April 14, 2015

Q: In addition to loans to owners, why isn't the net movement of loans to and from various related companies subtracted from subject cash flow.

A: The structure of a global cash flow is such that it computes Business "Cash Flow" available to service interest-bearing debt using a formula that is basically EBITDA minus distributions and loans to owners. The purpose of this cash flow proxy is to more clearly identify the impact that owners’ cash flow priorities and practices have on each company’s ability to service debt.

Inter-company loans are quasi-financing activities that may be used by the receiving company to meet a deficit at Business Cash Income. This quasi-financing is provided by another company with a surplus at Business Cash Income as a proactive effort to balance “family” cash flows outside the calculation of Business Cash Income. Inter-company loans do wash to zero, but they do so in the quasi-financing section of the global cash flow statement, which comes after computation of each company's surplus or deficit after meeting its debt service.

Q: Why doesn't global inter-company loans wash to zero dollars in the global cash flow?

A: The global cash flow computation process we suggest is intended to emphasize how the impact of owners’ personal cash flow preferences impact the ability of the business to service interest-bearing debt. Inter-company loans are generally made in an effort to balance cross-company deficits and surpluses revealed after Business “Cash Flow”. Inter-company loans are considered as a quasi-financing activity used to address the financing requirement defined in the UCA Cash Flow statement.

Distributions and Loans to Owners are included in computing Business “Cash Flow” since they are, in effect, compensation payments to owners and should, therefore, be considered as one of the expenses that sum to Business “Cash Flow”. Note also that loans to owners are rarely, if ever, repaid. They are, instead, often converted after the fact to salaries or reclassified as distributions - usually the latter.

Q: Was the situation and financial results in the session a real world situation? Thee operating companies did not have sufficient income to support the debt and that accumulated in years past. The companies never should have been able to accumulate all that debt to begin with. The top line revenue for the fast food restaurants indicate they had low performing stores that need to be closed.

A: The case we use in the webcast is, indeed, a real credit. We scale the numbers slightly and change the locations to disguise the case materials, but nothing else changes.

We use this case because the group in question was highly coveted by numerous lenders in the run-up to the Great Recession. 17 institutions - many quite small - provided term debt to the group of companies. The lead lender was a very large and highly respected institution. Because of its reputation in the market, the marginal lenders seemed to skip any serious credit assessment or due diligence. Assessment, if any, seem to stop with a quick review of the property's stabilized NOI provided in the appraisal report. No attention was given to the financial position of the underlying obligor nor to the financial position of the other parties in the Schumacher group.

As you point out, even a brief analysis of the accrual and cash position of all parties in the group would immediately identify a range of very pressing and, possibly, insurmountable problems.

The case material is dated, to be sure. But numerous lenders tell us that the old times and lending mentality seem to be re-emerging. Consequently, the lessons learned from prior excesses may have a point in today's environment.