Questions & Answers, Global Cash Flow Webcast, February 15, 2011
Q: Regarding distributions, why are they not taxable?
A: They are not taxable in accordance with Congressional legislation and the resulting income tax regulations. For a Subchapter S corporation, partnership, limited liability company (LLC) and sole proprietorship, the owners are subject to income tax on their pro-rata share of company profit only. Distributions from the company to the owners are not taxable events, given the income tax regulations. They are not reported on the owners’ personal Form 1040 as taxable revenue. In fact, they are not reported as expenses on a company’s accrual financial statements or business income tax returns.
Q: Shouldn't you consider Schumacher's personal tax return in case he has other cash flow, such as wages, in the global analysis as well as his debts?
A: We should attempt to pick up all the personal revenue streams flowing to the guarantor and certainly wages represent one of those streams in most instances. But the key point is that cash flows from a business to an owner dry up in a financial crisis. An owner may enjoy very robust personal cash flow – including wages – prior to a crisis. But once the crisis hits, those cash flows diminish considerably or dry up completely. Therefore, the value of a guarantee is the amount of ready cash a guarantor can access from highly liquid personal assets – not from personal cash flow – to help support debt service on the interest-bearing debt he or she guarantees.
As we saw with Fritz Schumacher, his personal net worth is $25.4 million, 2007 personal cash flow was $1.7 million, and, yet, his available cash on his personal financial statement was only $270,000.
Q: Isn't it possible that company equity going out the door in the form of loans and cash to owners or to other related entities explains increasing debt, payables, and accruals?
A: Absolutely. You see this clearly with Sequoia Properties, which distributed $1,230,735 to Clovis Supply, apparently bought $1,143,016 of fixed assets-in-process from Fresno Properties, and so on, while running up huge amounts of accruals and borrowing massive amounts of long-term debt. There is a very clear cause and effect relationship that proves your point.
Q: You discuss distributions but not contributions or loans from shareholders. Why?
A: Increases or contributions may suggest internal cash shortages or crises, forcing the owners or key employees to lend personal funds to the company.
If an owner loans money to his or her company, it usually represents emergency financing. That is, the company has likely exhausted all other possible sources of funding and, therefore, is compelled to rely on funding from an owner or owners in the form of a loan to the company. Since the financing support from the owner took the form of a loan rather than a capital injection, the owner implicitly expects to be repaid for the amount he or she has advanced to the company.
Infrequently, increases may reflect owner or management decisions to use personal resources instead of outside third party funding, thereby allowing owners to benefit from substantial interest rates they charge the company. Such interest rates have a negative impact on company financing costs and cash flow.
Q: Our bank specializes in commercial lending. We do global cash flows when the borrower is a business, partnerships or rentals and the owner(s) is the guarantor on the loan. An internal auditor mentioned that there are certain loans or structured loans when we do not need a global cash flow. The example he provided: If we are 1st DOT and have all the rental/lease agreement information, we should not have to do a global cash flow. Can you provide us with clarification on when we should do Global Cash Flows?
A: As I understand the policy guidelines from the regulators - and I'm attaching a set of slides that captures some key points along with the October 30, 2009 policy statement - they encourage a global cash flow analysis whenever there is a guarantor behind a loan to a commercial business or commercial real estate operation.
For example, if you're lending to a partnership or a single asset entity that owns an income producing property, and the loan is guaranteed by one or more partners, the regulators would encourage a global cash flow anaylsis that a) begins with an assessment of the partnership or single asset entity - which means you need the financial statements for the obligor - and then continues with an assessment of the guarantor's financial strength and likely cash support in a crisis, and then ends with an assessment of the property itself. Note that a property assessment is the last assessment, in effect.
The property isn't the obligor. The partnership or SAE is the obligor. And the obligor may have far more on its financial statements than the revenue and expenses for the income producing property it owns. In fact, many operating expenses get capitalized, such that property expenses are understated, e.g., the obligor may capitalize certain repairs and maintenance expense - quasi tenant improvements - so they end up on the balance sheet rather than passing through the property's income statement.
In addition, it always makes sense to identify any other company owned or controlled by the owner of the partnership/SAE in question and include those companies in a global cash flow analysis. The point here is that problems elsewhere in an empire might result in extreme pressure on your borrower to provide cash to support a failing company. If the pressure is sufficient, your borrower could find itself with insufficient cash flow - regardless of how much the property throws off - to service your interest-bearing debt.
In terms of related companies that should be included in a global cash flow analysis, we can take a page from the accountants' book and use an ownership level of 25% or greater as a starting point. That is, if the owner of your specific partnership or SAE also is a 25% or greater owner in any other business, include it in the global cash flow analysis.
In very general terms, I think the message from the regulators is to look far beyond the revenue and expenses of an income producing property - or properties - and look first at the business itself that owns the properties. Conduct a global cash flow analysis to identify potential problems other related parties - including owners and guarantors - might have that could impact your borrower's ability to keep the cash necessary to service your debt. Conversely, identify related parties - including owners and guarantors - that could help your borrower in a crisis to access the cash necessary to service your loan.
