Sean’s question:
I have a personal guarantor to my main borrowing entity. That guarantor also has ownership stake in 6 other partnerships/s-corps. To look at the global cash flow of my borrowing entity and the guarantor, would I just look at the K-1’s from those six other entities or would I need to review the full financials from those other entities? I believe I should only be concerned with the K-1’s since that pertains to cash inflow and outflow specific to my guarantor.
Linda’s answer:
Your question is a guidelines question, Sean. Many lenders doing a global analysis would only include the business returns of an entity obligated on the loan they are considering. They would use the K-1s of entities the guarantor owns as an indication of the guarantors available cash flow.
Other lenders would consider % ownership of the additional entities. At an extreme, it seems obvious if I am a 100% owner of another company, what I am taking from that company is less helpful in projecting my personal cash flow than what that company can afford to pay me. You can imagine, further, that if one or more of my closely held companies is in trouble, I might come to you with a company doing well to borrow on it, and then rob Peter to pay Paul.
Still other lenders might consider the relative impact of the k-1 cash flow from the non-obligated entity. If it is significant, and the largest source of guarantor cash flow – and you are strongly relying on guarantor cash flow – perhaps you need to be confident that K-1 cash flow is supported by an ongoing source.
So, I cannot give you a definitive answer. You will need to find out what the guidelines are for your company. It may be that if they are 25% owner or higher, you will at least need to get the entity tax return to determine that the K-1 cash flow is supported by operations.
The trouble with ‘just’ the K-1s
The danger will be that you rely on what someone has been taking home instead of what is sustainable. There are 6 sources of cash flow available to pay the owners, and only one that is sustainable.
- Operations
- Built up liquidity
- Borrowed money
- Capital injected from other owners
- Sale of assets
- Windfall
Without looking at the underlying tax returns you have absolutely no idea which it is. Your risk is probably less with a low % owner because they have less control over what they take home.
I am not saying you are wrong to follow your guidelines and use the K-1s when the entity is not obligated on the loan. I am saying that if you follow a cut-and-dried rule you probably will be wrong some of the time.
More on pass-through entities
These are the most challenging for most lenders, whether you are lending to the entity or to the owner. That is why seven of the 22 modules in the Tax Return Analysis virtual class for lending and credit professionals focus on them.
