Financial Lending Notes
November 25, 2009

Assessing Approaches - How Do You Measure Cash Flow?

Lenders use different methods to determine cash flow available to cover a business’ debt service. Since each has its own advantages and drawbacks, it usually makes sense to use more than one approach. Here are the primary ways to measure cash flow, and pros and cons of each.

EBIT/EBIDA/EBITDA: These and other variations on Earnings Before Interest, Taxes, Depreciation and Amortization are commonly used to help determine a borrower’s ability to earn enough money to service its debt. They all have relevance in a lender’s financial analysis because you don’t want to lend money to borrowers who can’t pay it back.

These approaches are especially helpful in establishing loan covenants, and they can serve as a basis of comparison with other companies in the borrower’s industry. EBIDA is a more accurate measure of a company’s ability to earn its debt service, provided you subtract an estimate of distributions in lieu of taxes (e.g., 34 percent of net income) for S corps, partnerships and LLCs.

Uniform Credit Analysis (UCA): The biggest drawback of the EBITDA methods is that, while they measure a borrower’s ability to earn its debt service, they don’t address what the company actually did with the money.

This is where the UCA method can help. It starts with the income statement and highlights changes in the balance sheet that impact cash. One of the biggest benefits is that it helps you see where cash is “pooling up.” A big increase in accounts receivable, for example, can be a huge cash pool that’s sucking a business dry.

UCA unwinds the timing differences introduced by accrual accounting, turning an accrual-based statement into a cash-based statement. It starts with sales and focuses on changes in receivables, inventory, payables, cost of goods sold, etc. Its main drawback is that it assumes that the first priority for the use of cash is working capital and everything else is discretionary.

While this may reflect reality, it doesn’t consider the borrower’s priorities. For most owners, growing the business becomes first priority, followed by paying operating expenses, supporting the owner’s lifestyle, and then paying taxes, interest, debt service and replacement of capital expenditures. But any owner who doesn’t service the company’s debt and replace fixed assets will soon be out of business.

Core Cash Flow: This method solves the primary shortcoming of UCA by addressing priorities for the use of cash and when it’s appropriate to change these priorities. As the name implies, it determines the core cash flow that’s available to service debt. The calculation is as follows:

Net Profit
+ Depreciation and Other Non-Cash Charges
– Replacement Capital Expenditures
– Scheduled Debt Service
– Distributions in Lieu of Taxes (S corps/LLCs)

Personal Cash Flow: None of these approaches works well with borrowers submitting personal financial statements and tax returns. After all, adjusted gross income on an IRS 1040 form doesn’t represent cash available for debt service any more than net income plus depreciation and other non-cash charges does. Personal Cash Flow available for debt service is calculated as follows:

Wages & Salaries
+ Interest & Dividends (excluding amounts paid to C corps and LLCs)
+ Net Income (Schedule C)
+ Depreciation & Interest
+ Rental Income (Schedule E)
+ Depreciation & Interest
+ Distributions (S corps and LLCs)
– Contributions (LLCs)
– Taxes – Estimate of Personal Living Expenses

Global Cash Flow: With more borrowers organizing as S corps, LLCs and partnerships, many banks are integrating business and net personal cash flow into what’s now known as Global Cash Flow.

Looking carefully at a borrower’s business and personal financial affairs may give you a better, more accurate picture of that individual’s true financial situation, especially for borrowers operating through multiple entities.

Do Your Own Due Diligence

As a lender, you should be prepared to complete due diligence on the financial condition of borrowers who are not receiving more comprehensive accounting information and assistance from their CPA. Begin by asking a few fundamental questions. For example, where did a borrower’s inventory numbers come from? How is inventory tracked, and what items were actually sold? If the owner can’t answer these basic questions, this will cast doubt on all the inventory numbers on the financial statement, which also calls into question the cost of goods sold, net income, retained earnings, etc. In effect, the accuracy of the entire financial statement is now in doubt.

 

Compliments of:

Porter Keadle Moore, LLP (PKM) is a full service accounting firm based in Atlanta, Georgia. PKM offers audit, tax and systems services to clients throughout the country. The firm focuses its efforts on companies registered with the Securities and Exchange Commission (SEC), community banks, the insurance industry, technology and life sciences companies and the real estate/construction industry.

Follow this link to learn more about PKM's banking practice.
 

To discuss this article contact Tim Messman, CPA with Porter Keadle Moore, LLP at tmessman@pkm.com.

Tim provides accounting and auditing services to financial institutions as well as clients in the construction, service, technology/life sciences and manufacturing/distribution industries. He routinely works with companies registered with the Securities and Exchange Commission; privately-owned companies and S Corporations. He has experience with Initial Public Offerings (IPOs), Mergers and Acquisitions, Sarbanes-Oxley compliance and internal control consulting.

 

Pat has over 23 years of experience in public accounting. He has worked with clients ranging from individuals to international Fortune 50 companies in a variety of tax consulting and compliance areas. He is most active in the real estate and banking industries, serving numerous clients across the Southeast. Pat has led PKM’s tax practice since 2003. Prior to joining PKM he was a partner with KPMG, where he spent 17 years of his professional career. You can contact Pat at ptuley@pkm.com.