Let Us Count the Ways to Measure

April 2013 The RMA Journal

Credit risk

Let Us Count the Ways to Measure Cash Flow

April 2013 The RMA Journal

This first article in a two-part series discusses

the four most widely used approaches to

defining cash flow and debt service. Each

approach offers a different perspective on

the borrower’s ability to repay debt.

ONLY

CASH

PAYS

LOANS

Let Us Count the Ways to Measure Cash Flow

April 2013 The RMA Journal

The company has four shareholders. The largest, Owner A,

owns 70%. Owner A’s income consists primarily of his salary

($192,500) plus his share (70%) of the distribution from the

company ($179,600). He has annual principal payments

on personal debt of $131,000 and a personal tax liability

of $184,200, including taxes on his share of the company’s

income. (See Table 1.)

Quantifying Cash Flow Available for Debt Service

Often, the biggest source of contention among lenders is

whether the borrower “cash ﬂows.” The conﬂict arises from

the correct but different conclusions reached using the mul-

tiple approaches to quantifying cash ﬂow and debt service.

• Traditional.

• EBITDA(Earningsbeforeinterest,taxes,depreciation,and

amortization).

• EBIDA (Earnings before interest, depreciation, and

amortization).

• UCA(UniformCreditAnalysis).

• Accountant’sdirectandindirectstatementofcashows.

• Corecashow.

• Personalcashow.

• Globalcashow.

The rst three—traditional, EBITDA, and EBIDA—

measure a borrower’s ability to earn its debt service but say

nothing about that borrower’s ability to pay its debt service.

This occurs because the cash the borrower has generated

internally could be used to grow the business, support the

lifestyle of the owner(s), or repay debt. That the borrower

can earn its debt service does not necessarily mean that the

borrower can or will pay its debt service. To determine what

the borrower did with the earnings, the lender must use either

the accountant’s presentation of the statement of cash ﬂows

ortheUCAapproach.

Unfortunately,thestatementofcashowsisavailable

only in an accountant-prepared full disclosure compilation,

review, or audit. Rarely do lenders get this quality of ﬁnancial

information from a small business borrower.

ThealternativeistheUCAapproachgeneratedbymost

vendor-provided ﬁnancial analysis software. An issue with

theUCAapproachisthatitassumestherstpriorityforthe

use of cash is working capital, with everything else (such

as replacement capital expenditures, interest, and principal

payments on debt) being discretionary.

EvEry succEssful lEndEr knows that only cash pays loans.

The problem for all involved in the underwriting, approval,

and review of business loans is that there is no unanimity

on how to deﬁne cash ﬂow and debt service.

Lenders also recognize that the business and personal

affairsofsmallbusinessownersareintertwined.It’s not

enough to analyze only business cash ﬂow. Lenders must

also analyze personal cash ﬂow and integrate the personal

cash ﬂow with business cash ﬂow to determine global cash

ﬂow. Another vexing and related issue is knowing when it is

appropriate to term out a revolving line of credit.

This article—and another appearing in next month’s

issue—will compare and contrast eight approaches to cash

ﬂow, detail their strengths and weaknesses, and demonstrate

the application of each approach using ﬁnancial information

contained in a case study. The two articles will demonstrate

why lenders cannot use just one approach in determining

a corporate borrower’s ability to earn its debt service and

assessing its ability to pay its debt service.

This article will discuss the four most widely used

approachestodeterminingcashow:traditional,EBITDA,

EBIDA, and UCA.Next month’s article willdiscuss the

accountant’s direct and indirect approaches, as well as core,

personal, and global cash ﬂow. The second article also will

demonstrate how cash ﬂow analysis can be used to gauge

when it is appropriate to term out a revolving line of credit.

Case Study

XYZCompanywillbeusedtopresentandinterpreteach

approach to deﬁning cash ﬂow.

The company is organized as an S corporation. Home

townBankoffersthecompanya$1.75millionasset-based

line secured by accounts receivable and inventory, as well

as several term loans secured by real estate and equipment.

The amount currently outstanding on the company’s line of

credit is $744,000. The company also has principal payments

due this year on term debt of $346,000.

by John barrickman and christine corso

April 2013 The RMA Journal

To properly assess cash ﬂow available for debt service,

the lender must use core cash ﬂow (a.k.a. recurring or free

cash ﬂow) to determine the priorities for the use of cash and

when it is appropriate to change the priorities. The “priorities”

are multiple in nature: maintain the viability of the business

through replacement capital expenditures, repay scheduled

debt,makedistributionsinlieuoftaxes(Scorps/LLCs),grow

the business through various means, support the owner’s life-

style, and amortize a line of credit used to fund a permanent

investment in current assets.

