Linda's Blog: Good Business. Good Loans.

My business reading this morning ran across the same statement from unrelated sources.

Owners working 'in' or 'on' the business

An interview with Michael Gerber of 'E-Myth' fame reminds business owners that they need to work 'on' their business, not just 'in' their business. I had heard that before and despite mostly working 'in' my business, I do raise my head up frequently and work 'on' my business, too.

But when I read that same phrase again within hours, I decided there must be a reason.

Read this blog post by Craig Dickens of OneAccord, a consulting company that focuses on building revenue for clients:

BoomerPreneurs - Securing Your Future

Is your boomer borrower 'banking' on selling their business?

What is the importance to lenders considering a loan to a business owner? Or a business loan that relies on the guarantee of the owner? If your borrower/guarantor is in the boomer generation, take a look at the balance sheet. If their business is the biggest asset and selling it is the only way to secure their retirement, consider that accoding to Dickens only 20% of boomers will successfully sell the business.

Most will simply liquidate and retire.

That can work just fine if the borrower made boat loads of money, invested it wisely, and survived the recession with enough retirement assets intact.

"What are your retirement plans?"

I remember when my commercial lender, Kathy O'Neil, asked me that routine question when re-upping a commercial line of credit for our family construction company. I had been working with her for over ten years and she had not asked it before. It was a good question, even though at the time I was just hitting 50. Are you asking your borrowers? If they say they plan to sell their business, consider if they are working 'on' their business or 'in' their business.

Business has been bumpy during the recession. But truthfully, almost every business, in any economy, has undergone many twists and turns.

When bankers analyze  tax returns to make the best loan decision, you are always looking for clues to whether the business is successful, will become successful, or regain success. It helps to remember that even in a great economy, the road to success is not paved. Bumps. Twists. Breakthroughs. Turns. Stumbles. Breakthroughs.

Frank Coker of Corelytics brought this article to my attention and it sure rang true with me. If you have a business borrower in a rough patch, it might be the economy. Or it might just be business as usual!

Enjoy! And then tell me what you think.

The Forgotten Secrets Of The Enterprise Giants: Virality, Word Of Mouth, And Other Radical Experiments

I am always on the lookout for concepts and tools that help businesses and their lenders evaluate how they are doing. And with my emphasis on cashflow analysis of tax returns for lending decisions, cashflow and cash management are subjects dear to my heart.

I found this blog-post by Frank Coker of Corelytics, a company that provides a financial dashboard for business management to support good decision-making.

The Art of Cash Management

In it Frank makes the case for moving from a tactical approach common to most small businesses (can I pay my bills next month) to a strategic approach to have sufficient cash to pay bills, grow the business, and withstand short-term challenges.

What is wrong with tactical?

Admittedly, during the recession, I narrowed my focus to tactical. At one point we updated our six-week cashflow on a weekly basis to stay on top of cash needs. Happily, as my business has recovered to pre-recession levels and better, i no longer have to take that short-term tactical focus and am expanding back into a more strategic approach.

Is selling the business an important part of your borrower/guarantor's plans?

Then a strategic approach to cash management is a critical component. As the business lender, do you know which approach your business borrower/guarantor is taking?

This post is generalized from an agblog, Farm CPA Today, by Paul Neiffer. Paul is a CPA with an ag background and serving the agricultural community in central Washington.

While his post is titled "Are You Ready for the Super Bowl of Farming?" the suggestions he makes to farmers to be sure their businesses are play-off ready could apply to many types of businesses.

So consider this checklist of 'best practices' for any business and see how your business clients measure up. I have put in {brackets} the places to substitute the appropriate wording or practices for the type of business you lend to.

As a manager of your {farm operation} are you:

• Using accrual accounting to determine your true {net farm} income for each year
• Taking advantage of {precision farming} to minimize your input costs and maximize your revenues
• Using a marketing plan each year for each {crop}
• Maximizing your equipment utilization to reduce your overall equipment cost {per acre}
• Providing appropriate incentives for your employees
• Taking advantage of a Web Site to provide information to your landlords, employees and other interested parties
• Being proactive with you banker by providing information before they ask and keeping them updated
• Obtaining education each year on how to improve each of the above items.

