I have heard of a shortcut for debt that you can use when you do not have the details. How is it calculated and when is it safe to use?
So glad you asked the ‘when’ question with the ‘how’, Teresa. I love shortcuts and this one is very handy when you are not lending to the company in question. That could be a consumer or mortgage loan to the owner. Or it could be a loan to another company owned by the owner.
How to calculate the shortcut
First, this does not work with a sole proprietorship or one-owner LLC filing either Schedule C or F in a 1040. We need a balance sheet.
When you have a balance sheet in an 1120, 1120S or 1065 return, go to Schedule L and find the line in liabilities called ‘Mortgage, Notes and Bonds Payable in Less than 1 year’. I would give you line numbers but they vary in the three returns.
This represents the principal due in the next 12 months, perfect for estimating the loan payments of the next year. If you have added back interest expense from the front page of the return, combine that interest expense with this principal and you have an estimate of annual term debt payments.
Or if you have not added back interest expense on the front page of the tax return, just subtract the principal. Same result…
When the shortcut is a bad idea and why
Using this shortcut assumes that debt has not varied since the balance sheet date. We are taking a chance that they have not either added new debt or paid down debt early. If they have, our shortcut estimate will be off.
Using this shortcut assumes they complete the balance sheet in the tax return correctly. Have you ever seen a tax return with mistakes in it? I have. One clue is if there is no entry in ‘Mortgage, Notes, Bonds Payable in Less than 1 year’ but there is a balance in ‘Mortgage, Notes, Bonds Payable in 1 year or more’. Sure, it is possible that the loan is interest only for the next year but my guess is it is more likely they did it wrong and did not break out the current portion of long-term debt.
Using this shortcut assumes they did not include the outstanding balance on an operating line of credit in ‘Mortgage, Notes, Bonds Payable in Less than 1 year’. LOC amounts ARE due in the next 12 months, so it would seem logical to put it there. But the LOC if it has to rest yearly is borrowed and paid back in the same year. So you do not need operating cashflow to pay the principal.
Who uses the shortcut?
Bankers of all types might use this shortcut to get an answer to cashflow available to pay debt and the owners, at least as a first step. Consumer and mortgage lenders regularly use the shortcut for the companies owned by their individual borrowers. Business development officers looking at a tax return for the first time to see what is possible often use the shortcut to get a quick-and-dirty guess as to the prospective borrower’s cash flow situation.
Check your guidelines to see if you, too, can use this shortcut. As long as you understand the drawbacks to the shortcut, I think it is a useful tool to have in the toolbox.
More on debt, debt ratios and debt shortcuts
One of the self-study online modules at Lender’s Online Training is on the topic. Go check it out!