Instructor Blog - Financial Analysis

Q: We have a question regarding the use of gain on sale in calculating a borrower’s traditional cash available for debt service. The borrower is a business operation that has a consistent turn over in equipment needed in the business. They show a substantial amount in Other Income listed as gain on sale of equipment. We have four years of history and they report some gain each year, with the first two years showing under $100K while the last two years the amount increased to $1-2MM. If we calculate traditional cash flow and deduct the gain on sale, the borrower shows a DSCR below 1.0. The lender states that the borrower expects the gain on sale to be recurring and about the same amount going forward.

Is includng the gain on sale in traditional cash flow used for debt service generally acceptable if recurring? How do we know whether there is associated debt against the equipment related to the gain on sale and if some of the gain is needed to pay the debt balance? If the borrower replaces the equipment that resulted in the gain on sale, did the borrower use some or all of the gain towards the cost of the replacement equipment? If we include the gain on sale, are we not over stating cash available for debt service?

1. It's unclear if there is any standard approach to including or excluding gains / losses on sale in computing traditional cash flow. However, it seems that most lenders are inclined to exclude a gain or loss on sale if it is non-recurring. In this respect, your approach seems to be the more common one used.

2. If gains or losses on sale are recurring events, then they should be included in computing traditional cash flow. You can consider them to reflect the success or failure of a standard, on-going part of the business operation.

3. You likely cannot determine if associated debt was paid off at the time of the sale. If the financial statements include a FASB 95 statement of cash flows, this statement may report the actual amount of long-term debt reduction in a separate line item under the Financing Activities section of that report. At any rate, the DSC ratio would include interest expense on the term debt but would be missing any debt repayment triggered by the sale - unless the FASB 95 statement provided some help.

4. Whether the borrower used some or all of the gain to purchase replacement equipment is impossible to tell without resort to the UCA cash flow statement. In the Fixed Asset spending section that report, you should be able to identify the net effect of the gain or loss on sale.

5. If this borrower is a pass-through entity, we suggest that you include distributions as a reduction to traditional cash flow in estimating the amount of cash available to service debt. Distributions are not discretionary for pass-throughs. They go for the payment of income taxes on taxable business income and for owner or partner compensation. Regardless of purpose, distributions are cash out the door that diminish cash available for debt service.

6. Given the size of these gains, it seems prudent to understand exactly what the borrower is doing and why it has increased its focus on gains. The huge jump in the amount of the gains raises a whole lot of questions, especially how sustainable this level of Other Income is going forward.

7. The best way to understand this borrower, in our opinion, is to construct and analyze a full UCA cash flow statement.