If you are an ag lender, take a look at Paul's blog. Understanding the business and tax side of agriculture will improve your lending knowledge-base.

What blogs or online resources do you use to keep abreast of business and business lending issues?

With a small to medium size business, you are likely to find the company has chosen the cash basis of accounting. While this choice actually gives you a better sense of cash flow, it can be misleading in understanding how profitable the company really was.

First, some background:

Cash basis: 

• Record income when received
• Record expenses when paid
• Advantage...the borrower defers taxes if the company receives the funds after they are earned and it overlaps the year-end.
• Advantage...this type of accounting is easy to do (checkbook and throw in some depreciation) so a very small business without an outside CPA can easily do their accounting themselves.
• Advantage...the borrower has some ability to impact the tax level by year-end acceleration of expenses or deferral of revenue.
  
• Disadvantage...the borrower pays taxes early if the company receives the funds before they are earned (a deposit) and it overlaps the year-end.
• Disadvantage...the tax return can be very misleading when their lender is using it to determine credit-worthiness.
  

Accrual basis:

• Income is recorded when earned. (Earned but not received shows up on the Balance Sheet as an asset: Accounts Receivable. Received but not earned shows up on the Balance Sheet as a liability: Deferred Revenue.)
• Expenses are recorded when incurred. (Incurred but not paid shows up on the Balance Sheet as a liability: Accounts Payable. Paid but not incurred shows up on the Balance Sheet as an asset: Prepaid Expenses.)
• Advantages and disadvantages when it comes to tax returns? Just reverse the ones noted in the cash basis section above.

What is a lender to do?

• You do not get to choose whether your borrower provides cash basis or accrual basis tax returns. And with a small- to medium-size business, you may not have influence on whether the financial statements they provide are on cash basis versus accrual basis.
• In the overview stage of analyzing the borrower's tax return (see my business tax manuals, page one of each type of return for the overview list) note whether the return is cash-basis or accrual-basis before you compare the years.
• If your software calculates accrual adjustments (most of my Ag Lending clients do) leave them in if cash-basis but zero them out if the tax return is already accrual basis.
• If you have the tax return for anything other than a sole proprietor or one owner LLC you may have the balance sheets per books in the tax return. (There is an exception of the company is small enough.) If the tax return is on the cash basis and the books are on accrual basis you'll spot the accounts receivable and/or accounts payable. And if you know how, you can then convert the income statement (front page of the tax return) from cash to accrual.

So to answer the question, no...cash-basis on a tax return is not a red flag.

Resources:

For a full explanation of cash vs accrual basis and the formula for conversion see Pages 2-5 through 2-7 in the self-study manual: Understanding the Business Scorecard: Financial Statement Analysis. 

For the overview list (including the tip to check on cash or accrual basis) for the 1065, 1120 and 1120S returns see Pages 2-9, 3-13 and 4-13 in the self-study manual: Beyond the 1040: Corporation, Partnership and LLC Tax Return Analysis.

Brian Hamilton, President of Sageworks Loan Analysis Software, will be addressing FDIC examiners in a few days about global cash flow. He asked for my thoughts about lender/analyst's typical questions, trickiest questions and what examiners should be asking about global cash flow in your financial institution.

So here is part one...a typical question on global cash flow.

Why do I need global cash flow if I can qualify the business borrower with the business information alone...or the owner with just their personal cash flow from the business?

Some lenders still think it is okay to qualify a business borrower with just the business information and that the personal information is not needed if the business looks good.

Or if they agree they need the personal as well to look at a guarantor analysis, they think it is okay to skip the additional businesses owned by one or more of the guarantors as soon as they get 'enough' cash flow.

They may be applying the idea that you can do a consumer loan based on just the 'borrower' and leave out the 'co-borrower' if you don't need the additional cash flow to qualify.

Those lender/analysts sometimes fail to see that the risk of loss is as or more important to pulling everything together for global cash flow as is the possibility they can find more income.

The answer...if a source of cash flow is significant to the borrower's overall ability to pay or if there is a significant risk of loss, it is important to include it in the analysis. Whether you do that through a global cash flow process or piecemeal, you have to do it.

