When I am calculating global cash flow and a partnership has a larger cash distribution than cash flow (EBITDA) for the year, what type of questions would you ask of the borrower? Are there any scenarios in which this is acceptable?
I would really want to know where the distribution is coming from. Once I answer that question, I can decide if I am concerned.
Source of distributions
For debt repayment capacity, lenders prefer recurring cash flow generated from operations. With a closely held company and global cash flow analysis, we look at the company combined with the owner since the owner can take out whatever is in the business bank account as compensation or distributions.
As in your situation, distributions may come from many sources:
- cash flow generated from operations
- cash flow from a nonrecurring windfall
- excess liquidity
- selling off critical assets
- selling off assets no longer needed
- another owner contributing capital
- the company borrowing money
Should you be concerned?
Since you have EBITDA you either have the full return or financial statements of the company. I’d take a look at the balance sheet to see if I can tell where the excess came from. If their liquidity is still solid and they did not sell of critical assets or exceed your debt covenants for debt coverage, I might not be concerned.
When I look at the balance sheet and the distributions in excess of recurring cash flow for the year result in too much debt for the asset value or too little liquidity, that is when I’d be concerned.
While you are at it, and since the focus of your question is global cash flow, take a look at the personal balance sheet if you have it.
- Why did the owner/guarantor need this distribution?
- How desperate is he?
- What is he planning to do with it and how will that impact his risk exposure?
I recently was asked if, in a global cash flow analysis, we need to consider the guarantor at all if their personal net cash flow is negative. If your guidelines call for global cash flow analysis, then I believe you always need to consider the guarantor. Again, I’d need to understand why the personal net cash flow is negative and whether that is an anomoly.
Global cash flow analysis is a great tool, and understanding what weight to put on the owner/guarantor and on the business is important. This depends, in part, on whether your loan is to the owner/guarantor or to the business, what assets are available, liquidity and other factors.
The rest of the story
After the first answer, Brad offered additional information. After the distribution, the cash position was not very strong and the prominent asset was a building. Retained earnings is negative. And the source of the excess was a short-term line of credit. YIKES!
Using short-term borrowing to pay the owners is definitely a concern.
- What is the purpose of the line of credit?
- Is it intended for operations?
- And, I am still interested in what the balance sheet looks like after the excess distributions. Clearly, the line of credit must be repaid, but does it create a debt-coverage ratio that is unacceptable?
Short-term really was short
As the drama unfolded and Brad kept asking good questions of the borrower to get to the bottom of the situation, it turned out the line of credit was very short-term while they waited for assets to sell out of another entity. It was secured by gold. By the time the question was asked, the owner had already paid back the secured line.
My last question: Who was in possession of the gold? Just curious!
Join the discussion
This exchange was part of the discussion after Brad viewed the module on 1065 K-1s at www.LendersOnlineTraining.com. If you need a resource to better understand global cash flow in small business lending, try our free modules.