National Credit Awareness and Resolution Association, Inc.

CRM #8 – Cash Flow Analysis

 

Business cash flow, cash transferred into and out of a business, is generally the primary source of repayment (PSOR) for most loans, and therefore, is very important to the stakeholders. Loans are underwritten with a comprehensive credit analysis to determine the strength and trend of the PSOR. Positive cash flow indicates that a company as the ability to repay future debt payments. Cash flow originates from business activities, including its operations (main activities of company), investing (investments, capital asset purchases) and financing (debt, equity infusions). Cash flow is analyzed primarily in two ways: traditional method, or the uniform cash analysis method. The traditional method is often used because the needed information is easier to obtain and calculate, and when statements are insufficiently detailed. It also does not recognize growth in accounts receivable or inventory, a slow-down in accounts payable, capital expenditures, or additional borrowings.

 

Traditional Method 

(Earnings before interest, taxes, depreciation, and amortization, or EBITDA, to cover debt service requirements) 

 

Net Income (Amount of net income reported on most recent annual income statement before taxes)

(+) Interest Expense (Add the total amount of interest expense for the period)

(+) Depreciation/ Amortization (Add all noncash depreciation and principal amortization on outstanding debt)

= Cash Flow Before Debt Service (Indicates net Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA. Amortization should include both principal and interest payments required on debt)

(-) Debt Service (Subtract scheduled principal and interest payments)

= Excess (Deficit) Cash Flow (Total amount of excess or deficit cash flow for the period after debt service)

= Coverage Ratio (Cash flow before debt service divided by principal and interest debt service)

 

The uniform or accrual method may be more accurate and reliable and utilizes both the balance sheet and income statement:

 

Uniform Cash Analysis (UCA)

(Cash flow from operational, investment, and financing activities available to service debt)

The cash flow statement will focus on future cash receipts (inflows) and cash disbursements or payments (outflows), from activities in operations, investing, and financing. The net cash position from these activities at the end of the period will be added to the cash at the beginning of the period for the overall cash position for a given period. Specifically, these activities may include:

 

Operating Activities – Include direct cash receipts from customers, and the collection of accounts receivable. Disbursements will include inventory purchases, general operating and administrative expenses, wage expenses, interest expense, and income taxes. Add the receipts, less the disbursements, to show the net cash flow available from operations.

 

Investing Activities – Include cash receipts from the sale of property and equipment, the collection of principals on Notes Receivable, or the sale of any investment securities. Disbursements will include cash paid for the purchase of property or equipment, loans made to others, and the purchasing of securities. The difference in receipts and disbursements will be your net cash flow from investments.

 

Financing Activities – Include cash receipts from any stock issuances or new borrowings, and cash disbursements from any stock repurchases, dividends or loan repayments. The difference in receipts and disbursements will be your net cash flow from financing activities.  

 

Another way to view the excess (or deficit) cash flow after all these activities, including the ability to service debt:

 

Sales (Dollar amount of sales in period)

(+/-) Change in A/R, INV., A/P (Represents the absolute difference of the current period from the corresponding period of the previous year in accounts receivable, inventory, and accounts payable). 

Formula: 

(a) An increase in any current asset is a use of cash and is subtracted from the calculation. Conversely, a decrease in any current asset is a source of cash and is added to the calculation; 

(b) An increase in any current liability is a source of cash and is added to the calculation. Conversely, a decrease in any current liability is a use of cash and is subtracted from the calculation.

(-) SGA (Subtract selling, general, and administrative expenses)

(+) Interest Expense (Add interest expense to the calculation if SGA ‘‘expense’’ includes interest expense)

= Excess (Deficit) Cash Flow (Represents cash available after debt service)

 

Individual Cash Flow 

Personal cash flow for individuals who guarantee commercial loans will be determined by analyzing individual federal tax returns. To calculate the cash flow and debt service coverage using individual tax returns, the actual cash received will need to be determined, together with all debt service requirements paid by the individual(s), taxes and living expenses. For example, using a Federal tax return:

 

Wages

(+) Interest Expense

(+) Dividends

(+) Net Income/Loss + Interest + Depreciation from: Schedule C (Profit or Loss from Business); 

      Schedule E (Supplemental Income and Loss);  Schedule F (Profit or Loss from Farming)     

= Beginning Cash Flow  

(-) Less Taxes (Federal and State Taxes)

(-) Less Living Expenses (Consider reasonable annual living expense amount)

= Cash Flow Before Debt Service

(-) Individual Debt Service: (Subtract individual’s scheduled principal and interest payments)