Lenders and underwriters in my training workshops on Cashflow Analysis of Tax Returns often stumble a bit on that word 'guaranteed'. After all, we all know what that means, right?

Well, it is dangerous to assume that words on tax returns or in financial statements mean the same thing the do in common usage. Read on and at the bottom of this post I'll tell you what 'guaranteed' means in IRSSpeak.

Where do you find guaranteed payments?

Guaranteed Payments show up on:

1. Form 1065 Page One
2. Form 1065 Schedule K
3. Form 1065 Schedule K-1 (for each owner who receives them)
4. Form 1040 Schedule E (although it is buried in the taxable amount listed for the partnership or LLC)

What are guaranteed payments?

Owners of partnership (partners) and LLCs (members) do not get paid wages. Their 'pay' is in the form of capital distributions which are based on % ownership...most of the time.

But what if my % ownership does not reflect the value of my contribution in terms of time, expertise or some other critical factor? Should I really split our 'profits' 50/50 just because I am a 50% owner, when I am the one who puts in the time or brings the expertise to the table to land the business?

Guaranteed payments are the way we can make distributions to the owners that are not related to the agreed-upon profit and loss split.

How guaranteed payments work

Here are some examples:

1. I own 25% of my LLC. The other owner owns 75%. We have an agreement that whichever one of us brings in a new client receives a 'finder fee' of 1% of first-year revenues from that client. Those payments will be made as guaranteed payments.
2. I own 50% of my partnership. I work full time in the business and the other 50% owner does not work for the business. We have an agreement that I get paid $20 per hour for each hour worked. Then we split the profits 50/50.
3. I own 75% of my partnership. I recruit a second partner who has an incredible reputation in the business. He does not work in the business but is an avid blogger and speaks at industry conferences. We have an agreement that he gets a $1,000 bonus for every referral that turns into a client.

What do you as a lender/underwriter do with guaranteed payments?

1. Form 1065 Page One: Nothing if you have already included them in taxable income either by starting with the bottom line of the return, with net income from Schedule M-1 or by subtracting total expenses on page one. Or include guaranteed payments just as you include other expenses if you are entering each type of expense on your spreadsheet.
2. Form 1065 Schedule K: Nothing
3. Form 1065 Schedule K-1 (for each owner who receives them): Include the Guaranteed Payments (Line 4 or 5 depending on which year return you are reviewing) in personal, historical cashflow
4. Form 1040 Schedule E (although it is buried in the taxable amount listed for the partnership or LLC: Do not use this number. It is a placeholder for the number you actually need, which is either historical personal cashflow or cashflow available from the company.

CAUTION!!!

If you are not in the habit of checking for guaranteed payments on a 1065 K-1 when you are calculating actual historical cashflow you run the risk of missing a significant, recurring source of cashflow.

IRS definition of 'guaranteed':

When it comes to guaranteed payments, this refers to the fact that these payments are guaranteed by an agreement between the partners that is unrelated to the agreement for the profit/loss split.

Just don't look at Schedule K-1, Guaranteed Payments...breathe a sigh of relief...and say to yourself: "Well, at least they are guaranteed income from this company."

One of the ways the Allowance for Loan and Lease Losses (ALLL) is impacted occurs when a financial institution grants a concession through modification of the terms of a loan due to the financial difficulty of the borrower. This is called a Troubled Debt Restructure (TDR).

Understanding whether a particular concession is material enough to qualify the loan as a TDR, or whether the cause of the concession is truly the financial difficulty of the borrower, is critical in determining the appropriate balance for the Allowance for Loan and Lease Losses.

And since that balance determines the expense, 'Provision for Loss', which determines profits for the period, which determines capital levels...the cascading impact of the wrong decision on a TDR can be significant.

Further, if an examiner or outside auditor does not think your bank or credit union is getting this right, it reduces confidence in the entire ALLL and in other major judgement areas as well...another cascading impact.

Two elements

Concession

Just changing terms does not mean you have made a concession. If your financial institution renegotiates to a lower interest rate because you want to keep the customer who could get that lowered rate elsewhere, that is not a concession. That is just good business.

But if you drop the interest rate or extend payments or allow interest-only for a short period which results in terms so favorable the borrower could not get them elsewhere, that is a concession.

But wait, there is more...

