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Keeping an eye out for warning signs is a step often overlooked when analyzing tax returns. It is too easy to do the number-crunching without keeping the thinking cap on as you go.
What kind of signs?
The business is in trouble
A lawsuit is in progress that could derail the company
The owner is getting set to retire and there is no successor in sight
The business is changing course
Watch for these signs and, if you see them, ask questions.
1. The owner is taking less out than the company can afford.
In most closely-held businesses, the company makes the money and the owners take it home. Period.
If the owners leave money on the table, it could be because the company is getting ready to expand significantly. Expansion periods tend to be riskier than stable periods.
2. Legal fees have increased dramatically.
This may mean a lawsuit is in progress. It also could be accounting or bookkeeping costs. Or perhaps other legal services such as intellectual property protection are in the works.
If a lawsuit is in progress, focus on the likely and the worst future outcome. Can the company handle it?
A contract dispute in which they’ll have to pay if they lose is not much of a problem if they can afford it. A product dispute in which they may lose the right to manufacture their best product is a problem.
Lawsuits and settlements happen in business. The important factor is whether they can handle the outcome.
3. Discretionary expenses have dropped significantly.
A common short-term fix to problems is to cut back on costs. If repairs and maintenance has dropped dramatically when they have not recently replaced older equipment, it is worth noticing.
I would then start looking for a pattern with other costs…and for other signs of problems. It may be nothing. They may have done a lot of preventative maintenance last year which is why this year’s cost are lower.
4. Ownership has changed.
For a corporation, you can check Schedule E, Compensation of Officers in the 1120 return. For a partnership return, look at k-1s if you have them or at Schedule B, Other Information. One of the questions in that schedule is about distribution of property or a transfer of a partnership interest. You need a source other than the tax return for the same information on an S Corporation unless you have all the k-1s.
For closely-held companies, the continued success is tied closely to the experience of the owner/managers. Make it a practice to find out if the ownership/management has changed, even when the tax return you are reviewing is another business owned by the guarantors and not the primary business you are lending to.
5. Cash reserves are low or have dropped.
While it is not apparent in a sole proprietorship (or a one-owner LLC filing Schedule C), the corporation and partnership returns include a balance sheet with information on beginning and ending cash. Watch for a significant drop or amounts that are not adequate.
With closely-held c-corporations, it is common for the liquidity to be low in the business because the owners take compensation out each year to bring the company to zero profit, often at the advice of their tax professional. And the owners of pass-through entities like LLCs, partnerships and s-corporations may not be focused on company liquidity if they are putting excess compensation or distributions in liquid assets they own personally.
If the guarantor’s personal balance sheet shows good liquidity and net worth, many commercial lenders either use that as a compensating factor or do a global analysis of both the business and the primary guarantor.
You can require minimum cash balances or other liquidity indicators as a condition of your loan.
6. The business is selling off equipment that is critical to operations.
Check Form 4797 to see if there is a Gain or Loss on Disposal of Business Assets. Or take a look at the borrower’s internal equipment list if you have access to it.
Consider if this is just the normal selling and replacing of equipment. If a business is selling off critical items and not replacing them, it may mean cashflow problems or a dramatic change in the business.
7. The family-owned sole proprietorship is not paying wages to family members.
Actually, there is nothing wrong with this practice and it is common in small companies. The problem is if you don’t notice it, and mistakenly think that the sole proprietorship profit is just paying one person instead of two or more.
Make it a practice to understand if and how family members are getting paid. And consider if some of the non-wage family members may be leaving the business soon, requiring hiring of others.
8. The owner is taking out more than the company can afford.
This may seem obvious…and that is why you need to be careful. There is nothing wrong with the owner taking out more than the company can afford on occasion.
There may have been a cash windfall because of the sale of an asset no longer needed, an insurance settlement or a one-time contract that won’t be repeated.
And when you project cashflow, you leave out nonrecurring income items which were available to boost owner take-home. I’d take it home…wouldn’t you?
9. The owner is writing off significant, personal expenses.
Many people, including many lenders, think this is one of the ‘perks’ of being in business for yourself. When it is blatant and excessive, it signals a willingness on the part of your borrower to mislead third parties (the IRS) for financial gain (less taxes).
Your bank is a third party and they want money from you.
There are groups of borrowers who are extremely aggressive in their tax-returns. Commercial Real Estate developers and investors come to mind. Know what is normal for your clientele.
10. Taxes and licenses do not seem to be sufficient given the wages paid.
Payroll taxes vary, but run between 10% and 40% of wages. It is a very quick check to compare 10% of wages to the figure in the taxes and licenses line.
Payroll taxes are only a part of the ‘Taxes and License’ line item on the return. If it doesn’t even cover adequate payroll taxes you may have a problem. Or they may have an overpayment rollover from a previous year.
I can promise you that if you and the IRS are in line to get money from this business, you are not in front!
Watch for these warning signs. In most cases they won’t kill the deal at the outset, but will require that you ask questions and understand the situation better before you make your loan decision.
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