= Excess (Deficit) Cash Flow (Represents cash available after debt service)

= Coverage Ratio (Cash flow before debt service divided by individual’s principal and interest debt service)

 

Importance: 

 

It’s pretty much a given that during an economic downturn, your cash flow will be impaired. Many businesses will lack the cash flow to stay in business. In today’s economic reality, cash flow problems are ‘off the chart’, clearly in unprecedented times and circumstances. So, NCARA appreciates what you too, may be experiencing. Assuming you are in business, and cash flow has been materially impacted, you need to prepare current and accurate financial statements: Balance Sheet, Income Statement, Cash Flow Statement, and a pro forma Cash Flow Statement for the upcoming year. Please see the NCARA post entitled: “Cash Flow Analysis, Pro Forma Projections”, as this is important and will help you to have a successful work-out loan modification plan. Yes, you are empowered to take matters into your own hands.

 

Utilize your CPA, or google up and review the numerous examples of cash flow statements if you’re not well versed and need additional clarification. When your financial data is prepared, you will need to ensure you are using it from consistent periods (i.e., annually, quarterly, monthly) year over year. Year-to-date financial reporting for the interim period is also important. Consistent financial reporting makes it possible to observe trends and help eliminate any misinterpretation of cash flow for any given business cycle or reporting period. You may request a copy of the ‘financial spreads’ from the creditor showing all your analyzed financial statements. 

 

When creditors originated your loan, they no doubt had certain debt service coverage (DSC) requirements for your longer-term loans. They usually like to see a minimum DSC ratio of 1.25x; they want there to be $1.25 of available cash flow to service every $1.00 of debt. There needs to be some cushion in there, because if it’s less than 1.00x, you may potentially fall short on being able to repay. Depending on the level of deficit cash flow, it doesn’t necessarily mean that you have a serious financial condition that you can’t work-out of. It may be an indication that your business is in a growth stage and you just need some working capital financing to assist with the growth in assets (i.e., accounts receivable, inventory). But if you are experiencing losses, don’t expect the creditor to fund those losses with additional borrowings. If you understand what’s causing the losses, you should be able to make certain decisions to remediate the same while renegotiating your existing debt. You can do this. It’s your responsibility to do so.

 

Again, assuming there are some structural issues affecting your cash flow, like a sustained decline in sales revenues, or other increases in operating expenses, this will likely end up being a work-out loan and you’ll need to prepare a repayment strategy using a pro forma cash flow statement. It is what it is, and you need to actually understand your cash flow, and your ability to repay. You have to absolutely know and understand the root cause of there being deficient cash flow. If you don’t understand the actual reason(s) you can’t fix the problem. So, you have to be prepared with a plan to fix the problem, that which caused the stressed cash flow. Again, you have to know that you can fix it, how you will do it, when you will do it, how much it will cost, etc. Ask questions, talk to your CPA; read on. But, don’t stop until you know you understand your cash flow picture, how it came about, how it will be resolved, and document your assumptions, or your way out of it – you have to present a repayment plan to your creditor and convince him to accept it, or otherwise reach a win-win arrangement. 

 

Your pro forma cash flow statement will be the KEY to getting through this. It will represent your strategy or plan to fix the problem. If you really ‘get it’ and are totally convinced you will bring the plan to fruition, that sir, is the level of ‘ownership’ that will come through loud and clear to your creditor. The creditor needs to get a sense of this level of ownership; he needs to see that you own this. Actually, your creditor should have a strong sense of your ownership in resolving your cash flow issues.

 

You’re the captain. The creditor needs to feel secure enough that if he decides to ‘jump into the boat’ and do a work-out loan with you, as you ‘head out to sea’, he will be okay. You need to see and appreciate the position he and the other creditors are in as you approach this cash flow dilemma. So that you can quickly see where you stand, take a fresh look at your balance sheet. What’s the relationship of debt (creditor) to equity (you)? If it’s higher than 3:1x or even in the 5:1 plus range, well, you pretty much had better be well-prepared in presenting your repayment plan. Why? Because the creditors have 3x or 5x plus more interest in the business than you do, that’s why. 

 

When you ask creditors to get in your boat and go out to sea with you, they have a lot more to lose in the business than you do. Yes, the creditors (generally) have much more to lose than you do. So, before you think this is all about you, do your homework and be well-prepared to have a legitimate and compelling conversation. You are empowered to do this. Let your documented debt resolution plan be based on your best efforts pro forma cash flow statement. The creditor will recognize your ownership and effort, although the cash flow will probably not be what he expected (will likely be less), it is your best work, and therefore your plan should be considered to be a prudent plan that both can agree upon. It will be a ‘win-win’.

