Global Cash Flow Webcast on April 19th 2012
Q: Why don't you also include "loans from owners, or additional contributed capital" in business “cash flow”?
A: Loans from owners and capital contributions serve an entirely different purpose than distributions and loans to owners. Distributions and loans to owners are cash outflows for operating expenses, since those cash outflows represent cash for income tax payment on company profit by the owners and cash for owner compensation, if the sum of distributions and loans exceed the amount the owners need to satisfy the company income tax obligation.
When owners put money into the company in the form of loans or capital contributions, those loans or capital contributions represent financing, usually emergency financing, because the company can’t get the money anywhere else.
Q: What would the impact be on the global cash flow if a minority partner of one of the related entities contributed cash capital to that business?
A: If a minority partner, or majority partner, made a cash capital injection that would have no effect on global cash flow because a capital injection is considered to be financing. It is not an operating cash flow. It would be nice to know if such a possibility existed, once we compute the likely global financing requirement to meet anticipated debt service.
Q: If loans to owners are subtracted from cash flow, what happens when the owner loans to the company?
A: As noted above, loans to companies are treated as financing and do not impact operating cash flow and, therefore, the financing needed to meet debt service, if such financing is needed.
Q: For distributions to owners that are discretionary, can that amount be left in the cash flow calculation?
A: Discretionary is extremely difficult to assess. One way to think about this is that salary is discretionary, bonuses are discretionary, and distributions are really no different. The money has gone out the door, and once that money has gone out the door, it is indeed gone.
Quite frequently, owners become accustomed to a certain life style. They are accustomed to spending the money, and they get locked into personal financial obligations and elevated living expenses. These outflows from the company to the owners are the lifeline that supports the lifestyle, and so these distributions are not the slightest bit discretionary.
In the case of Fritz Schumacher, we see that the $1.7 million that he took out of his companies in 2007 is gone. We have no reason to believe that his spending habits will be any different in 2008.
To confirm whether or not that is the case, we need to be in close communication with, in this instance, Fritz Schumacher. For all of our borrowers, we need to determine how tightly they are tied to the company and where their money does go.
Rich life styles are really hard to reverse – people get used to their lifestyles and cutting back requires a tremendous amount of discipline. So in most cases distributions are not discretionary. Rather, they are more mandatory than we like to believe.
Q: If we can agree that a DSC ratio of 1.15 to 1.20 is a minimum acceptable level for an entity. What would you expect the global DSC ratio to be? The same or higher?
A: 1.15 to 1.20 would be a minimum. As risk increases for any party included in a global cash flow scenario, the minimum DSC should also increase. The minimum debt service coverage is subjective and is based on our perception of the likelihood that the business “cash flow” (this proxy for cash flow from business operations) will all be converted to cash. If we were 100% certain, then the minimum DSC would be 1.00. If we believe that there is risk that not all of that business “cash flow” will be converted to cash, then the DSC increases.
Q: You portray mini perm debt as all due at maturity without considering for an extension of maturity on this debt. Shouldn't the global analysis include an analysis of the likelihood of this debt being extended for a number of years?
A: It is difficult to determine if that term debt can be restructured. We need to work with the existing debt repayment schedule to determine the magnitude of the problem and assess the prospects that so much debt could indeed be restructured or rescheduled. At this point in our analysis, we have no way of knowing what the lenders – who have extended credit on these terms – are willing to do. We certainly hope that Fritz Schumacher can be successful at negotiating a restructuring, but as we concluded in the session, hope is not a risk mitigant.
Q: Are you deducting “historical” loans to owners out of current business cash flow? If so, I am having trouble understanding that concept because it appears that current year business cash flow does support the loan if you exclude loans that were made to owners prior to the current year. The funds left the company and went to the owners in prior years but are taken out of current cash flow analysis (except the revised analysis at the end which makes sense to me).
A: We look at loans in the current period, which have a cash flow impact in the current period. Loans in the current period to owners have the very same dollar-for-dollar impact as distributions in the current year. In addition, loans to owners are frequently advance distributions which are subsequently converted to distributions after the cash has left the company by means of a very simple set of accounting entries.
Q: How do you handle recurring and non-recurring global cash flow because it appears that there is a combination of recurring and non-recurring in the analysis? It seems that on a recurring cash flow basis things are pretty good but when you add in non-recurring such as a loan coming due, it looks really bad.
A: It's critical to use non-recurring revenues and expense but it is also critical to identify future events that can have a significant impact on individual and collective cash flow. Such is the $2,284,569 scheduled debt payment. It is THE problem this company and group of companies must address. It's non-recurring after the coming year. If we overlooked such an issue, we would shoot ourselves in both feet. So, it's a matter of judgment. For example, we exclude most capital gains and losses as non-recurring events when projecting cash flow. But if we knew of a forthcoming cash loss of any magnitude, it would be an essential consideration in our assessment.
Q: How many companies are going to have enough cash to pay off a substantial real estate loan that is coming due? I understand the underwriting concept of looking at a real estate loan coming due but to expect the payoff of the loan to be supported by cash flow is confusing to me assuming the funds were borrowed to purchase real property.
