BUSINESS LENDING FINANCIAL SOLUTIONS Consulting Services 
Commercial Lending BasicsPart Three - Income Statement and Cash Flow Income Statement Since revenues are the lifeblood of any business, it is important to determine the quality and stability of reported revenues. Are all sales final or are consignment sales included? The magnitude and history of sales returns and allowances will give insight into the quality of sales along with the quality of the product being sold. Service and progress payment revenues may be subject to future adjustment. A single major customer does not provide as strong a sales base as a widely diversified customer list. Sales to weak firms or depressed industries may not always be collectible. Competition, new products, and technological advances can have serious impact on future sales. Gross margin is the most important single percentage on the income statement. Modest changes in gross margin have significant impact on net profit due to the magnitude of dollars involved. Accounting methods that tend to increase income also increase book value of inventory on the balance sheet. During periods of rising prices, FIFO inventory accounting will tend to increase reported profits as well as inventory valuation. It is important to understand the principal component of Cost of Goods Sold and the relative importance and sensitivity of labor, material, and overhead costs. Operating expenses should be reviewed as to magnitude, trend and method of accounting. Conservative balance sheet accounting will tend to reduce reported net income. Be certain that strong reported earnings are not the result of capitalizing expenses. In businesses selling directly to consumers, material reductions in marketing expense may well lead to lower levels of future sales. It is important to understand the nature and sources of other income and other expense if these items are material in nature. Certain types of retail businesses tend to break even on sales of product or service, and then make their profit from finance charges from the resulting receivables. Some basic knowledge of income taxes is important to be able to evaluate the accuracy of reported tax provisions and liability. Many firms use different accounting methods for financial reporting and tax purposes giving rise to deferred taxes. This can be an important source of funds. The lender needs to understand the tax position and policies of a borrower. The taxman has a priority claim for taxes on the profit earned. Many closely held corporations will use Sub-Chapter S for federal income tax purposes. This transfers the tax liability to the personal returns of the owners. Consequently, the tax liability frequently appears as withdrawals or dividends when the funds are distributed to the owners. Equity may be overstated as funds to pay taxes may not be withdrawn until the following year. Sometimes withdrawals will be required to pay prior year taxes even though the current year shows a net loss. Net profit is the basic objective of most business firms. Trends in net profit are more important than its absolute magnitude or its relationship to sales, assets, or equity. However, a firm that consistently earns less on sales, assets or equity than others will have difficulty in attracting or retaining investment funds. How the net profit is utilized is also significant. Retained earnings build the equity base to support increased volume or reduce dependence upon debt. Dividends limit equity growth, but may be important to help maintain the market value of publicly traded stock. In many family-owned firms dividends are an important source of income to family members not active in the business. Sometimes family-owned or closely controlled concerns manage income to minimize taxes and the reported net profit may not fully reflect earning power, since significant economic benefits are provided to the owners through various expense items. Cash Flow In the final analysis, a business must generate cash to meet its obligations. Evaluation of the sources and uses of cash is critical in terms of future ability to repay loans. The traditional definition of cash flow being net profit plus depreciation (and other non-cash charges) less dividends is not usually an adequate analysis. There are myriad of transactions involving cash for most businesses that do not represent current revenue and expense. Increases and decreases in trading assets and liabilities, acquisition or disposal of non-current assets, borrowing or repaying money, or changes in equity through distribution or new investment usually involve cash. These transactions are not reflected in the income statement, except to the extent profits or losses are realized. There are three broad areas of sources and uses of cash for the typical business enterprise: Operating Cash Flows - cash produced and used as a result of normal business operations. Investment Cash Flows - cash used or obtained in other transactions, including fixed asset purchases or sales. Financing Cash Flows - cash obtained from financing sources and used to repay or service financing. Historically, in depth evaluation of cash flow has been balance sheet based. In recent years the Uniform Credit Analysis approach has become widely used. This approach adjusts the income statement to determine net cash income and then includes other balance sheet changes to arrive at the net change in the cash account. Both methods