responsible for paying the income tax obligation on taxable company income.

If a profitable pass-through company is short of cash and cannot provide distributions to owners in an amount sufficient to meet at least their income tax obligation on taxable company income, the owner or owners must then use their personal cash resources to pay the personal income tax obligation on taxable company income, an event they obviously wish to avoid if at all possible.

If the company can borrow to provide distributions when it is short of cash, it will invariably do so because of pressure from the owners, one or more of whom may be part of company management. In addition, the company, its owners, and its management may attribute the cash shortage to events other than distributions, such as a necessary build up in inventory or a slow down in collecting receivables.

Borrowing under such circumstances may also reflect the attraction for the owners of receiving tax-free income in the form of distributions. Unless distributions exceed an owner’s basis – basically his or her net worth in the company – they are not reported as taxable revenue on Form 1040. As a result, owners of this mindset seek to stretch the amount of the tax-free distribution for their personal benefit regardless of the impact on company cash flow.

The question is a very appropriate because it highlights the need to identify the borrowing cause correctly and completely. Frequently, the cash impact of distributions is overlooked in the analytical process, especially if the lender does not use the UCA cash flow statement to identify borrowing causes.

Course overview: The Five Cs of Credit

Q: Shouldn't leverage have increased with unfunded pension liabilities on the balance sheet?

A: The definition of leverage can cause a problem. For a commercial business, leverage is, in general, liabilities divided by net worth. Low leverage is desirable since there are more assets to cover the liabilities in the event of default and liquidation.

In this instance, leverage is defined as assets divided by liabilities. The higher the leverage ratio, the greater the asset coverage and the less the risk. If the leverage ratio decreases, it means less assets available to cover every dollar of liabilities. For Calistoga, reporting unfunded pension liabilities dropped the leverage ratio from 2.67 to 1.98, signaling greater risk, i.e., fewer assets to cover each dollar of liabilities.

Q: The last chart statement pointed out lower interest rate environment over the period and reduced principal which shows less need to borrow.

A: A very good observation.

In 2011, the 20-year municipal bond rates varied between 4.75% and 5.50%. In 2015, the rates had dropped to roughly 3.25% at the lower end of the range to 3.85% at the upper end - 150 to 165 basis points difference. This period would obviously translate to lower debt service per dollar of debt.

Course overview: Fund Accounting and Municipality Analysis: Part II of II

Q: If the Subchapter S corporation is not profitable and still distributing funds to owners, unless they have cash on the balance sheet, they may be borrowing to make those distributions. Should you include those distributions in cash flow if it is borrowed funds.

A: Yes. Include the cash distributions as a cash outflow in a cash flow statement since one of the major objectives of a cash flow statement, especially the UCA cash flow statement, is to identify the borrowing cause or causes. In the case you cite, one borrowing cause could well be distributions at a point in time when the company did not have the cash resources to make such distributions. It is very important to know this to assess the risk profile of the company and borrower and to correctly identify the source of cash used by the borrower to meet its debt service.

Course overview: Business Income Tax Returns

Q: I've seen distributions reported in equity as cumulative amounts. Why would this be done and is there an advantage in doing it that way?

A: This is an interesting approach. By reporting distributions as a cumulative balance within the equity section of the balance sheet as a negative amount, the financial statements clearly show the impact distributions have over time on retained earnings and net worth. It would be helpful if this practice were more common.

Course overview: Financial Statement Review and Ratio Analysis