Credit analysis


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."

Really? Can you do that?

Check your Guidelines

Well, first, consider that a lender/underwriter can do whatever the financial institution's (FI) guidelines allow assuming they are consistently applied in a legal manner. So if your FI allows you to use asset conversion, you can.

What is the difference?

Asset Conversion

You are counting on the borrower to liquidate assets to service the debt.

Income

You are counting on the borrower to generate income from earnings (or operations if a business) to service the debt.

Is there a preference?

Most lenders prefer to lend on income from earnings (or operations if a business) rather than counting on the prospective borrower to liquidate assets (asset conversion) to make their debt payments on a timely basis.

Wait just a minute!

There are groups of borrowers who absolutely count on asset conversion to service debt, with the blessings of their lenders. This includes retired people for whom, if they did it right, their asset conversion is now their primary source of income. Drawing from IRAs and Pensions is asset conversion. Selling off an accumulated stock portfolio or real estate is asset conversion.

Borrowers who are real estate investors, especially if they have done okay during the recession, are buying (and sometimes rehabbing) and then selling real estate. I know we are all leery of the 'flippers' but some of them did just fine.

My advice:

Consider whether the income from asset conversion is sustainable given the borrowers networth and access to readily converted assets. Your guidelines may allow you to use this in borrower projected cashflow. If not, it may at least be a significant compensating factor.

Do you use asset conversion as cashflow? If so, when and how?

Here is how you end up with Interest from a Schedule K-1 on 1040 Schedule B:

  • Schedule B includes all taxable income.
  • Interest income received by an S Corporation or a 1065-filing entity like an LLC or partnership is passed through and taxed to the owner of the company
  • Thus interest not received by an individual will be listed on Schedule B
This is another example, once again, that taxable income is not necessarily cashflow.

What do you count?

My favorite answer...and if you are a regular reader of my blogs or have attended my training for lenders and underwriters on Tax Return Analysis...you know what is coming! It depends.

My approach

I do not include Schedule K-1 Interest in personal cashflow. The 1040 filer did not receive that cashflow. It does not mean they did not receive ANY cashflow from the company. But if they did, we'll find what they actually received on their K-1.

The K-1 is a schedule of the 1120S or 1065, not the 1040. So you won't have it unless you ask for it.

It still depends

With a lower % owner, of if you only want to consider actual cashflow from the company to the owner/guarantor, obtain the K-1 and cashflow that. Don't know what to use? Time to come to class, take the Business Tax Return Analysis series of nine eCourses at www.LendersOnlineTraining.com, or order the manual.

Okay, you could also do a site-wide search of this site and find the answer. But if you are a lender, underwriter or analyst -- for a bank or credit union or creditor -- and you have that question, you have other important questions that need a more extensive review of tax return analysis.

With a higher % owner who has control over what she takes from the business, you might prefer to use cashflow available from the company instead of what she took the last couple of years. Obtain the full 1120s or 1065, determine company cashflow, and then give her credit for her share. This is where interest income received by the company will come in.

How low is low and how high is high?

Most lenders provide a guideline for determining whether you request only the K-1 or the entire tax return. Residential mortgage lenders often use a 25% threshold. SBA lenders often use a 20% threshold. I've seen as low as 10% and as high as 51%.

Check your guidelines to decide.

Common sense and judgment

Also consider what type of flexibility you are expected to exercise in the area of judgment and common sense. Are your guidelines more 'guide' or more 'lines in the sand'. Even if the borrower owns less than 25%, if you know the underlying company is in trouble should you consider that? I can't tell you the answer but you need to find out.
One of the LinkedIn Groups I belong to is having a raging debate about whether that first C of Credit, 'Character', can be considered any more. Or should be considered again! (BTW: Connect with me at LinkedIn. My profile is at 'Linda Keith CPA'.)

Small Business Banking Professionals

That is the group. The discussion posed this question:

Banks are digging deeper into the character of their borrowers. How are you or your bank addressing the "character" issue?


Bankers from around the country and from banks big and small have weighed in. The answers are all over the map, too. Here are some samples:

  • We have to get back to character lending
  • We cannot get back to character lending
  • The business bankers don't make the underwriting decisions and the underwriters don't know the borrower, so character as part of the equation is lost
  • Newer lenders don't get the training or the mentoring they used to and don't know how to take character into account
  • Character lending in any form has the potential to be discriminatory in nature
  • Character is indicated when a borrower has been through very tough times recently but continued to pay as agreed, keep on employees and support the community
  • A red flag for character is If the borrower has run up credit cards or consumer loans for toys (boats, fancy cars) without increased net worth to show for it
  • If business has been tough, finding out how they have treated their vendors, suppliers and customers might be a clue to character
  • A quality centralized underwriting team can coach front-line lenders in the questions to ask and how to document answers that will give the underwriters the 'character' clues they can't get first hand
  • If the lenders compensation is based on origination volume, they might not take the character issues seriously that the underwriter won't be able to discern

Wow, as I said, all over the board.

So how about you?

Does character still factor in? And if so, how? And how do you find out about it?


Many business lenders use global analysis to consolidate cashflow among related entities. For example, if a small business has one 80% owner and another 20% owner, it is likely you'll consider the cashflow of the business combined with the cashflow of the 80% owner.