Personalcashowfocusesonsourcesandusesofcash

to support the owner’s personal living expenses, lifestyle,

personal investments, and personal debt service. Recognizing

that the business and personal affairs of the owner and the

business are often closely intertwined, a lender must integrate

business and personal cash ﬂow into global cash ﬂow. The

integration is particularly important when the owner has

investments in multiple operating entities—for example,

builders and developers or owners of convenience stores

and hotel/motels.

Eachapproachprovidesanimportantperspectiveoncash

ﬂow. One should not be used to the exclusion of the oth

ers.Infact,inordertogetanaccurateassessmentofthe

borrower’s ﬁnancial condition and ability to repay debt, all

the approaches should be used.

Traditional, EBITDA, and EBIDA Approaches to Cash Flow

These approaches to cash ﬂow represent cash available for

debt service only if accounts receivable, inventory, ﬁxed

assets, payables, and accruals remain exactly the same from

period to period—in short, nothing on the balance sheet

changes except cash, ﬁxed assets to the extent of deprecia-

tion, and retained earnings. Obviously, this scenario is totally

unrealistic. To the extent that anything on the balance sheet

changes, it represents a source of cash or a use of cash. As

such, these approaches measure the borrower’s ability to

earn its debt service but say nothing about its ability to

pay its debt service.

Banks use these three approaches in underwriting

because lenders want to loan money to borrowers who can

earn their debt service. Lenders also employ debt service

coverage(DSC)ratiosinloanagreementssotheycanconfront

the borrower if deterioration starts to occur in the borrower’s

abilitytoearnitsdebtservice.It’simportanttodothiswhile

Table 1

XYZ Company, Selected Financial Information ($000s)

Balance Sheet 2009 2010 2011

ASSETS

Cash 65 141 84

Accounts Receivable 623 785 709

Inventory 265 435 291

Total Current Assets 953 1,361 1,084

Net Fixed Assets 3,941 4,143 4,726

Due from Stockholders 597 701 1,035

Other Assets 155 59 175

Total Assets 5,646 6,264 7,030

LIABILITIES

Notes Payable–Banks 511 947 744

CMLTD 379 346 319

Accounts Payable 664 645 634

Accruals 89 187 89

Total Current Liabilities 1,643 2,125 1,786

Long-term Debt 2,969 2,624 3,307

Total Liabilities 4,612 4,749 5,093

Total Net Worth 1,034 1,575 1,937

Total Liabilities and Net Worth 5,646 6,264 7,030

Tangible Net Worth 445 814 902

Working Capital (690) (764) (702)

Income Statement 2009 2010 2011

Sales 8,665 10,522 11,229

Gross Proﬁt 3,634 4,394 4,684

Operating Expense 2,991 3,304 3,714

Operating Proﬁt 643 1,090 970

Other Income 23 53 56

Interest 352 341 348

Net Income 314 802 678

Depreciation 276 269 327

Distributions 0 320 257

Additions to Fixed Assets 79 471 920

New Long-term Debt 17 1 1,002

April 2013 The RMA Journal

the borrower is still reasonably cooperative and

retains a viable core business and before the

bank’s collateral position is eroded. Meanwhile,

DSC,leverage,andliquidityratiosareemployed

in loan agreements to give lenders the oppor-

tunity to restructure or demand payment on

existing debt before the borrower defaults. The

challenge is in deﬁning the components of cash

ﬂow and debt service:

• Doweusethisyear’scurrentmaturitiesoflong-

termdebt(CMLTD)orlastyear’s?Thechoice

dependsontheobjectiveoftheanalysis.Uselast

year’sCMLTDiftheobjectiveistomeasurethebor-

rower’s ability to earn this year’s debt service, generally

when monitoring compliance with covenants in a loan

agreement.Usethisyear’sifthebankisunderwritinga

new loan request.

• Doweassumealineofcreditisfullyfundedforpurposes

ofcalculatinginterest?Generally,yes.

• If we add back depreciation to determine cash ow

available for debt service, should we include an estimate of

replacement capital expenditures (CAP X) in the

calculation? The bank should include an estimate of

replacementCAPX,orbepreparedtofundreplacement

CAPXwhentheborrowerhastoreplacexedassets.Unfor

tunately,veryfewbanksconsiderreplacementCAPXwhen

calculatingaDSCratio.

