Performing aggregate analysis

RMA Journal, The, Oct, 2003 by Richard A. Clarke

Leverage rules. That said, the lender needs to be sure to look at the true aggregate leverage of the entire enterprise. Here's a useful how-to for community banks seeking to find this true leverage as well as ways to measure it. Lenders who accommodate borrowers with marginal leverage and cash flow are actually providing pseudo equity at a conventional rate and will fall victim to losses.

According to an old Indian fable, six blind men each describe an elephant quit, differently depending on which part of the animal he happens to be touching. Lenders who do not consider the true aggregate leverage or cash flow of the entire enterprise are just like the blind roan holding the elephant's tail while declaring that "the elephant is very like a rope." It makes no sense to view the corporate leverage of just one affiliate or the cast flow of one piece of real estate without knowing the total leverage of the entire organization or the aggregate cash flow of the combined entities.

Why Leverage Is Important

It is much easier to assess the future borrowing potential of a business enterprise if the lender is fully aware of the debt burdens borne by various affiliates. This concept flies in the face of the dogmatic approach to narrow cash flow lending, prevalent in the early 1990s but now quite discredited.

Smart lenders support smart entrepreneurs who preserve unused borrowing capacity for either emergencies or opportunistic transactions. This capacity is measured by both aggregate leverage in relation to industry standards and the level of unused formula availability under secured borrowing arrangements.

Conversely, many borrowers "pig out" at the debt buffet and move from one liquidity crisis to another. The old adage "For want oft shoe nail, a kingdom was lost" certainly applies here. These businesses have a high failure rate, are the prime causes of bank loan losses, and do not show the desired characteristic of developing into the type of stable long-term relationships that banks desire.

Therefore, it is most appropriate for modern bankers to return leverage analysis to its prior prominence. In doing so, however, it is vital to look at the true aggregate leverage of the entire enterprise. Remember that corporate resources as well as your own low proceeds will always flow to the location of greatest need. Upstreaming and downstreaming covenants are helpful, but if an entrepreneur has a cash emergency in a related company, most likely there will be a covenant violation not usually detected by the lender for some time. On a positive note, more solvent affiliates can and will support your borrowing entity in time of need.

How Do We Measure Aggregate Leverage?

* Procure full consolidating financials for all consolidate entities as well as for unconsolidated affiliates (and ensure that your UCC filings are appropriate).

* Mark all assets to realistic market values if there is reason to believe there is material overstatement.

* Eliminate goodwill, especially if your borrower overpaid for the assets in question and is now losing money as a result.

* Do not accept net asset values for significant investments. Separate out the asset and debt components. If your borrower has a partial ownership interest, simply apportion the amounts accordingly. Remember that even nonrecourse debt has to be repaid for the equity component to have value, so it is highly appropriate not to exclude any debt forms. This simple exercise could have prevent ed bank funding of the Enron disaster.

* Include all known liabilities, both direct and contingent, whether shown on the financial statements or not. Bankers who take the time to read audit footnotes will find a wealth of information in this regard.

* Do not include subordinate debt as equity unless there are absolutely no rights of acceleration, full and complete subordination, and no ongoing debt service, and the subordinated debt otherwise exhibits all the true characteristics of equity, not debt.

* Question all transactions that appear to create equity other than by way of real cash contributions or earnings substantiated by audit confirmation and/or tax returns. Creative accounting remains a problem in spite of recent events and publicity. Remember that the receipt of financials is the starting point of your analysis, and officer value adjustment are always appropriate.

* Now comes the easy part. Simply aggregate the realistic asset and liability totals and perform the traditional leverage calculation of dividing total assets by total liabilities. RMA's Annual Statement Studies provides excellent standards by which to assess your borrower's leverage in comparison to others in the industry. (RMA numbers may not include all of the related entity debt or debt associate with balance sheet net investments.)

Had Enron reported all debt relating to net investments or otherwise held by unconsolidated affiliates, the total result would have precluded any of the loan approvals that subsequently occurred.

If a privately held small business owns and operates its own production facilities, the real estate debt should be included in both the leverage calculation and the debt service analysis methodology discussed in the following section.