have their advocates, but both wind up with essentially the same date. Regardless of the specific approach used, it is important to understand the dynamics of cash uses and sources. Cash Flow Analysis Since there is considerable truth to the statement, "Nothing happens in a business until a sale is made," there is sound logic to starting an analysis of cash flow with net cash receipts from sales. Converting the conventional accrual income statement into a cash income statement does this. Reported sales are converted to cash sales by adding beginning receivables and subtracting ending receivables to determine cash collections from sales for the period. The same result can be obtained by subtracting any increase in receivables or adding any decrease in receivables for the period-to-period sales. The resulting number represents cash received from sales during the period. In a similar manner, cost of sales for the period must be adjusted. Inventory represents costs incurred but not yet matched to sales. Any increase in inventory represents additional cash costs. Any decrease in inventory represents utilization of cash costs in a prior period. However, since accounts payable generally represent unpaid inventory costs, an adjustment must also be made for changes in accounts payable. To the extent payables increased, cash was not utilized. To the extent payables decreased, additional cash was used. Consequently, the adjustments to convert cost of sales to a cash basis involve adding increases in inventory and decreases in payables or subtracting decreases in inventory and increases in payables. Similar adjustments need to be made to operating expenses. Increases in prepaid expense or decreases in accruals need to be added to operating expense and decreases in prepaid expense or increases in accruals need to be subtracted from operating expense to arrive at cash operating expense for the period. Depreciation or amortization, which do not represent cash expenditure, should be deducted from reported expense wherever they are reflected to arrive at cash expenditures. Subtracting the adjusted cash costs of sales and operating expense from the adjusted cash revenues will give cash produced or lost from operations. This number indicates cash profitability from operations. Important as cash flow from operations is, even a positive number at this level of analysis needs further review to evaluate the non-operating cash flows that may absorb or supplement operating cash flow. Investment cash flows represent transactions involving cash as a result of changes in fixed or other assets. Capital expenditures, additions to fixed assets, are the most common of these types of transactions. The typical business firm needs additional fixed assets to expand capacity as it grows as well as to replace worn out or technologically obsolete items. Cash used for capital expenditures is determined from the change in fixed assets adjusted for depreciation for the period. To the extent that net fixed assets at the end of the period have changed other than by the reduction from depreciation taken during the period, there have been capital expenditures. A precise determination of capital expenditures will adjust for the effect of disposals. If disposals are significant, data is normally provided in the footnotes. Changes in other assets or liability accounts not covered elsewhere must also be utilized to make the final net cash flow figure agree with the change in cash on the balance sheet. Financing is an important source of cash for most business firms. Financing commits future use of cash to service the obligation. Equity is a form of financing. Cash required to pay dividends is as much a financing cost as debt servicing requirements. Cash used to support financing includes the current portion of term debt from the prior balance sheet, since this figure represents amounts that were contracted to be paid in the coming year. If term debt does not reduce by the appropriate amount, new borrowings had to take place. Changes in short term borrowings represent sources or uses of cash from financing depending upon whether short-term borrowing increased or decreased. Changes in equity, other than from profits, losses, or dividends also represent cash uses or sources from financing. From a purist point of view, interest expense is a use of cash to support financing. Whether interest expense appears in the analysis as a cash operating expense or a financing use of cash does not significantly affect the result as long as its importance is recognized. For more highly leveraged firms, interest expense may be a significant cost. Many analysts use an Interest Coverage Ratio (Pre-tax Profit + Interest Expense / Interest Expense) to determine the degree of cushion in earnings over interest cost. The business that barely covers interest expense will rarely have sufficient cash flow to make principal payments. The net of financing transactions provides either a use of cash or additional cash flow for operating or investment purposes. Presentation of cash flow analysis normally includes at least the following data: Net Cash Sales Cash Cost of Sales Cash Gross Profit Cash Operating Expenses Net Cash From Operations Capital Expenditures Change in Other Assets Net Investment Cash Dividends Change in Short Term Debt Change in Term Debt Change in Subordinated Debt Change in Other Liabilities Equity Invested or Retired Net Cash From Financing Net Change in Cash Sufficient additional detail should be provided to make the presentation complete enough for the user to understand where cash comes from and where cash goes. Balance Sheet Based Cash Flow Analysis Balance sheet analysis of cash flow is based on the balance sheet equation (assets equal liabilities plus equity). Since by definition, the balance sheet must balance, changes in any balance sheet account must be offset by equal changes to other accounts. Changes in balance sheet accounts represent sources and uses of cash in the following manner:
