Questions & Answers, Global Cash Flow, April 12, 2011
Q: Regarding repayment sources, it's always been considered that the order should be: NOI or OCF (depending on loan type), liquidation of collateral and third, guarantor. Guarantor is last because they don't necessarily have the assets to cover the loan amount.
A: As we 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 (SAE) 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: Generally, unless the related companies are Guarantors to the proposed deal, we do not have access to the related company's financials nor would we use their sources/uses in global cash flow calculations. We would only use the Borrower and Guarantor info for analysis. Is that the case in this example?
A: You are correct in the sense that if you do not have the guaranty of related parties, you do not have a legal recourse to their cash flows.
However, if you don't have access to related party information or don't require access to such information, then the resulting global cash flow statement and all the messages from it will be incomplete and possibly misleading.
In this instance - Fresno Properties and Fritz Schumacher - the lender required all related party information as a condition precedent to considering the loan. Regardless of legal obligations, etc., the lender simply said we won't consider this deal until we have all relevant information. To this lender, Schumacher was the whole show and it was his guarantee that mattered, particularly since he owned and controlled the other related parties. Even more important to the lender was information about the related parties and not necessarily their guarantees.
Do not forgo the pursuit of possibly critical information because it's not delivered as part of the package. Problems elsewhere in the system could be devastating to our specific borrower.
Q: Would you add back cash contributions and loan repayments to the cash flow?
A: It is fairly common to find a Due from Shareholders account on the asset side of a borrower’s balance sheet and then a Due to Shareholders account on the liability side of the same balance sheet. Further, the balances in both accounts normally change from period to period. Depending on the direction and magnitude of the changes, the shareholders or owners either put cash into the company or take cash from it on a net basis. Consequently, it seems simplest to collect the changes in one location on the cash flow statement and designate that line item as either a) a cash inflow to the company, which decreases its financing requirement, or b) a cash outflow from the company, which adds to its financing requirement.
But it is not so simple. There are two separate accounts because the cash flows into and out of these accounts take place for very different reasons.
The answer is no. If the owner had wanted to eliminate his or her loan from the company with a $100,000 payment to the company, he or she would have specified that the $100,000 was for the purpose of repaying the loan. The balance in the Due from Shareholders account would have been eliminated by the cash inflow from the owner. But the owner obviously had no intention of repaying the loan. Furthermore, by designating the $100,000 cash inflow to the company as a loan and not as a capital injection, the owner very definitely intends to be repaid the full $100,000 when the company has the cash resources to do so.
There are some further complications in interpreting movements in the Due from Shareholders and Due to Shareholders accounts. If the balance in the Due from Shareholders account decreases, we quite naturally assume that the owner has repaid some or all of the money he or she has borrowed from the company.
But the facts may be very different. If the company in question is a Subchapter S corporation, partnership, limited liability company, or sole proprietorship, the reduction in the Due from Shareholders account may simply reflect the conversion of a loan to a distribution or withdrawal via a set of offsetting accounting entries,. That is, the owner borrows from the company during the year either to make quarterly income tax payments on company profit or to increase his or her effective compensation. At the end of the year, the internal bookkeeper or outside accountant decides to convert some or all of the loan balance to a distribution or withdrawal with a credit entry to Due from Shareholders, which decreases that account balance, and an offsetting debit entry to Distributions or Withdrawals, which decreases retained earnings or proprietor’s capital.
The reduction in the Due from Shareholders balance does not reflect a cash repayment of some or all of the outstanding loan balance. Quite the contrary. Cash went out of the company to the owner when he or she borrowed the money initially that increased the balance in the Due from Shareholder account. The subsequent reduction in the Due from Shareholders account reflected a non-cash event that converted some or all of the loan balance to a distribution or withdrawal.
For a Subchapter C corporation, a reduction in the Due from Shareholders balance will not reflect the conversion of loans to distributions, but it frequently reflects the conversion from loans to an owner to additional salary to that same owner. In the conversion process, the company will provide the owner with the additional cash necessary to meet the tax withholding requirements on the newly provided “salary”.
Loans to owners and distributions or withdrawals, on the one hand, represent either income tax expense or compensation or both. Regardless of how we classify these events in accordance with accounting conventions, they are operating expenses for the company and need to be recognized as operating expenses, which effectively decrease reported profit and decrease debt service resources.
Loans from owners, on the other hand, represents financing and, usually, emergency financing. Such loans are not offsets or reductions to loans to owners but a very separate event with a very different objective.
Consequently, it is critical in assessing the risk profile and the debt service prospects of a borrower that we fully acknowledge the fundamental difference between these two categories of cash flows. One is an operating event, which belongs in the expense stream on the income statement and in the operating section of the cash flow statement. The other is a financing event, which does not touch the income statement but, rather, belongs on the balance sheet and in the financing section of the cash flow statement.
Q: Regarding repayment sources, it's always been considered that the order should be: NOI or OCF (depending on loan type), liquidation of collateral and third, guarantor. Guarantor is last because they don't necessarily have the assets to cover the loan amount.
