June 7, 2010

Accurate and consistent cash flow analysis is the foundation of effective business lending, because cash flow is the primary source of repayment for commercial loans. Although there are other important factors to consider—such as the financial strength of the borrowing entity, the quality and value of the collateral, the strength of the guarantor and the current economic conditions—a good lending culture focuses on repayment capacity: cash flow.

Strong cash flow lenders can assist their members by pointing out weaknesses in their ability to generate cash flow and recommend ways to increase cash flow and reduce overall debt. Profitability analysis is the next step in this process. This entails looking at the roadblocks to profitability—low margins, low sales volume, high expenses, etc.—and helping the borrower determine strategies to reduce these barriers.

One of the most common member business lending program issues that examiners find is inconsistent and poorly performed cash flow analysis. Cash flow analysis must be consistently applied and used in the credit decision-making process, and commercial lending decision makers must understand its fundamentals. Cash flow analysis should also be performed during annual commercial loan reviews and when modifying, extending or changing commercial loan terms.

What is Cash Flow?

Cash flow is the amount of cash generated over a time period (usually one year). Cash flow is generated from one of the following three sources: (1) increase in equity (includes profitability); (2) decrease in assets; and (3) increase in debt. The only one of these items that is sustainable is the increase in equity through the generation of profits; however, selling assets, increasing debt, and depreciation expense are other important sources of cash flow. Depreciation expense is typically added back to profits to increase cash flow, because it is a non-cash expense that decreases profitability.

Even though cash flow means different things to different segments of the financial community, it is important that both profit & loss statement and balance sheet changes be taken into consideration when determining a company’s operational cash flow. Cash flow derived from only profit & loss statement information, such as EBITDA (earnings before income taxes, depreciation and amortization) or EBIT (earnings before income taxes) doesn’t take into consideration the changes in the balance sheet accounts that can impact cash flow.

For example, if any of the earnings have not yet been collected, those earnings overstate the amount of cash flow generated. Adjusting for changes in the balance sheet account, accounts receivable, helps to correct these overstatements. Therefore, focusing only on EBIT or EBITDA can lead to serious underwriting issues and may unintentionally mislead a lender to fund a problematic loan, especially if a commercial borrower disguises its financial condition by showing large working capital due to growing the business. Thus, it is essential that cash flow analysis take into consideration balance sheet changes.

It is also very important for the lender to determine what sustainable and non-sustainable cash flow is. For example, if the borrower sells $100,000 in working capital assets to increase cash flow, but doesn’t replenish those assets, it will generate operational cash flow—but is this sustainable? Most likely, it is not. In fact, this action will reduce the borrower’s ability to generate cash flow in the future, because the borrower has fewer assets with which to generate profits. Similarly, if the borrower has a nonrecurring gain from the sale of assets, the lender would overstate the borrower’s ability to repay the loan if this nonrecurring gain is included in recurring cash flow.

Also fundamental to cash flow analysis is a borrower’s ability repay its long-term debt. The basic measurement of this ability is debt service coverage ratio. The primary source to repay long-term debt should come from the cash flow generated by accrual profits in the normal course of business. For commercial real estate borrowers who use an accrual method of accounting the DSCR is:

Net Operating After-Tax Profit (NOP)*
Annual Principal & Interest Payments Due on All Long-Term Debt

 Net Operating Profit (*NOP) is usually considered to include the following:

• net after-tax profits;

• plus depreciation and amortization expenses;

• plus interest expense (use only interest expense on real estate loans; provided the denominator has the interest payment also); and

• minus capital investments (such as leasehold improvements and equipment purchases) less any new long-term debt that was used to help fund those capital purchases.

A debt service coverage ratio of less than one indicates inadequate coverage, because the cash flow generated by the property is less than the commercial mortgage loan payments. An approximate industry standard for acceptable DSCR ranges from 1.2 to 1 to 1.3 to 1.

Cash Flow Analysis Software

Most commercial lenders utilize integrated software that provides the foundation for performing cash flow analysis. These programs are important tools to use and can help provide consistency in how cash flow is determined. Most of these programs include enhanced features that perform sustainable growth analysis, calculate numerous financial ratios and provide industry ratio benchmark standards, perform sensitivity analysis on balance sheet accounts, and provide other important analytical functions. The most critical facet for commercial lenders is that they understand how the cash flow software is designed and how it is to be used. If the software is not used properly and/or data is improperly inputted into the model, then poor results will follow.

In-depth training on the cash flow software is imperative for all commercial underwriters and MBL department managers. More minimal or basic training should be given to anyone having delegated commercial lending approval authority, including all commercial loan committee members.

Since the quality of cash flow analysis depends on the financial information provided by the borrower, it is very important that updated and accurate financial information be received. The better the financial data, the more useful the cash flow analysis will be. It is also important to have multiple years of financial statements and tax returns because trends are very important. Every effort should be made by the lender to receive updated, accurate and multiple years of financial statements. Note: Loan covenants should require that commercial borrowers provide this.

What Will Examiners Look For?

Examiners will focus on the overall adequacy and consistency of how cash flow is calculated and reported. Specifically, examiners will look for the following:

• Consistency – How consistent is cash flow analysis being performed (i.e. is cash flow being consistently overstated, is cash flow being consistently calculated by all the underwriters and are consistent errors being made?).

• Major mistakes – Are major mistakes made in the calculation and the reporting of cash flow?

Cash flow is the primary source whereby commercial lenders are repaid. Thus, it is important that credit unions that originate and/or purchase commercial loans understand cash flow and how it should be used in the commercial credit decision-making process. If done properly, cash flow analysis will identify most commercial loan weaknesses. If not done properly, cash flow analysis is an ineffective tool that will most likely result in poor commercial lending decisions being made.

Doug Lacy-Roberts a financial examiner supervisor for the State of Washington Division of Credit Unions.