A: You don't have this information but in 2004 or 2005 Sequoia Properties had a similar sized scheduled debt repayment which it met by increased borrowings from related companies that channeled the proceeds to Sequoia. Schumacher will likely try that again in 2008 but now he and his companies are in a far different lending environment. We do expect companies to service their debt obligations from business cash flow. In fact, all or our analysis around income producing properties is to determine if the property can throw off sufficient cash to service the debt, which means paying interest expense and repaying long term debt as scheduled. In this instance, I'd give Sequoia and Schumacher very low marks for agreeing to such a repayment schedule in the first place. I'm also curious why a lender would impose such a payment. I suspect Schumacher thought he could either re-negotiate when the time came or use other companies to borrow the money, since he had done so in the past.
Q: I have a problem accepting your global cash flow analysis on two points. One is that in your model you penalize an owner for taking a distribution from the company in your global cash flow analysis yet when that same owner puts money back into the company you do not want to consider that money in your global cash flow analysis. Many times owners take such distributions prior to year end to shift tax burden from the company to themselves and then repay the company right after year end, yet you are saying we should not consider the debt repayment to the company in our global cash flow analysis. This makes no sense to me.
The other point is your approach to mini perm debt. It is my firm belief that when mini perm debt is coming due that the bank should assess that particular loan and see if it would qualify for renewal under the analyzing bank’s guidelines. If it does then use the CPLTD on such a debt restructure/renewal in your global analysis, not the principal that is coming due. If it does not then I would agree with your logic that it is money that has to be repaid at maturity.
A: Let me outline the approach we use in constructing and assessing cash flow and global cash flow.
1. Following the Uniform Credit Analysis (UCA) format and classification rationale, we treat distributions and loans to owners as operating expenses representing cash payments to owners for their tax payments on company taxable income or for compensation if the distributions and loans exceed the required amount of cash necessary to satisfy the income tax obligation on underlying pass-through company taxable income.
2. We categorize loans to owners in this operating expense category since many distributions begin life as a loan to owners that is subsequently reclassified as a distribution via a simple set of accounting entries after the fact. However, if an owner repays the loan by reducing the Due from Owners balance, we consider that an operating cash inflow for the company - or a reduction in operating expenses - and, in effect, give credit for this cash inflow. Frequently, a reduction in a Due from Owners balance reflects a reclassification of an earlier loan to a distribution. For this reason we focus on the sum of distributions and loans to owners and not on each separately.
3. If an owner puts money back into his company as a loan which increases the Due to Owners balance, we consider that a related party financing event. As such, it drops out of the operating cash flow section of the UCA cash flow statement and is included in a related parties section below fixed asset spending but before the summation of all cash inflows and outflows that provides the financing requirement or surplus for the year. Since the owner channeled his or her loan to a Due to Owners account, he or she obviously expects to be repaid at some point. In my experience, such owner loans are very frequently emergency financing, reflecting company difficulty in arranging outside financing quickly enough to meet pressing cash flow needs.
4. If an owner provides a capital injection, we classify that as a financing event in the UCA cash flow statement along with changes in short term and long term debt from outside third parties. If the sum of such financing events exceeds the financing requirement, the cash balance increases...and vice versa.
5. In the UCA and global cash flow construction, we attempting to determine if individual company cash flow as well as global operating cash flow is sufficient to meet individual and global cash flow debt service. If it is not, then we look historically to determine the source of cash to meet debt service. The source of cash may be, in part, loans from owners or capital injections from owners. When we project forward, it's the same issue and, once again, loans from owners may be a source of cash to meet any debt service requirements.
6. We don't wish to penalize an owner's contribution in servicing company debt. But we examine a possible cause for an inability to properly service company and global debt by focusing on the role distributions and loans to owners play. We then examine a possible solution to the cash flow deficit by identifying loans from owners and owner capital contributions. We keep the two cash flow streams separate because they serve different purposes and arise for very different reasons.
With respect to distributions to shift the income tax burden from the company to the individual, I'm not sure how readily this occurs. Distributions do not impact a company's taxable income since they cannot be deducted as an expense. Therefore, if an owner were to take significantly large distributions from the company in the final quarter of the year, it would have no impact on the company's taxable income and no impact on his or her pro-rata share of company taxable income he or she must report on Schedule E and bring into Line 17 on Form 1040. The personal income tax burden would remain the same regardless of the size of the distributions since the company's taxable income has not changed and distributions are tax-free to the recipient, i.e., they are not captured or reported as taxable revenue on Form 1040.
Further, if an owner decided to swap fourth quarter salary and bonus for distributions, the impact would be a wash. He or she would pay less income tax on reduced salary and bonuses but reduced salary and bonuses increase company taxable income, which flows back to Schedule E and to Line 17 on Form 1040.
A salary/distribution swap that makes sense would revolve around the Section 179 deduction. For example, suppose a company purchased $200,000 of fixed assets that were eligible for a $200,000 Section 179 deduction. To take the full amount of that deduction, the company's ordinary business income must be at least $200,000. Therefore, to assure a $200,000 profit, an owner could cut back on his or her salary sufficiently to assure the $200,000 profit and then take a dollar-for-dollar distribution to offset the salary reduction. Not only does he or she get more after tax-dollars, but the owner now gets to eliminate his or her personal income tax burden on the company's taxable profit via the Section 179 deduction. From the company's perspective, and from its debt service prospects, nothing has changed except that it now has a lesser FICA and Medicare tax payment because of reduced employee salaries.
I do frequently see very heavy fourth quarter distributions to satisfy the personal income tax burden but that personal income tax burden, in these instance, is usually driven by considerable company profit that the owner must report as his or her personal and taxable income. It's company profit in the non Subchapter C corporations that drives up the personal income tax burden and the need for heavy distributions.