 

When you are ‘out to sea’ for a few months with your repayment plan, update your financials and send them to the creditor(s), regardless if there is a financial reporting requirement to do so or not. Take ownership, and show the creditor if you’re on plan or not. Be proactive, and defend your financial performance. If you’re ahead of schedule, explain why. Communicate. Overly communicate. Build a relationship of trust, clarity, and understanding. You may need the creditor’s assistance in the near future, possibly more than once or twice – which is perfectly fine. This isn’t a ‘one and done’ situation. You’re going to stay with this until the issues or problems are resolved, and your loans are repaid – period. 

 

Creditors will likely have more into your business than you do, and it may always be that way for most small businesses. So, don’t take any of your creditors for granted, be they the vendor suppliers, or the long-term lenders for your office/warehouse. They granted you credit in good faith that you will repay pursuant to the underlying terms and conditions, and likely have charged you a competitive and reasonable market rate of interest and fees. So, when your cash flow is deficient, that’s not the creditor’s fault. If you see yourself blaming your creditors for your problems, then please think again.

 

Based on experience, NCARA believes you’d be mistaken to not take full ownership for your business, and therefore well-advised to reconsider your relationships with creditors. Seriously, who is responsible for, and regardless for the reason that caused you to experience financial difficulties, the deficient cash flows? If you’re the owner, then you are responsible. You may not have been behind the actual reasons for the deficiency in cash flow, but you own this business and you are responsible for it. So, act like it, especially if you made decisions that negatively impacted your cash flows. And negotiate in good faith; you may not be as awesome as you think you are if you fail to live up to your loan documentation requirements. 

 

At the end of the day, though, just do your best; that’s all that NCARA is asking. Document your best with current financial statements, and especially the pro forma cash flow statement for the next year. Make your recommendations to the creditor and get the loan modification you actually need. 

 

As a guarantor, the stakeholder creditors will realize that you can only do so much to support deficit cash flows. Your willingness to do so, however, may be less than you might expect – especially if you’ve had to put money into the business for an extended period already, or because you’re beginning to feel insecure about your own personal financial well-being. You can only do what you can do. In the end, if the cash flows have completely failed NCARA believes it’s not worth your marriage and well-being to have a tax return that shows alimony and child support. Surely, you understand.  

 

On a more positive note, please reconsider this word of caution. If your DSC ratio is at least 1.25x, and the trend is increasing over the past few years, it shows that your business is functioning as you intended; your ability to repay is stronger and improving. But before you get too confident, and as you likely well appreciate already, anything can be taken from you almost overnight. We seem to be living in uncertain times. So, it’s wise to control the level of debt and the rate of growth of your business, else you run the risk of having too much debt to service if or when those unexpected economic challenges pop-up. The economy is fragile, indeed very, very fragile.

 

As a reminder, when analyzing the balance sheet, keep in mind how increases or decreases in any balance sheet category is either a source or use of cash. To make this simple to remember, just think of any asset or liability and how cash is affected when it increases or decreases. If you sell a piece of equipment ( decreased asset), you’re going to increase your cash, right? If you obtain a new loan, when the loan is disbursed (increased liability), your cash is also going to increase, right? The following illustration shows whether a change in the balance sheet components is a source (+), or use (-) of cash.

 

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When it comes to things like sources and uses of cash, just realize this is the language the creditor speaks and understands; you should speak and understand it too. Your balance sheet is going to change constantly, the levels will be higher (increase) or lower (decrease) as business decisions are made over time. This simply means that those increases or decreases will result in the cash flow also increasing or decreasing. You want to understand that as you change these levels how it will affect your cash. You’re the ‘pilot’ of your business, your hand is on the ‘throttle’. 

 

Lastly, using the airplane example, the decisions you make as to how fast and high your ‘plane’ or business flies, that’s totally up to you. Creditors avoid making those decisions for you, as they want to avoid potential lender liability issues. But you need to know that your decisions have an immediate impact on your cash. Rest assured that the creditor can see the effects of your decisions and the impact they have on your cash flow. While he may not fully (yet) understand the drivers or root causes behind your cash flow deficiencies, he can likely see whether or not you are going ‘full throttle’ into a mountain side. Knowing why you have cash flow problems, having a clear solution on how you’re going to solve those issues, and being able to document those assumptions behind the cash flows, on a pro forma cash flow statement to show your best efforts to repay, all these are measures are essential to resolving your debt repayment solutions.