Cash Flow Calculations

Posted on October 5, 2017 Published by

Cash flow is the primary repayment source for most loans provided by commercial lenders. Collateral is an important secondary repayment source, but in most instances, operating cash flows of the borrower is what is expected to repay the loan. It is very important to calculate a borrower’s cash flow as accurately as possible to ensure there will be sufficient funds to repay the debt. Whether you choose to use debt service coverage (DSC) or fixed charge coverage (FCC), you need to ensure you are including all non-cash adjustments to ensure you are obtaining an accurate figure for cash available for debt service.

Some of the common adjustments that get missed in cash flow calculations include:

Gains/losses on asset sales: If an item is sold, an accounting adjustment is required to record the gain or loss realized from that sale in income. This is a non-cash item that should be accounted for in your cash flow calculation by subtracting gains and adding back losses. The borrower very likely realized cash from the sale of the item, but this cash might have been used to repay debt outstanding on the item or to purchase a replacement asset. Additionally, the goal is to determine operating cash flows of the borrower; these extraordinary gains or losses are not generated by the daily operations of the borrower, so they should be removed from the cash flow calculation.

Cash value of life insurance: Companies that own life insurance policies on their key employees are required to record the cash surrender value of these policies as assets on their balance sheet. The cash value changes from year to year, with this non-cash change being recorded in the income statement. Any increases in cash value should be subtracted from the cash flow, while any decreases should be added back.

Distributions: Distributions paid to the owners of the company should be subtracted from cash available for debt service. This is especially important if you do not have personal guarantees for the debt, as you have no link to those funds once they leave the company. In some cases, the distributions paid are returned to the company in the form of a shareholder loan. These distributions would not be required to be subtracted from cash flows as the cash remained available to the borrower. However, ensure you know the terms of the shareholder debt and are accounting for it appropriately in your debt service requirements for future periods.

Expenses paid by related holding companies: Companies very commonly use separate entities to own their real estate and/or equipment, with the operating company paying rent to these entities for the use of the assets. A global cash flow should be calculated in this instance, including the cash flows of the related entity, as well as its debt service. When doing this, it is very important to obtain the tax returns or income statements of the holding companies to ensure you are including all expenses paid. Adding back the rent paid by the operating company will be overstating cash flows if the holding company pays insurance, real estate taxes, and any other cash expenses such as utilities or property maintenance.

Vacancies and replacement reserves: Investment real estate properties should have two cash flows completed. The first determines the actual historical cash flows and debt service coverage based on the financial statements. The second is a pro forma cash flow based on the current rent roll. The pro forma cash flow should include an allowance for vacancies, as well as an allowance for replacement reserves. It is important to ensure there will be sufficient cash available to meet debt service requirements if the borrower realizes the loss of a tenant, assuming it will take some time to find a new tenant. A 5% reduction in rental income is typically used to account for this potential loss of income, but this vacancy factor should be adjusted based on the actual vacancy rates realized in the area. Replacement reserves should also be included in cash flow calculations, as the borrower should have excess funds to set aside to maintain and repair the property. The amount of the reserve varies with the type of property, as well as its location, so be sure you understand the requirements for the subject property. For example, $0.15/sq ft might be an acceptable reserve for some, but not others.

These are just some of the common cash flow adjustments. There are others that might be realized as well. If you receive accountant-prepared financial statements from your borrowers, the statement of cash flows is an excellent source of information to determine the true cash flows of the borrower. Any non-cash adjustments are reported in this statement, allowing you to determine what adjustments you should include in your cash flow calculation.

Kathy Fries is Manager at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Kathy directly, please call: (920) 569-2946.

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