Instructor Blog - Financial Analysis

Q: If a 1065 or 1120s entity does a cash distribution to it's owners in order for them to pay their personal income tax liability, for credit analysis purposes, do I subtract the distribution from the business cash flow and then add it to the guarantor global cash flow? If that is the case, do I then have to "hit" the guarantor for their tax liability because that is what the distribution was for? Technically the distribution wasn't really cash income, it went into one hand and out of the other. How do other financial institutions handle cash distributions in terms of global cash flow?

A: A few comments:

1. You do indeed subtract the cash distributions from business cash flow and then add it back as cash revenue in estimating guarantor personal cash flow available to service his or her company's debt.

2. You do need to account for income taxes paid by the guarantor But these are all state and federal taxes paid by the guarantor. The personal cash flow statement has four sections - cash revenue, cash expenses, cash taxes paid, and cash debt service on personal debt. Frequently, a guarantor can avoid most income tax associated with S Corp or partnership income via a Section 179 Deduction. At any rate, taxable income from S Corps or partnerships and LLCs are included with all other taxable sources of income in determining the guarantor's personal income tax obligations.

3. The distribution was cash revenue to the guarantor, which he or she does not report as taxable income on Form 1040. It falls outside the tax structure. The heroic assumption in including it as cash revenue in estimating a guarantor's personal cash flow surplus is that the distribution is always readily available to meet company debt service in a crisis, which is nonsense.

4. Other financial institutions handle distributions exactly as you describe.

5. Our preference is to discard the estimate of a personal cash flow surplus in structuring global cash flow and use, instead, the highly liquid cash resources of the guarantor. A personal cash flow statement is a very faulty document. We're never sure if we get the cash revenue number right. We have no idea if cash living expenses are within the ballpark since we never required documentation. Our estimate of personal cash taxes paid is the most accurate of all estimates since we use federal income tax returns for this information. And cash paid for personal debt service is usually a rough guess.