Changes taken solely from the balance sheet represent net amounts without sufficient detail to be very useful. Therefore, the raw balance sheet changes need to be expanded with additional information from the income statement and footnotes. Fixed assets, term debt, and changes in equity are the areas in which additional information is usually the most informative. Capital expenditures, generally producing increases in fixed assets, are the difference in net fixed assets plus depreciation charged to expense during the period. Disposals, if they are material, should be added to arrive at total capital expenditures. Net increases in term debt should be adjusted for any contractually required payments as reflected in current portion of term debt shown on the prior balance sheet. If the debt has not been reduced by the required payments, there has been additional borrowing. Changes in equity result from net income, losses, and dividends paid or equity retired or obtained during the period. Other asset or liability changes may warrant more detailed examination to reflect the cash flows taking place. Cash flow analysis based on the balance sheet can be presented in several ways. One of the more common presentations is: Net Income Depreciation and Amortization Cash From Operations Change in Receivables Change in Inventory Change in Payables Change in Accruals Net Cash From Operations Capital Expenditures Change in Other Assets Change in Other Liabilities Investment Cash Flow Dividends Change in Short Term Debt Change in Term Borrowings Change in Subordinated Debt Equity Invested or Retired Financing Cash Flow Net Change in Cash Funding Requirements Based Cash Flow Analysis Another format for presentation of cash flow analysis is primarily balance sheet based, but reflects the concept that cash needs drive cash sources for the typical business firm. Even though sales are the driving force for any business concern, certain cash expenditures must be made before sales can take place. There must be a place to do business. Inventory, in most cases must be on hand before customers can be solicited for sales. The typical business manager does not have the luxury of having surplus resources that can be deployed in a discretionary manner. Rather, the typical business manager is faced with allocating limited cash resources among competing needs. The following presentation format recognizes that needs of the business require obtaining cash from whatever source may be available: Funding Requirements Receivable Increase Inventory Increase Capital Expenditure Other Asset Increase Term Debt Payment Dividends Total Funding Requirement Internal Sources Net Profit Depreciation and Amortization Accruals Increase Deferred Taxes Increase Total Internal Sources Net Funding Requirements External Sources Payable Increase Short Term Debt Increase Term Debt Increase Other Liabilities Increase Equity Increase Total External Sources Net Cash Change Regardless of the approach used, a detailed evaluation of cash flows is critical to understanding both borrowing needs and sources of future repayment. Summary of Cash Flow Analysis There are a number of ways a bank can implement a system to perform Uniform Cash Analysis. (UCA) Some bank's still use a manual spread system using a calculator to compute ratios and cash sources and uses, while others have developed a Lotus or Excel based automated system using as a template a spread sheet similar to the one attached. Others have developed simple tables analyzing working assets and inputting into a summary table to determine surplus or deficit cash. This is a very simple procedure and a good way to implement cash analysis if no other method is available. Working Assets
By computing working assets for current year and determining change from previous year, the following table can be completed showing the cash surplus or deficit for the current year under analysis. CASH FLOW
Another alternative is one of a number of commercial spreadsheet analysis programs on the market such as Fast, Baker Hill and Famas by Crowe Chezik. Some of these programs are modest in price and not only perform the spread analysis but will generate a consultative report listing strengths and weaknesses of financials as well as a detailed analysis of each item on the balance sheet and income statement as well as a comparison to RMA Statement Studies.. Some of the vendors will allow a 60 to 90 day free trial of their software. Regardless of the method used, it is important to remember that "only cash pays loans" and an evaluation of the sources and uses of cash is critical in terms of future ability to repay loans. Part One - Nature of Business Enterprise and Borrowing Purpose Part Two - Source of Loan Repayment and Analytical Process Part Four - Definitions, Formulas and Loan Check List Ray Beaufait beau1943@beauproductions.com Top of Page |