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CapEx and DCR: Missing something?

David’s question:

What is the best rule of thumb for Capital Expenditures (CapEx) and how it reduces cash flow? When I use the UCA statement to get the debt service coverage ratio it really isn’t factoring in CapEx at all. Shouldn’t it?

Linda says:

This is the second question on CapEx this year and as companies that held off on capital expenditures during the recession gear back up, it makes sense that lenders are noticing.

Business lending or Farm lending?

I am wondering if you are primarily in commercial business lending or farm lending. I ask because in my experience, AgLenders are much more likely to take what they refer to as Capital Asset Replacement into consideration in a more formal way. Business lenders often notice, but I am not sure many have a standard approach. (If you are a business lender who does, I’d love to hear from you).

Common approaches

Do not consider outflow for CapEx:

  1. A simplifying assumption is made that either the company is not growing and recent capital expenditures are not recurring in nature, or
  2. A simplifying assumption is made that any significant capital expenditures are financed and, therefore, the cash outflow is represented in the debt payments to be serviced.

Consider outflow for CapEx:

I have not seen outflow for CapEx folded into Cash Flow Available to Pay Debt (Debt Repayment Capacity) but have seen it considered in the analysis in a couple of ways:

  1. After calculation of cash flow available to pay debt and reduction of the annual debt service, some lenders do a final calculation with the resulting margin. They may compare it, for example, to the down payment made on the capital expenditures during the covered period to be sure the unfunded portion of capital expenditures was covered.
  2. I have also seen the margin adjusted downward by the excess of depreciation over out-of-pocket down payment on capital expenditures plus principal payments of capital expenditure financing. The idea here is that the depreciation represents a reasonable annual outflow for equipment replacement and if, this year, they spent less the ‘under-replacement’ is counted against the margin. Note this is after they meet your Debt Coverage Ratio requirements using your standard approach. And it assumes depreciation is a meaningful figure.
  3. Same as above, except, the lender substitutes the depreciation in the tax return or financial statements for a better estimate of necessary capital expenditures from experience or a formula. As an example, AgLenders lending to an operation that is equipment intensive might compare what was spent on down-payment and principal payments on equipment loans to 10% of the cost of equipment in use in the operation. Again, if they are ‘getting behind’ by this measure, the lender will reduce the margin by the equipment replacement shortfall. This allows better analysis of a year when the operation did not need to replace equipment. The lender still considers their ‘normal’ needs.
  4. Finally, consider, with a growing company with accelerating capital expenditure needs or a company that has been growing and is now tapering off, requesting a forecast of capital expenditure near- term needs and factor that in, both to operating cash flow and to liquidity considerations.

Important for Cash Flow and Debt Repayment

As you can see, there are a variety of ways to look at this and to factor it in, if at all. Whatever your process, though, if significant CapEx are not reflected in the usual formulas you can still point out the prospective borrower’s need for higher margins or liquidity due to their CapEx short-term needs.

Another loan for you to make?

On the plus side, perhaps through the focus on CapEx you will uncover a need for future equipment financing that you can start discussing before they need it.

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Linda Keith, CPA

Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis.
She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans.
Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.