July 23, 2014

Q: What factors are used for living expenses on a personal cash flow?

A: Generally, a guarantor will provide rough estimates of his or her living expenses, which we always accept with a healthy dose of skepticism since the expense estimates are never supported with underlying documentation. In this instance, Mr. Schumacher did not provide any information about personal living expenses, so we are compelled to rely heavily on our ability to “know the customer” and understand his or her lifestyle. Such knowledge and familiarity should help us develop some very rough estimates of personal living expenses. For example, it we become familiar with a guarantor’s community involvement, social status, and personal habits, we can use this knowledge as building blocks in establishing a fundamental estimate of personal living expenses.
 
Note, too, that we can identify some personal expenses, such as alimony payments and medical and dental expenses from information provided on Schedule A, for example, in a guarantor’s personal income tax returns.  

In addition, we can take some degree of guidance from the fact that the average U.S. savings rate in recent years has been around 4% to 5% of disposable personal income (DPI). DPI is defined as “the amount of money that households have available for spending and saving after income taxes have been accounted for”. Using the complement to this statistic, individuals are spending roughly 95% of DPI on housing, personal living expenses, debt service, taxes other than income tax, and medical / other expenses.

Regardless of whether a guarantor provides information about his or her personal living expenses or whether we are compelled to estimate those expenses, the resulting estimate is very rough and highly uncertain in the best of circumstances. That, in turn, strongly suggests that the bottom line numbers in a personal cash flow statement, i.e., the personal cash flow surplus or deficit, may be highly inaccurate, which throws further doubt on the use and value of a personal cash flow statement as a measure of guarantor support for company debt service in a crisis.

Q: Where will the owner get the $1.65mm in down payment for the apartment building purchase if there is not enough cash shown on the balance sheet?

A: Cash not currently available to any company generally comes from one of three sources – cash from operations, additional borrowing, or from additional equity investment.

Since Fresno Properties cash flow is somewhat strained, the cash to be invested must come from additional borrowing or from an additional cash equity infusion. This is an important question to review with Mr. Schumacher because the source of the new cash will have an impact on the balance sheet structure, the company’s leverage and ability to service debt in the future, and our strategy in structuring a new loan.

Q: Could you address the impact if there were loans from shareholders?

A: Loans from shareholders would show up as financing and, therefore, affect the leverage of the company. As financing, they do not play a role in our estimate of individual or global cash flow available to service interest-bearing debt. In other words, we do not classify loans from shareholders as an offset to either distributions to shareholders or loans to shareholders. Loans from shareholders are expected to be repaid. Further, they frequently represent emergency financing and appear only because the company could not obtain financing from other sources.

Based on our analysis of Fresno Properties, Mr. Schumacher, and the related parties, we would want to subordinate repayment of shareholder loans and carefully monitor all forms of compensation to the shareholder(s) granting the loan.

Q: Can you talk about different percentage ownerships. Is 82% on the Modesto Services Schedule K-1 a typo?

A: The Modesto Services, Inc. Schedule K-1 issued to Mr. Schumacher as an 82% owner is correct. Clovis Supply (100% owned by Schumacher) owns the other 18% of the company (confirmed in Modesto Services F/S Footnote #4).  

The ownership breakdown for each of the companies is as follows: