Questions & Answers, GCF, September 15, 2011
Q: What is NOI?
A: Net operating income (NOI) is the amount of income for an income producing property remaining after accounting for all property operating expenses, excluding depreciation expense, i.e., the amount of property income – or property cash flow – available to a) service interest-bearing debt on the property and b) provide a return on investment to the equity investors in the property.
Q: What about the $4,112,432 capital contribution to Sequoia Properties as shown on the 2007 K1 in section L?
A: According to Footnote 4, Schumacher converted $4,112,432 of debt to equity in 2007, i.e., he converted $4,112,432 of loans to the company to equity. That means that actual new long-term debt was greater by the amount of the conversion, since that amount was replaced and then added to during the year to arrive at the totals for 2007. In effect, 2006 long-term debt decreased in 2007 by $4,112,432 from $18,939,965 to $14,818,533 when the conversion from long-term debt to equity occurred by two simple accounting entries – a $4,112,432 debit to long-term debt and a $4,112,432 credit to a partners’ capital account. At the end of 2007, long-term debt was the sum of $2,284,569 of current maturities and $19,710,939 of remaining long-term debt or $21,995,508. Measured against adjusted 2006 long-term debt of $14,818,533, the amount of new long-term debt arranged by the company in 2007 was $7,176,975.
Q: How do you reconcile multiple guarantors in a global cash flow hypothesis? For example, say all of these entities share ownership with two other people (John and Jane Doe). Traditionally we have made the assumption that you take all 3 guarantors capacity plus the businesses and net it all out to get the global. I have had a lender tell me he did not like that method because it assumes that all 3 people are paying each other's personal debt as well. Is it best then to simply do a global cash flow using liquid worth (from PFS) and to ignore FYE cash flow from each guarantor?
A: We need to focus on the liquid cash resources on the balance sheet of a guarantor as the ultimate cash support the guarantor may provide to a relationship and not the annual cash flow that guarantor may receive. In addition, we need to consider the total amount of debt the owner has guaranteed.
As an example, in the case of Fritz Schumacher, owner of Fresno Properties, we calculated that his personal cash surplus in 2007 was $1,757,955 and, yet, Schumacher’s ready cash support on his personal balance sheet that year was only $272,706. Additionally, we determined that Schumacher had total guaranties outstanding of approximately $25 million. If we focused on personal cash surplus, we would be badly over-estimate the actual amount of cash support available from Schumacher.
Of course, the opposite could prevail. Schumacher could have more liquid cash available to support company debt service than cash flow for the year. Either way, it’s the liquid cash support that counts, not the personal cash surplus.
Q: The global cash flow shown includes distributions and loans to shareholders. Do you ever consider including contributions? These distributions and loans may be one time-events offset by either the sale of an asset, capital contributions by other partners, or loans against assets? If not: Why?
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: What is NOI?
A: Net operating income (NOI) is the amount of income for an income producing property remaining after accounting for all property operating expenses, excluding depreciation expense, i.e., the amount of property income – or property cash flow – available to a) service interest-bearing debt on the property and b) provide a return on investment to the equity investors in the property.
Q: What about the $4,112,432 capital contribution to Sequoia Properties as shown on the 2007 K1 in section L?
A: According to Footnote 4, Schumacher converted $4,112,432 of debt to equity in 2007, i.e., he converted $4,112,432 of loans to the company to equity. That means that actual new long-term debt was greater by the amount of the conversion, since that amount was replaced and then added to during the year to arrive at the totals for 2007. In effect, 2006 long-term debt decreased in 2007 by $4,112,432 from $18,939,965 to $14,818,533 when the conversion from long-term debt to equity occurred by two simple accounting entries – a $4,112,432 debit to long-term debt and a $4,112,432 credit to a partners’ capital account. At the end of 2007, long-term debt was the sum of $2,284,569 of current maturities and $19,710,939 of remaining long-term debt or $21,995,508. Measured against adjusted 2006 long-term debt of $14,818,533, the amount of new long-term debt arranged by the company in 2007 was $7,176,975.
Q: How do you reconcile multiple guarantors in a global cash flow hypothesis? For example, say all of these entities share ownership with two other people (John and Jane Doe). Traditionally we have made the assumption that you take all 3 guarantors capacity plus the businesses and net it all out to get the global. I have had a lender tell me he did not like that method because it assumes that all 3 people are paying each other's personal debt as well. Is it best then to simply do a global cash flow using liquid worth (from PFS) and to ignore FYE cash flow from each guarantor?
A: We need to focus on the liquid cash resources on the balance sheet of a guarantor as the ultimate cash support the guarantor may provide to a relationship and not the annual cash flow that guarantor may receive. In addition, we need to consider the total amount of debt the owner has guaranteed.
As an example, in the case of Fritz Schumacher, owner of Fresno Properties, we calculated that his personal cash surplus in 2007 was $1,757,955 and, yet, Schumacher’s ready cash support on his personal balance sheet that year was only $272,706. Additionally, we determined that Schumacher had total guaranties outstanding of approximately $25 million. If we focused on personal cash surplus, we would be badly over-estimate the actual amount of cash support available from Schumacher.
Of course, the opposite could prevail. Schumacher could have more liquid cash available to support company debt service than cash flow for the year. Either way, it’s the liquid cash support that counts, not the personal cash surplus.
Q: The global cash flow shown includes distributions and loans to shareholders. Do you ever consider including contributions? These distributions and loans may be one time-events offset by either the sale of an asset, capital contributions by other partners, or loans against assets? If not: Why?
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.