Getting Behind the Numbers

RMA Journal, The, July, 2001 by Frank DiLorenzo

This is the seventh in a series articles that identify situations in which further questioning of computer-generated financial ratios may be warranted. In this article, the author focuses on how nonrecurring balance sheet changes can distort debt service coverage.

We all know that balance sheet changes can generate large sources and uses of cash, materially affecting a company's cash flow. The most common changes to do so include receivables, inventory, and payables. If the additional step of evaluating whether these sources and uses of cash are recurring or nonrecurring is not taken, the analyst may draw erroneous conclusions about cash flow and debt service coverage. Some very bankable requests could be turned down, while some very marginal requests could be approved.

Let's look at three fiscal year-end cash flow statements for ABC company (Figure 1). On the surface, looking only at the spreadsheet-generated debt service coverage numbers might lead to the wrong conclusion that debt service coverage for ABC Company is declining. In fact, ABC Company's base level of debt service coverage has remained quite stable throughout all three years.

When reviewing cash flow statements such as those in Figure 1, it's necessary to look beyond Net Cash After Operations to examine what makes up that number. In the years shown in Figure 1, there are two nonrecurring events--one in 1998 that made cash flow (and debt service coverage) appear higher, and one in 2000 that made cash flow (and debt service coverage) appear lower.

In 1998, ABC Company extended its payables, generating $150,000 in cash. This was a one-time occurrence, as ABC has no plans to further extend payables. Further extending payables could adversely affect ABC's relationship with its suppliers.

In 2000, ABC was able to buy $150,000 of inventory from a competitor who was retiring from the business and liquidating her assets at bulk sale prices that were well below market. Had this $150,000 inventory purchase not occurred in 2000, there would not have been the $150,000 use of cash.

In 1998, debt service coverage would have been 1.5x [(485 - 150)/225] if ABC had not extended payables. In 2000, debt service coverage would have been 1.6x [(210 150)/225] if ABC had not made the large inventory purchase. As you can see, both 1998 and 2000 adjusted debt service coverage ratios are comparable to 1999's 1.4x debt service coverage ratio--a year in which no material balance sheet changes occurred. These adjustments are needed to properly recognize that the $150,000 source of cash from payables in 1998 cannot be duplicated in future years, and the large inventory purchase in 2000 that required $150,000 in cash was unusual and, similarly, will not be repeated. The irony is that the period in which debt service coverage appears to be its weakest (0.93x in 2000) is actually when things are going the best for the company. In 2001, ABC will be selling off that low-priced inventory it bought in 2000, resulting in an improvement (albeit, again, a one-time improvement) in both profitability and cash fl ow.

Of course, not all large uses of cash on the balance sheet are discretionary events like the examples just shown. Take a situation where receivables are slowing--the use of cash may in fact be recurring, and no adjustment should be made.

There are two things to keep in mind when reviewing the balance sheet changes reflected in the Summary UCA Cash Flow Statement:

1. To what extent are the balance sheet changes nonrecurring?

2. To what extent can the borrower control the balance sheet changes?

Answering (1) and (2) can be determined by thorough investigation and discussions with your borrower.

Adjusted cash flows are a tool to help one determine what cash flow may be on a recurring basis. This is what the lender needs to know in order to make informed credit decisions. When evaluating a company's cash flow, you want to look at both the actual debt service coverage number provided in the spreadsheet and the adjusted cash flow of the company. It is in this manner that one can determine what is really going on with the cash flow of a firm.

When using spreadsheet generated debt service coverage ratios, take the time to determine what is going into those numbers. Failure to do so could result in the Bank saying "yes" when it should say "no", and saying "no" when it should be saying "yes." Either error can impact the profitability of the bank.

DiLorenzo is a former SVP with First Bancorp in Naples, Florida, and is now pursuing his MBA at Florida State University.

Figure 1
Year-end Cash Flow Statements
Amounts in $000's                           1998       1999       2000
Net Sales                                  3,000      3,000      3,000
 /- Change in Receivables                   (30)       (20)         20
=   CASH COLLECTED FROM SALES              2,970      2,980      3,020
-   Cost of Goods Sold                   (2,250)    (2,250)    (2,250)
 /- Change in Inventories                     25       (25)      (150)
 /- Change in Accounts Payable               150        (5)        (5)
-   S.G. & A. Expense                      (400)      (400)      (400)
=   CASH AFTER OPERATIONS                    495        300        215
 /- Other Income (Expense)                  (10)         15        (5)
=   NET CASH AFTER OPERATIONS                485        315        210
-   Interest Expense                       (175)      (175)      (175)
=   CASH AFTER FINANCING COSTS               310        140         35
-   Current Portion of Long Term Debt       (50)       (50)       (50)
=   CASH AFTER DEBT AMORTIZATION             260         90       (15)
Debt Service Coverage                       2.2x       1.4x      0.93x
                                       (485/225)  (315/225)  (210/225)