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By Vimal Patel - Sageworks
If you hadn’t guessed by my name, my family is in the hotel business. A few years ago my father sought to purchase another property along with a family friend. As they compiled all of their financials for the loan request, I noticed that the two files of financials that were being submitted to two different banks were of different sizes.
Our friend’s bank (Bank A) asked for the business financials for the new purchase, and the personal financials for both of them. I don’t think anyone would be surprised by this. However, my father’s bank (Bank B) asked for more information. Bank B wanted the financials for my father’s two existing hotels, and our friend’s three existing hotels.
Same project, same hotel, same loan, but two very different processes and sets of information with which to make lending decision.
It wasn’t too long ago that everyone operated like Bank A. A business loan could be obtained by anyone demonstrating his/her ability to repay that loan. Now the rules have changed because of regulator induced pressure from the FDIC, FED, OCC, and the OTS; and real risk in the economic environment.
Like Bank A, many banks will do a cash flow analysis on a particular business and then say that additional support is provided by the guarantor who is worth $XX million dollars. However, this doesn't tell the whole story about how strong the guarantor is or is not, much less the credit.
From the regulators’ perspective, the lack of effective Global cash flow analysis is a recurring theme in problem banks (FYI, Bank A was on the problem bank list). A large net worth guarantor who has all of his/her assets tied up in non-cash producing real estate or a business venture that is losing money may not have the capacity to support the debt if the bank calls upon them to honor their guarantee.
When a banker lends to a borrower that is involved with several different businesses, LLCs, or properties, it can be difficult to evaluate the credit risk of the bank's loan without an analysis of all these entities that can affect the borrowers’ ability to repay the lender. In many ways business and personal cash flow may be comingled:
- It’s common for owners to lend personal funds to or borrow funds from their businesses.
- It’s common for the business (for tax advantages primarily) to rent its office/warehouse/production facilities from a real estate holding company or partnership controlled by the business owners.
- It’s common for owners to control their own levels of salaries, bonuses, benefits, and dividends-to the extent allowed by prudence and tax regulations.
Comingling can be a challenge, and so can cash deprived entities.
Let's assume my father’s hotel (business A - which borrows from First Bank) generates sufficient cash flow to service its debt. But my father, “John”, also guarantees the debt of other related entities (hotel B and C), and these other entities do not generate sufficient cash flow to service their debt obligations at Second Bank. The credit risk in business A increases at First Bank because businesses B and C need financial support from “John”. “John”, as guarantor, may need to fund the cash flow shortages of businesses B and C by using or diverting some of the cash flow generated by business A. If the cash flow shortfall continues or increases, it could eventually negatively affect “John’s” ability to service debt at First Bank AND Second Bank.
The OCC’s Internal Guidance from April 9, 2008 puts it this way:
An analysis of the guarantor’s global cash flow should consider inflows, as well as both required and discretionary cash outflows from all activities. This may involve integrating multiple partnership and corporate tax returns, business financial statements, K-1 forms, and individual tax filings. Anything short of a comprehensive global cash flow analysis diminishes confidence in the assessment of guarantor strength, even in the face of significant liquid assets since that liquidity may be needed to fund contingent liabilities and global cash shortfalls.
When performing a global cash flow analysis, two common errors take place.
First, First Bank could decide to ask for all the information from the secondary entities and business, and even spread them all individually. However, there is never an effort to combine these into a single Global Cash Flow.
As one examiner stated, “The guarantor’s global cash flow should consider inflows, as well as both required and discretionary cash outflows from all activities. This involves integrating multiple partnership and corporate tax returns, business financial statements, K-1 forms, and individual tax filings.” The integration of all this information is key to a comprehensive global cash flow analysis that leads the banker to the best decision and gives examiners confidence in their process towards that decision.
Second, First Bank can decide to ask for all the information from the secondary entities and business, even spread them all individually. Even combining all the spreads in a single cash flow, but then making no attempt to discern the overlapping income.
The goal of comprehensive Global cash flow analysis is getting to the real dollar(s) available for debt service. In most of these case there is 1040 Schedule E part 1 or part 2, Schedule K distribution, or other overlapping income where A + B + C is actually leading the banker not only to a wrong number, but a higher wrong number making the borrower look stronger than they really are.
Since so much of the bankers’ decision and regulators confidence in the bankers’ decision hinges upon a comprehensive Global cash flow analysis, the approach must be define clearly and executed thoroughly for each credit.
Global cash flow analysis is an invaluable tool. When done properly, its ability to recognize the comingling of business and personal funds makes this approach the most comprehensive and accurate tool available in bank lending for small business.
By the way, my father never got the loan. Bank B found out that my father’s friend had a hotel dumping cash left and right and had the potential to drag new property into the ground. My father, as a customer of Bank B, was glad to find out before he entered into a tenuous situation, thanks to Bank B’s effort in conducting a thorough Global cash flow analysis.
Global Cash Flow Analysis: What is it good for? Saving my dad’s business and the bank’s performance.
- Vimal Patel
Sageworks, Inc.
