For most small business owners, there’s a very fine line between their personal and business financial affairs. That’s because most small businesses are now established as pass-through entities (S corps, LLCs or partnerships), with some items of business income and expenses passing through to the owner’s personal tax return.
In addition, many owners are now financing their businesses via personal credit cards and home equity lines of credit, further blurring the line between personal and business affairs. As a result, there is a significant interrelationship among the income, expenses and cash flow of most small businesses and the business owner’s personal finances.
It’s more critical than ever that lenders carefully examine borrowers’ complete business and personal financial situations when analyzing small business loan requests and integrate them into what is referred to as global cash flow. Otherwise, there’s a good chance you will get an incomplete (and possibly very inaccurate) picture of the business’s and owner’s true financial situation.
The mortgage meltdown that started earlier this year and the resulting credit crunch are all the more reason to sharpen your focus on global cash flow. One of the main repercussions of these developments has been a disappearance of liquidity, which may hit small business owners – and residential builders and developers, in particular – especially hard. (See boxed article on page 3 for more details on the impact on builders and developers.)
Figuring Global Cash Flow
Global cash flow should include all of an owner’s business and personal income/salary, debt and other financial obligations, and liquidity.
On the business side, cash flow is fairly straightforward:
+ depreciation/amortization and interest
On the personal side, the calculation is as follows:
Salary + interest/dividend income +/- Rental cash flow
+ Cash distributions from Schedule K-1 (for S corps, LLCs, partnerships)*
– Contributions from Schedule K-1 (for LLCs and partnerships)
*Some are required and some are discretionary.
This total is multiplied by a percentage that excludes taxes and personal living expenses – 40 percent, for example (allowing 60 percent for taxes and living expenses). Personal debt service (typically figured as the debt revealed on the owner’s personal credit report cross checked with the borrower’s loan application) is then subtracted from this to arrive at net personal cash flow. Note: Personal debt obtained on the corporate side of the bank (e.g., owner-occupied real estate) is typically not disclosed on the personal credit report.
To arrive at a bottom-line figure for global cash flow, simply add business cash flow and net personal cash flow. The next step is to determine an owner’s global debt service capability, which is global cash flow divided by business debt service. See the global cash flow worksheet for the detailed calculation.
How might the failure to determine and analyze global cash flow skew your financial analysis?
For one thing, the owner may be taking significant sums of money out of the business in distributions, which may cause the cash flow of the business to appear weak. However, if the money isn’t needed in the business and the owner is investing it in liquid assets, this shouldn’t be a problem.
Conversely, the business may have strong cash flow, but the owner may have assumed an excessive amount of personal debt (perhaps even to finance the business itself) that will require him or her to take too much money out of the business, thus weakening global cash flow.
However, if the owner has other sources of income outside of the business (such as ownership in income property or another business, for example), this will strengthen the global cash flow position. Similarly, if the owner has invested heavily in liquid assets, this will also improve the global cash flow picture.
Here are a few more important points to keep in mind when determining global cash flow:
- For small businesses that operate via multiple pass-through entities (S corp, LLC or partnership), with significant income and expense items flowing through to the owner’s personal tax return, the adjusted gross income on Schedule 1040 will likely bear no relationship to the actual cash generated
- It’s critical to obtain the owner’s Schedule K-1 in order to identify these pass-through items and the amount of cash the owner is actually taking out of the business. This cash won’t show up anywhere else on the owner’s personal tax return
- From the lender’s perspective, net personal cash flow is the all-important amount of personal cash that would be available for business debt service
- In today’s environment, liquidity – especially personal liquidity – is king. Unfortunately, many small business owners have little or no personal liquidity outside of their retirement accounts, which by law cannot be liquidated or attached, even in bankruptcy
In calculating global cash flow, your primary goal is to determine a borrower’s ability to generate cash to service debt. Remember, however, that not all business cash flow will be available for personal and business debt service: A portion of it must also be used to support the daily operations of the business (working capital, replacement capital expenditures, etc.)