Financial Difficulty

If you make a concession just to keep a customer because you don't want to lose their business, but they are not in financial difficulty, then it is not a Troubled Debt Restructure.

Some of the indicators that a borrower may be in financial difficulty even though they are currently paying your loan as agreed include

• they are out of compliance with another loan
• you have updated your cashflow forecast and it does not appear they will be able to continue paying your loan as agreed
• they have filed for bankruptcy
• their CPA-prepared financial statements indicate in the CPA letter that there is substantial doubt that the company is a going concern

So what's a financial institution to do?

Make sure you are current on the rules for TDRs. The Financial Accounting Standards Board (FASB) has issued an update, Accounting Standards Update (ASU) No. 2011-02, Receivables (Topic 310): A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring, that is effective for nonpublic entities for annual periods ending on or after Dec. 15, 2012.

Be sure your software solution for the Allowance for Loan and Lease Losses (ALLL) handles TDRs correctly. (I like Sageworks Surety.) Identify correctly which impaired loans should be selected for TDR status. Document your thinking on why, or why not, you will treat that loans as a TDR.

The more transparent your thought process and decision-making, particularly if the examiners and outside auditors agree with your findings, the better.

Resources

• Contact Sageworks Surety for a demo of their ALLL solution.
• Read my book on The ALLL Triple Play: Examiners and Auditors Reveal Best (and Worst) Practices in your Method, Transparency & Efficiency
• Read this article by CliftonGunderson LLP, a CPA firm with a financial instituitions practice, on New Guidance and Clarification on Troubled Debt Restructuring

Many lenders and their financial institutions don't want to count on income from capital gains as a recurring source to service debt. I get that and don't necessarily disagree. Although see the post on 'Lending on Asset Conversion instead of Income' for another point of view.

Why the confusing blog title?

Admittedly, you are more likely to read a controversial title. But that is not why I said what I said.

Even if you do not plan to use the cash inflow from capital gains, whether stock or real estate, as a recurring source of cashflow to service debt going forward...the cash inflow (or outflow) happened! It may explain some things like where the borrower came up with the money to:

• fund their lifestyle
• contribute capital to their business
• purchase equipment without financing it

If it seems unlikely that any of those could happen with the cashflow you have calculated, it might lead you to suspect fraud.

Notice capital gains as a source even if you won't use it as a recurring source

I suggest you notice capital gains as a source, maybe even mention it in your write-up. If you don't, the borrower's situation make not make sense and may even be suspicious.

An installment sale, where the taxpayer will receive payments over time from the sale of an asset, is treated differently in the tax return. The lender needs to spot it to find out:

• how much the borrower is receiving each year
• if there are balloon payments anticipated that might impact available cashflow
• if the borrower is receiving payments as agreed
• how much longer the contract/note receivable will create cashflow

First of Two Tax Forms Needed:
Schedule B Interest and Dividend Income.

Click on the image to enlarge.

The interest received from the note or contract receivable will show up on Schedule B, right along with the interest from a credit union or bank. You can usually spot it because the source does not sound like a financial institution. If 'Linda Keith' is listed as a payer, then the borrower likely has a note or contract receivable from me.

The amount showing on the Schedule B is only the interest. So unless I am paying interest-only, it does not show the entire cashflow provided by the note or contract.

Second of Two Tax Forms Needed:
Form 6252 Installment Sales

Click on the image to enlarge.

Check Line 21: Payments received during the year NOT including interest. This is the principal payments received during the year.

Calculate amount received and then what?

You can add the interest income from Schedule B to the Installment Sale principal received from Form 6252 Line 21 to find out how much I paid (and the borrower received) in 2011. That is historical cashflow. If that is what you want, you are done.

If you want recurring cashflow, you still need a copy of the contract. From there you can determine how much longer the borrower will be receiving the payments.

How to spot a red flag:
Compare the contract and the tax return

If you want to know whether your borrower is receiving payments as agreed, compare the terms of the contract to the amount calculated as received from Sch B and the 6252. If they don't give you the same answer you have uncovered a red flag.

Perhaps the payer was not paying as agreed. And if that is the case, you'll have to decide whether to count it going forward even if the contract says there are plenty of years left on the contract.