• ManyofourborrowersareorganizedasScorporationsor

LLCs,andtheownersareresponsibleforthetaxesonthe

income of the business. Should we assume a distribution

inlieuoftaxes?Yes.Assume34%ofthenetincomeofthe

business as a required distribution in lieu of taxes. These

distributions are not discretionary.

• WhenusingEBITDA,weaddbacktaxestothenumerator.

The denominator contains a pre-tax payment—interest—

and an after-tax payment—principal. Should we tax-effect

(principal payment ÷ 1 – tax rate) the principal portion of

thepayment?Failingtodosocouldsignicantlyoverstate

the borrower’s ability to earn its debt service, depending on

theprincipalportionofthepayment.Unfortunately,very

few banks tax-effect the principal portion of the payment.

To address the issue, more and more banks are turning

toEBIDAtodenethenumerator,recognizingthattaxes

are a required payment.

• ShouldwesubtractreplacementCAPXandtaxesfromthe

numerator,oraddthemtothedenominator?Theanswer

willresultintwodifferentDSCratios.Addingtheitems

to the denominator is more conservative.

• Inincomepropertylending,weusenetoperatingincome

(NOI)asameasureofcashowavailablefordebtser

vice.IsthisthefunctionalequivalentofEBITDAinC&I

lending?Itisthefunctionalequivalentwithtwocaveats:

1) There are limited working capital (inventory and re-

ceivables) considerations in income property lending, and

2) responsible income property investors make a provi-

sionformaintenancecapitalexpenditures(CAPX)inthe

operatingstatement.Unfortunately,manyincomeproperty

lendersaremakingthetransitiontoC&Ilendingwithout

beingsensitivetothemultiplemovingpartsinaC&I

borrower’s operating company.

• Manyofourlinesofcredit(LOC)arerenewedannually

and at some point they will need to be termed out. Should

weassumeanamortizationoftheLOCindetermining

debtservice?TherstquestionisiftheLOCisfunding

a temporary investment in current assets, generally for

seasonal or liquidity purposes, or a permanent invest

ment in current assets that are constantly turning over.

IftheborrowercanreducetheLOCtozeroperiodically

and does not extend payables or artiﬁcially reduce

receivables and inventory to accomplish the cleanup, an

assumedamortizationisnotnecessary.IftheLOCisnot

signiﬁcantly reduced periodically, the facility is funding

a permanent investment in current assets and can only

be repaid from future earnings, which will require a term

out of the line of credit. The alternative is to ﬁnd another

lender/investor or liquidate the permanent investment in

current assets, which will put the borrower out of business.

To avoid loaning too much money, the bank should assume

a three- to ﬁve-year amortization of the line of credit with

Each approach provides

an important perspective

on cash ﬂow. One should

not be used to the

exclusion of the others.

April 2013 The RMA Journal

control exercised over the current assets—for example,

theborrowingbase,controlledaccount,orlockbox.In

the absence of control, the line should be secured with

alonger-livedassetorSBAguarantytojustifyalonger-

assumed amortization. The assumed amortization does

not suggest the bank will immediately term out the line.

Itonlydemonstrateswhetherthebankcouldtermout

the line over a reasonable period of time and maintain an

acceptableDSCratio—forexample,1.25X.(See Table 2.)

• Table 2 shows the calculations for XYZ Company. It

illustrates the importance of making a provision for

distributions in lieu of taxes and assuming an amortization

of the line of credit. The line of credit offered to XYZ has

not been reduced signiﬁcantly for the past three years.

The reduction in the most recent year is the result of a

temporary decline in inventory and receivables. Since the

line is structured as an asset-based line, the reduction in

eligible collateral would necessitate a reduction in the line.

• ThisexamplehighlightssomeoftheweaknessesofEBITDA

asameasureofcashowavailablefordebtservice.EBITDA

suggestsstrongdebtservicecoverage.EBIDAindicates

XYZ can barely earn the debt service, including the

assumed amortization of the line of credit over a reasonable

periodoftime.TheEBIDAcalculationsuggestsitmaybe

appropriate to term out the line of credit.