A: As we 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 (SAE) 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: Generally, unless the related companies are Guarantors to the proposed deal, we do not have access to the related company's financials nor would we use their sources/uses in global cash flow calculations. We would only use the Borrower and Guarantor info for analysis. Is that the case in this example?
A: You are correct in the sense that if you do not have the guaranty of related parties, you do not have a legal recourse to their cash flows.
However, if you don't have access to related party information or don't require access to such information, then the resulting global cash flow statement and all the messages from it will be incomplete and possibly misleading.
In this instance - Fresno Properties and Fritz Schumacher - the lender required all related party information as a condition precedent to considering the loan. Regardless of legal obligations, etc., the lender simply said we won't consider this deal until we have all relevant information. To this lender, Schumacher was the whole show and it was his guarantee that mattered, particularly since he owned and controlled the other related parties. Even more important to the lender was information about the related parties and not necessarily their guarantees.
Do not forgo the pursuit of possibly critical information because it's not delivered as part of the package. Problems elsewhere in the system could be devastating to our specific borrower.
Q: Would you add back cash contributions and loan repayments to the cash flow?
A: It is fairly common to find a Due from Shareholders account on the asset side of a borrower’s balance sheet and then a Due to Shareholders account on the liability side of the same balance sheet. Further, the balances in both accounts normally change from period to period. Depending on the direction and magnitude of the changes, the shareholders or owners either put cash into the company or take cash from it on a net basis. Consequently, it seems simplest to collect the changes in one location on the cash flow statement and designate that line item as either a) a cash inflow to the company, which decreases its financing requirement, or b) a cash outflow from the company, which adds to its financing requirement.
But it is not so simple. There are two separate accounts because the cash flows into and out of these accounts take place for very different reasons.
- If an owner borrowers from his or her company – which increases the balance in the Due from Shareholders account – it is invariably to a) use the cash as an advance distribution to pay personal income taxes on company profit or b) to use the cash for compensation – or both.
- If an owner lends money to his or her company – which increases the balance in the Due to Shareholders account – it is usually to provide emergency financing in the absence of necessary financing from outside third parties.
The answer is no. If the owner had wanted to eliminate his or her loan from the company with a $100,000 payment to the company, he or she would have specified that the $100,000 was for the purpose of repaying the loan. The balance in the Due from Shareholders account would have been eliminated by the cash inflow from the owner. But the owner obviously had no intention of repaying the loan. Furthermore, by designating the $100,000 cash inflow to the company as a loan and not as a capital injection, the owner very definitely intends to be repaid the full $100,000 when the company has the cash resources to do so.
There are some further complications in interpreting movements in the Due from Shareholders and Due to Shareholders accounts. If the balance in the Due from Shareholders account decreases, we quite naturally assume that the owner has repaid some or all of the money he or she has borrowed from the company.
But the facts may be very different. If the company in question is a Subchapter S corporation, partnership, limited liability company, or sole proprietorship, the reduction in the Due from Shareholders account may simply reflect the conversion of a loan to a distribution or withdrawal via a set of offsetting accounting entries,. That is, the owner borrows from the company during the year either to make quarterly income tax payments on company profit or to increase his or her effective compensation. At the end of the year, the internal bookkeeper or outside accountant decides to convert some or all of the loan balance to a distribution or withdrawal with a credit entry to Due from Shareholders, which decreases that account balance, and an offsetting debit entry to Distributions or Withdrawals, which decreases retained earnings or proprietor’s capital.
The reduction in the Due from Shareholders balance does not reflect a cash repayment of some or all of the outstanding loan balance. Quite the contrary. Cash went out of the company to the owner when he or she borrowed the money initially that increased the balance in the Due from Shareholder account. The subsequent reduction in the Due from Shareholders account reflected a non-cash event that converted some or all of the loan balance to a distribution or withdrawal.
For a Subchapter C corporation, a reduction in the Due from Shareholders balance will not reflect the conversion of loans to distributions, but it frequently reflects the conversion from loans to an owner to additional salary to that same owner. In the conversion process, the company will provide the owner with the additional cash necessary to meet the tax withholding requirements on the newly provided “salary”.
Loans to owners and distributions or withdrawals, on the one hand, represent either income tax expense or compensation or both. Regardless of how we classify these events in accordance with accounting conventions, they are operating expenses for the company and need to be recognized as operating expenses, which effectively decrease reported profit and decrease debt service resources.
Loans from owners, on the other hand, represents financing and, usually, emergency financing. Such loans are not offsets or reductions to loans to owners but a very separate event with a very different objective.
Consequently, it is critical in assessing the risk profile and the debt service prospects of a borrower that we fully acknowledge the fundamental difference between these two categories of cash flows. One is an operating event, which belongs in the expense stream on the income statement and in the operating section of the cash flow statement. The other is a financing event, which does not touch the income statement but, rather, belongs on the balance sheet and in the financing section of the cash flow statement.