Q: Regarding distributions, why are they not taxable?
A: They are not taxable in accordance with Congressional legislation and the resulting income tax regulations. For a Subchapter S corporation, partnership, limited liability company (LLC) and sole proprietorship, the owners are subject to income tax on their pro-rata share of company profit only. Distributions from the company to the owners are not taxable events, given the income tax regulations. They are not reported on the owners’ personal Form 1040 as taxable revenue. In fact, they are not reported as expenses on a company’s accrual financial statements or business income tax returns.
Q: Shouldn't you consider Schumacher's personal tax return in case he has other cash flow, such as wages, in the global analysis as well as his debts?
A: We should attempt to pick up all the personal revenue streams flowing to the guarantor and certainly wages represent one of those streams in most instances. But the key point is that cash flows from a business to an owner dry up in a financial crisis. An owner may enjoy very robust personal cash flow – including wages – prior to a crisis. But once the crisis hits, those cash flows diminish considerably or dry up completely. Therefore, the value of a guarantee is the amount of ready cash a guarantor can access from highly liquid personal assets – not from personal cash flow – to help support debt service on the interest-bearing debt he or she guarantees.
As we saw with Fritz Schumacher, his personal net worth is $25.4 million, 2007 personal cash flow was $1.7 million, and, yet, his available cash on his personal financial statement was only $270,000.
Q: Isn't it possible that company equity going out the door in the form of loans and cash to owners or to other related entities explains increasing debt, payables, and accruals?
A: Absolutely. You see this clearly with Sequoia Properties, which distributed $1,230,735 to Clovis Supply, apparently bought $1,143,016 of fixed assets-in-process from Fresno Properties, and so on, while running up huge amounts of accruals and borrowing massive amounts of long-term debt. There is a very clear cause and effect relationship that proves your point.
Q: You discuss distributions but not contributions or loans from shareholders. Why?
A: Increases or contributions may suggest internal cash shortages or crises, forcing the owners or key employees to lend personal funds to the company.
If an owner loans money to his or her company, it usually represents emergency financing. That is, the company has likely exhausted all other possible sources of funding and, therefore, is compelled to rely on funding from an owner or owners in the form of a loan to the company. Since the financing support from the owner took the form of a loan rather than a capital injection, the owner implicitly expects to be repaid for the amount he or she has advanced to the company.
Infrequently, increases may reflect owner or management decisions to use personal resources instead of outside third party funding, thereby allowing owners to benefit from substantial interest rates they charge the company. Such interest rates have a negative impact on company financing costs and cash flow.
Q: Our bank specializes in commercial lending. We do global cash flows when the borrower is a business, partnerships or rentals and the owner(s) is the guarantor on the loan. An internal auditor mentioned that there are certain loans or structured loans when we do not need a global cash flow. The example he provided: If we are 1st DOT and have all the rental/lease agreement information, we should not have to do a global cash flow. Can you provide us with clarification on when we should do Global Cash Flows?
A: As I understand the policy guidelines from the regulators - and I'm attaching a set of slides that captures some key points along with the October 30, 2009 policy statement - they encourage a global cash flow analysis whenever there is a guarantor behind a loan to a commercial business or commercial real estate operation.
For example, if you're lending to a partnership or a single asset entity that owns an income producing property, and the loan is guaranteed by one or more partners, the regulators would encourage a global cash flow anaylsis that a) begins with an assessment of the partnership or single asset entity - which means you need the financial statements for the obligor - and then continues with an assessment of the guarantor's financial strength and likely cash support in a crisis, and then ends with an assessment of the property itself. Note that a property assessment is the last assessment, in effect.
The property isn't the obligor. The partnership or SAE is the obligor. And the obligor may have far more on its financial statements than the revenue and expenses for the income producing property it owns. In fact, many operating expenses get capitalized, such that property expenses are understated, e.g., the obligor may capitalize certain repairs and maintenance expense - quasi tenant improvements - so they end up on the balance sheet rather than passing through the property's income statement.
In addition, it always makes sense to identify any other company owned or controlled by the owner of the partnership/SAE in question and include those companies in a global cash flow analysis. The point here is that problems elsewhere in an empire might result in extreme pressure on your borrower to provide cash to support a failing company. If the pressure is sufficient, your borrower could find itself with insufficient cash flow - regardless of how much the property throws off - to service your interest-bearing debt.
In terms of related companies that should be included in a global cash flow analysis, we can take a page from the accountants' book and use an ownership level of 25% or greater as a starting point. That is, if the owner of your specific partnership or SAE also is a 25% or greater owner in any other business, include it in the global cash flow analysis.
In very general terms, I think the message from the regulators is to look far beyond the revenue and expenses of an income producing property - or properties - and look first at the business itself that owns the properties. Conduct a global cash flow analysis to identify potential problems other related parties - including owners and guarantors - might have that could impact your borrower's ability to keep the cash necessary to service your debt. Conversely, identify related parties - including owners and guarantors - that could help your borrower in a crisis to access the cash necessary to service your loan.