Caution:

The issues outlined above demonstrate why lenders

candisagreeaboutwhetheraborrower“cashows.”Ide

ally, the bank’s loan policy should clearly deﬁne the bank’s

approachtoaddressingeachoftheseissues.Exceptionsto

the bank’s deﬁnition of cash ﬂow and debt service would

be a variance from procedure and should require a higher

level of approval.

Uniform Credit Analysis (UCA)

Developedinthelate1970s,theUCAapproachtocashow

analysis is embedded in all of the most widely used ﬁnancial

statement models. This approach also unwinds the timing

differences introduced by accrual accounting.

WhenreviewingtheUCAcashow,alendershouldfocus

on four key items:

• Cashfromtradingactivities. A positive number indicates

the company could internally fund its working capital

requirement.

• Cashafteroperations. A positive number indicates the com-

pany could internally fund its working capital requirement

and operating expenses.

• Cashafternancingcosts. A positive number indicates

the company could internally fund its working capital

requirement, operating expenses, cash taxes, interest, and

distributions to the owner.

• Cashafterdebtamortization(CADA). A positive number

indicates the company could internally fund its working

capital, operating expenses, taxes, interest, distributions,

and scheduled debt service.

The framework accounts for capital expenditures and

other long-term investments to determine if the company

hasanancingsurplusorrequirement.TheUCAapproach

then summarizes changes in short-term debt, long-term debt,

capital, and cash.

AnumberofissuesarisewheninterpretingaUCAcash

ﬂow statement:

• Implicitly,theUCAapproachsaystherstpriorityforthe

use of cash is working capital; everything else is discre-

tionary,includingdebtservice.Whilethismayaccurately

reﬂect the ﬂow of cash in a business, it does not accurately

reﬂect the priorities for the use of cash and when it is

appropriate to change the priorities (for example, term

out a line of credit).

• From2002toearly2007,manyborrowershadaposi

Table 2

Calculations for XYZ Company ($000s)

Traditional Cash Flow

Net income + Depreciation – Distributions in lieu of taxes (34% of net

income)

Last year’s CMLTD

2011

678 + 327 – 231= 2.24

346

EBITDA

Earnings before interest, taxes, depreciation, and amortization

Interest + Last year’s CMLTD

2011

678 + 348 + 327= 1.95

348 + 346

EBIDA

EBIDA – Distributions in lieu of taxes

Interest + Last year’s CMLTD + Assured 4-year amortization of outstanding on

LOC

($744k)

2011

678 + 348+327-231 = 1.28

348 + 346 +186

April 2013 The RMA Journal

tiveEBITDAbutanegativecashafteroperations(CAO),

primarily because they were growing and all the internally

generated cash plus additional borrowings on a line of

creditwereusedtosupportgrowth.Bydenition,there

was insufﬁcient cash ﬂow to pay existing interest and

principal payments, much less distributions to the owner,

unless the bank was willing to continue to lend money

and not ask to be paid.

• Fromlate2007tothepresent,manyborrowershavehad

anegativeEBITDAorinsufcientEBITDAtoservicedebt,

primarily because of reduced proﬁtability or operating

losses.Cashafteroperationshasbeenpositiveprimarily

because borrowers have been liquidating accounts receiv-

able and inventory as sales fell, in addition to forgoing

replacementcapitalexpenditures.Borrowershaveused

thepositiveCAOtomaintaintheirlifestylesandtomake

currentdebtservicepayments(positiveCADA).

• Typically,borrowerswithapositiveEBITDAandaposi-

tiveCADAarematurecompaniesinmatureindustries.If

thecompanyisgrowing,itcangenerateapositiveCADA

because it has a large gross margin reﬂecting a signiﬁcant

source of competitive advantage and a short operating

cycle.Veryfewborrowerstthisprole.Infact,many

will pursue strategies that are diametrically opposed—

for example, cutting prices, offering extended terms, or

carrying a broader range of inventory—which exponen-

tially increases the borrower’s ﬁnancing need if sales grow.

Compoundingtheproblem,theborrowerwillbeginto

take a large salary or distributions to enhance his or her

lifestyle, creating signiﬁcant ﬁnancing needs often funded

with a line of credit.

• InterpretingaUCAcashowstatementrequiresacom-

prehensive assessment of the sources and uses of cash as

outlinedintheUCAcashowframework.

• TheUCAcashowwillhighlighttheincreasingreliance

on short-term debt, but will not provide guidance on when

it is appropriate to term out the line of credit.

TheUCAcashowhelpsthelenderdeterminewherecash

came from and where cash went in a borrower’s business.

