Cash Flow Analysis

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Val Stark

The lending world has changed significantly over the last 20 years. In the past, lenders would base their credit decisions on how well collateralized a credit was, as, the thinking was, that was the “strength of the credit.” If borrowers could not repay their debt, the bank would foreclose or repossess the asset. This is not the culture any longer. When underwriting a loan, a lender has to factor in many other components that were overlooked in the past, such as cash flow.

The main focus these days is cash flow analysis, or the ability of the borrower(s) to repay the loan. But when calculating cash flow it is critical that the credit analyst performing this duty has the necessary tools for more accurate results. Common questions are:

  • Should I use a company prepared financial statement, or an independently prepared financial statement?
  • Is it better to obtain audited financials or to use the tax return?

The answers to these questions depend on what type of entity the bank is dealing with and what type of business it is. Generally speaking, tax returns are the most commonly used tool and most banks require at least three years of tax returns when a customer is applying for a loan. For bigger and more complex entities, banks may require additional financial reporting such as audited or reviewed financial statements. One trend seen recently is the requirement for quarterly statements, especially on commercial loans. Lenders are being proactive, making sure there is no deterioration that could impact their repayment capacity. Cash flow analysis is the main focus on credit presentations. It is the reason a credit is originated and it is proof to the institution that borrowers can afford their debt. In the last few years, many banks have implemented an annual review process. Not only are they requiring the borrower to provide them with financial statements and tax returns, but also they are analyzing the financial information received and drawing their conclusions on an annual basis. This may reduce risk by determining whether the borrower’s repayment capacity has diminished.

Personal cash flow analysis can be tricky at times and some institutions rely solely on the numbers provided on the first page of the borrower’s tax return. While there are several items that are on the first page that are crucial to the calculation, namely wages, interest, dividends, tax refunds, and capital gains (if they are recurring over the years, as well as retirement, pensions and SSI), it is also important to go to each individual schedule (C, E, F) and account for all the add-backs, such as interest, depreciation and amortization. It is also important to use K-1s, when applicable, to ensure that pass through income is not being used in the credit analysis, but rather distributions/contributions or guaranteed payments. Also, remember to always deduct tax liabilities.

Business cash flow analysis seems to be more straightforward. When using business tax returns for the calculation of cash available to service debt (CASD), the formula is the sum of net income, interest, depreciation and amortization. K-1s play an important role in the calculation and it is necessary to deduct distributions and guaranteed payments or add contributions when applicable. In some cases, IRS Form 8825 for rental income will come into play, or Schedule F for farming income will need to be included in the calculation (with the respective add backs) just like in personal tax returns.

In the current credit environment, cash flow is the most important factor in determining credit worthiness, as it is ultimately the main source of repayment. Cash flow is the key element to most credit presentations, and it is being reviewed on an annual basis by most credit analysts to make sure there hasn’t been any deterioration over the course of the year.