After all, if the owner is guaranteeing then his/her personal cashflow from other sources may come into play. And besides, the cashflow they take from their business may be higher or lower than the company can clearly afford.

So what about the balance sheets?

I got this question from one of my AgLending clients last week. In a training on Tax Return Analysis for Agriculture we had used their proprietary software (as is my custom when doing in-house training).

Like many Ag Lenders they look at the consolidated balance sheets as well. The question:
Do you go ahead and consolidate balance sheets with two owners and the farming operation when each owner is only guaranteeing 50%?

They were considering consolidating all three entities at 100%. They were also considering removing 50% of each asset class of the two guarantors, clearly much more work.

My answer is my favorite...'it depends'. My first inclination always is to do it the most simple way if the harder way won't improve the credit decision.

My questions, her answers, and our solution.

Q: What do you use the consolidated balance sheets for?
A: Current ratio and Debt-to-Assets

Q: Does it look like it will make a difference either way?
A: Not really

Q: What do you think the examiner would think?
A: The examiner happens to be here  and she thinks if we consolidate all three and make a note that the guarantors are each only guaranteeing 50% we'll be fine.

Less work, good credit decision and happy examiners...

It doesn't get any better than that!

Let's assume your question is on a K-1.
There is a K-1 for a 1065 (Partnerhsips and some LLCs), a 1120S (S Corporations), as well as trusts and estates.

Use the site-wide search
The quickest way to find what you need when you have a tax return analysis question is to do a site-wide search of www.LindaKeithCPA.com.

Go ahead, at the top of the page, click on the magnifying glass. Type in k-1. You'll find 4 pages of entries and one of them will be just what you need to know.

The list will include
  • blog posts
  • articles
  • answers to 'Ask Linda' questions
Ask Linda
And if you don't find what you need, click on 'Contact us' and ask me yourself!

IRS.gov
If you decide to use www.irs.gov follow these steps.
  1. Use their search box for the type of income or expense you are questioning
  2. From the resulting list, click on the pdf for the publication that covers it.
  3. When you have the pdf opened, go to the very end and find the index.
  4. Find the item in the index and go directly to that page
Within less than a minute you have a pretty good chance of being on the page that gives you a better understanding of that item, if not the actual answer that you need.

Consider printing just that page for documentation to include in the file. If you did not already know the answer, perhaps the person reviewing the file doesn't either.

I get questions all the time from bank and credit union lenders on lending to businesses and to business owners. Here is one from last week: Can I use the self-employed income on the 1065 K-1?

Wouldn't that be easy?

The 1065 K-1 has a line for 'Self-employed Income'. It is Line 14 on the 2009 K-1. It is already calculated for you. Easy, right?

Yes, but it is not what you need!

Sorry, can't use it.

Self-employed income is the taxable income on which the partner/LLC member must pay into social security. It is a combination of their share of the ordinary (taxable) income and, if they are receiving any, their share of guaranteed payments.

(If you don't know what guaranteed payments are, use my site-wide search box to find out.)

Never* use taxable income as if it were cashflow

* I should know better than to use the word 'never' but this is a pretty good time.

There are three choices for cashflow to use when calculating owner cashflow from a closely-held company.
  1. The owner's share of taxable income
  2. What the company actually paid to the owner
  3. What the company can afford to pay
The self-employed income reported on 1065 K-1, Line 14 (2009 return) falls into the first category. And we do not lend to businesses nor to business owners based on taxable income, right? If we did, we would just use AGI and call it good.
Often lenders add back depreciation everywhere they find it...front page, 4562, Schedule K of an 1120S or 1065 (Section 179), M-1 of an 1120, 1120S or 1065 (both the left and the right side of that schedule)!

Often, they are adding back too much. The only depreciation to add back, ever, is depreciation that was subtracted from a figure you are using.

Add back depreciation on:

  • Schedule C, Business
  • Schedule F, Farm
  • Form 1120, 1120S and 1065, Page One
For most of you, do not add back depreciation on:

  • Schedule K of an 1120S or 1065 (it was not subtracted from taxable income so no need to add it back)
  • Schedule M-1 of an 1120, 1120S or 1065 (it was not subtracted from or added to taxable income on Page One of the return so no need to add it back)

So what have you been missing?!?!

I received an email from a lender who attended the October training on Tax Return Analysis for Lenders. Within the week, she had gotten an approval that she would not have gotten before the training. And when I checked back two months later, she had used this 'new' add-back again to change a denial into an approved loan.

There is depreciation buried in the middle of Form 8825, Rentals owned by corporations and partnerships. And yes, she had been missing the add back.

1040 Rentals...Line 3 minus Line 19?

Many lenders when analyzing a 1040 that includes rentals simply add the revenue and subtract the expenses BEFORE depreciation. Depreciation is separated out after the rest of the expenses and this is easy to do.

But on a business rental, Form 8825, the depreciation is in the middle of the rest of the expenses. Sure, you can still add income and subtract expenses, but then you need to ADD BACK DEPRECIATION.

I know, I am yelling, I am sorry. But I don't want you to miss a valid add back and turn down a good loan. That would be sad!