Qualifying the borrower


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."


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.

2011SchB1040.PNG

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

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2011f6252.PNG

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.

What about a track record

To count capital gains activity for recurring cashflow many, if not most, financial institutions will want to see a track record. But not all.

A lesson learned from lenders to High Net Worth/High Income Clients

What if your borrower has a million-dollar portfolio? Does it really matter that s/he has not tapped it in the last few years? In fact, is it a plus that during the recession s/he did not have to tap it?

Here is the way some lenders look at a significant portfolio:

  • Consider first discounting the portfolio value significantly, perhaps 30% to 50%.
  • Assume a very conservative rate of return, perhaps 1% to 2%.
  • Amortize potential liquidation of the portfolio value after discounting over 20 or 30 years.
  • Include the potential yearly cashflow from portfolio liquidation in your cashflow calculation or as a quantifiable compensating factor.

Guidelines Rule!

Look to your financial institution's guidelines to decide what you can use and how. Often when your guidelines do not allow you to count an income source formally you can still use it in your write-up.

What less traditional sources of income are you using to qualify your borrower in this post-recession environment?

First decide if you will count it at all

See this post on 'Lending on Asset Conversion instead of Income'.

Here is the form

Click on the image to zoom.

2011SchD1040.PNG

Beware non-cash entries

Line 12 (2011 Form 1040) is a pass-through from a K-1. It is not cashflow to this borrower, although now you know you'll need to ask for the k-1(s) to find cashflow from them. Or perhaps the full source return (1065 or 1120S) to determine cashflow available from the entity to your borrower/guarantor.

Line 14 (2011 Form 1040) is a carryover. It is a long-term loss from a prior period that was not allowed because they were over the limit for capital losses. You should have counted this loss against them (if at all) when they actually incurred it.

Where is the cashflow if it is Stock?

Well, it is not the gain or loss. Let's say they bought stock in 1995 for $100,000 and sold it in 2011 for $80,000. Gain or loss? How much?

The tax return will properly show a loss of $20,000. But what happened in the checkbook in 2011?

Their cashflow increased by $80,000! So a loss in a 1040 can actually camouflage a real increase in cashflow.

The rest of the story...

But we are missing an essential piece of the puzzle. The taxpayer does not report the purchases of stock on the Schedule D. So in the example above, you can spot the $80,000 in the column for proceeds. But you don't know if they just called up their broker and said: "Sell XYZ stock, take the $80,000 proceeds and by ABC stock."

If you decide to give your borrower/guarantor credit for cashflow from stock transactions you will need to get a copy of their broker's statement to determine the real cash inflow or outflow for the year in question.

What if your guidelines say otherwise?

Lenders in my Tax Return and Financial Statement Analysis workshops hear me say it often: "Guidelines rule". But I also say: "Guidelines are guidelines". You need to know if your guidelines are hard-and-fast rules or a common starting point.

If your guidelines allow you to use a figure from Schedule D, whatever it is and whatever line it comes from, you are making a simplifying assumption. If you need to know their real cashflow from stock transactions the Schedule D just alerts you that there were transactions. The broker's statement will tell the story.

First decide if you will count it at all

See this post on 'Lending on Asset Conversion instead of Income'.

Here is the form

Click on the image to zoom.

2011SchD1040.PNG

Beware non-cash entries

Line 12 (2011 Form 1040) is a pass-through from a K-1. It is not cashflow to this borrower, although now you know you'll need to ask for the k-1(s) to find cashflow from them. Or perhaps the full source return (1065 or 1120S) to determine cashflow available from the entity to your borrower/guarantor.

Line 14 (2011 Form 1040) is a carryover. It is a long-term loss from a prior period that was not allowed because they were over the limit for capital losses. You should have counted this loss against them (if at all) when they actually incurred it.

Where is the cashflow if it is Real Estate?

It is not here. We can see the proceeds in column d (2011 Form 1040) but since we have no way of knowing what the amount of the underlying mortgage or contract was that had to be paid off, we are missing critical information.

If not the tax return, where do we get the essential information?

Use the tax return for the list of what Real Estate was sold. Then request the closing statements so you can determine 'cash to seller'.

The rest of the story...

If you decide to give your borrower/guarantor credit for cash from real estate sales, it is likely you also need to count against him or her the cash invested in new real estate purchases. No where on the tax return does the borrower/guarantor list purchases. That is because, once again, the IRS does not care. But we do.

Look to the borrower's application to see what Real Estate they own. Find the RE acquired in the year in question. Ask for the closing statement and count against cashflow the 'cash from buyer'. Now you'll have a complete picture of the cash in and out from their RE activity.

What is short-term and where do I find it?

Schedule D, Part 1 is where you'll find short-term capital gain or loss. This is related to assets held one year or less.

Here is the form

Click on the image to zoom.

2011SchD1040.PNG

Beware of non-cash entries

Line 5 (2010 Form 1040) is a pass-through from a K-1. It is not cashflow to this borrower, although now you know you'll need to ask for the k-1(s) to find cashflow from them. Or perhaps the full source return (1065 or 1120S) to determine cashflow available from the entity to your borrower/guarantor.

Line 6 (2010 Form 1040) is a carryover. It is a short-term loss from a prior period that was not allowed because they were over the limit for capital losses. You should have counted this loss against them (if at all) when they actually incurred it.

Where is the cashflow?

Given the assets are held one year or less, and backing out any non-cash items (see paragraph above), the gain or loss in column f (2010 Form 1040) is also the impact on cashflow.

Should I use it in recurring cashflow?

That is another question altogether. Take a look at this blogpost on 'Lending on Asset Conversion instead of income'.

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?