Itiscriticallyimportantinassessingaloanrequestifthe

borrower does not provide an accountant-prepared statement

of cash ﬂows. (See Table 3.)

SomeLendersuseCashAfterOperations(CAO)orNet

CashAfterOperations(NCAO)asthenumeratorincalculat-

ingadebtservicecoverageratio.CAOistheequivalentof

EBITDAandNCAOistheequivalentofEBIDAifaccounts

receivable,inventory,accountspayable,prepaidandaccrualsdo

notchange.UsingCAOandNCAOinthenumeratorofadebt

service coverage ratio implicitly assumes the borrower will

internally fund working capital requirements. Many Lenders

Table 3

UCA Cash Flow, XYZ Company ($000s)

Dec. 31

Net Sales 11,229

Change in Current Receivables 76

Cash from Sales 11,305

Cost of Goods Sold (Less Depreciation) (6,545)

Change in Inventories 144

Change in Accounts Payable (11)

Cash Production Costs (6,412)

CASH FROM TRADING 4,893

Selling, General & Admin. Expenses (3,167)

Other Operating Expenses (206)

Changes in Prepaids 0

Change in Accrued Expenses (98)

Changes in Other Cur/ Assets/Liabilities 0

Cash Operating Costs (3,471)

CASH AFTER OPERATIONS 1,422

Other Income (Expense) 56

Income Tax Expense 0

Change in Income Taxes Payable 0

Taxes Paid & Other Inc. (Exp.) 56

NET CASH AFTER OPERATIONS 1,478

Dividends or Owner Withdrawals (257)

Interest Expense (348)

Cash Financing Costs (605)

CASH AFTER FINANCING COSTS 873

Current Portion Long-term Debt (346)

CASH AFTER DEBT AMORTIZATION 527

Capital Expenditures (920)

Change in Long-term Investments 0

Change in Intangible/Other Assets (464)

Cash Used for Plant/Invest (1,384)

FINANCING SURPLUS/REQUIREMENT (857)

Change in Short-term Debt (203)

Change in Long-term Debt 1,002

Change in Contributed Capital 0

Other Changes in Retained Earnings 1

Total External Financing 800

CHANGE IN CASH (57)

April 2013 The RMA Journal

incorporatedebtservicecoverageratiosinaloanagreement.It

is impractical to hold a borrower responsible for a ratio he or

shecannotcalculatewithoutaccesstoaUCAcashowmodel.

TheUCAcashowdemonstratesthatXYZin2011was

able to internally fund its working capital requirement,

operating expenses, interest, and the distribution in lieu of

taxes, as well as its scheduled debt service. The company

could not internally fund the addition to ﬁxed assets or the

loantostockholders.Itwasabletoreduceitslineofcredit

primarily because it reduced inventory and accounts receivable

even though sales grew. The company covered the shortfall

in internally generated cash by increasing its long-term debt

and drawing down its cash balance. The cash ﬂow further

highlights an issue the lender must investigate—why the own-

ers have to take so much out of the business in the form of

loans to shareholders.

Caution:

TheUCAapproachtocashowanalysismayac

curately reﬂect where cash comes from and where cash goes

in a business, but it doesn’t help the lender determine the

priorities for the use of cash. The borrower may use the cash

to grow sales, enhance his or her lifestyle, or amortize a line

ofcredit.Also,theUCAapproachdoesnotaddresswhenit

is appropriate to change the priorities (for example, to term

out a line of credit).

Conclusion

This article discussed the four most widely used approaches

todeningcashowanddebtservice.Eachapproachoffers

a different perspective on the borrower’s ability to repay debt.

Nextmonth’sarticlewilldiscussfourmoreapproachesto

deﬁning cash ﬂow, offering additional insights from the ac-

countant’s statement of cash ﬂows and core, personal, and

global cash ﬂow. The core cash ﬂow approach will determine

the maximum amount to be made available on a line of credit

used to fund a permanent investment in current assets. The

article also will compare all eight approaches to cash ﬂow

using ﬁnancial information from the XYZ case study.

••

John Barrickman and Christine Corso are principals of New Horizons Financial

Group, Amelia Island, Florida. For more information about New Horizons, visit

NewHorizonsFinancial.com.

More information is available in RMA’s Cash Flow Analysis course.

Visit www.rmahq.org. Click on Events and Training.

April 2013 The RMA Journal