As global cash flow has become more of a necessity than an option, the majority of financial institutions are now performing some type of combined ratio analysis. The issue lies in the fact that there are several methods of global cash flow analysis being used. And some lead to erroneous conclusions. Once regulators and the economic environment made GCF analysis imperative, financial institutions started implementing some form of GCF calculation to satisfy credit risk management pressures, even if it was not the most accurate method available. It is vital for financial institutions to review their GCF analysis to ensure they are lending safely and productively.
Global cash flow analysis is used to assess the combined cash flow of a group of people or entities to get a global picture of their ability to service the proposed debt. Global cash flow is looking at the business’s cash flow, the owner’s cash flow and the cash flow of all related people and businesses and combining them in the proper way to arrive at global cash flow ratios such as debt service coverage ratio that will be the basis of a credit decision. It is no longer enough to simply look at the business by itself and the guarantors by themselves because owners and their businesses are becoming more and more comingled every year.
Business and personal cash flow can become comingled when owners lend personal funds to or borrow funds from their businesses. It is also common for the business (for tax advantages primarily) to rent its office and other facilities from a real estate holding company or partnership controlled by the business owners. And owners can control their own levels of salaries, bonuses, benefits and dividends to the extent allowed by prudence and tax regulations.
When performing a GCF analysis, there are several mistakes that financial institutions make that could be the difference between approving and denying a loan request.
Obtaining business and personal financials but not combining them into a single cash flow. It may seem obvious that this isn’t a GCF analysis by definition, but this mistake happens. The lender believes it is performing a “global” analysis by obtaining and analyzing all of the people and businesses involved in the loan request, but it is not truly global until all of these cash flows are combined into a single GCF.
Not analyzing or requesting all of the necessary tax forms. Tax returns and their supporting schedules are vital to performing a GCF analysis correctly. Without the necessary tax schedules, cash flow numbers can be greatly skewed due to using paper transactions that change income or expenses for tax purposes but have nothing to do with actual cash flow. For example, the K-1 forms are crucial for obtaining the distributions and contributions applicable to the individual, which provide an actual cash flow amount.
Double counting income. Again, it may seem obvious to remove portions of income that are counted twice (once by the business and once by the individual, for example), but this is a point that is often overlooked by less experienced analysts when performing their GCF analysis. The most common error starts when the business borrower is given full credit for EBITDA without subtracting distributions to shareholders. It is compounded when shareholder or guarantors are given full credit for 1040 Schedule E part II “earnings” rather than distributions. The error increases if shareholder K-1 earnings are added to their 1040 E part II amounts.
Inconsistencies between employees in GCF analysis. This key point is often unnoticed by financial institutions. Each employee performing GCF needs to execute it in the same way to create consistency at the institution. Different people calculating GCF in different ways will result in poor loan, pricing and risk rating decisions. A consistent approach to global cash flow should be a top priority for lenders once they decide on a standard and accurate GCF method. Regulators will pick up on these inconsistencies and exploit them during reviews. Once they find inconsistencies in your calculations they dig deeper. And loan downgrades will lead to an increase in reserves.
Global cash flow has quickly become a litmus test for credit analysis and risk rating. However, analysts and lenders must apply industry best practices to their GCF process to ensure accuracy. In addition, Chief Credit Officers and members of your loan committee must insist on quality and consistency across individuals and departments. Used properly, GCF can easily become the most valuable and accurate credit risk management tool available when making lending decisions. Performing a precise Global Cash Flow analysis is not only helpful to the financial institution, but also to the health of the economy and to the individuals trusting the lender to provide insight and judgment on the validity and security of their loan requests.
Brad Schaefer is an analyst at Sageworks Inc.
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