Created especially for APPEXassociationofagriculturalproductionexecutives.org/Duelke Notebook... · – grading, crop dusting, custom cultivating, trucking, controlled atmosphere/warehousing,

Copyright 2012 by Deannco Financial Enterprises. All rights reserved. Used by permission @ AAPEX Meeting – February 2012

1

Commercial Lending An Inside View of How Commercial Lenders Think

Speaker Dean W. Duelke

President

Deannco Financial Enterprises Specializing in Credit Training to the Banking Industry

4790 Irvine Blvd, Suite 105-125, Irvine, CA 92620-1973 www.deannco.com

Created especially for

The Ritz-Carlton Key Biscayne, Miami Tuesday Afternoon, February 14, 2012

Association of Agricultural Production Executives APPEX

Copyright 2012 by Deannco Financial Enterprises. All rights reserved. Used by permission @ AAPEX Meeting – February 2012 2

Improving Your Borrowing Relationship PURPOSE: To provide an understanding of what a commercial banker/lender does, what they need in order to evaluate a loan request or renewal, what they look for when they analyze a borrower financial operation, and a little about the analytical process that lies behind most commercial lending decisions.

TAKE-AWAYS: Help improve your credibility and communication skills with your

lenders Become more aware of what influences growth and cash flow Realize how a prudent lender evaluates repayment ability Understand the consequences of taking on long-term debt Learn what key factors ensure healthy financial performance Estimate your asset growth potential --- it impacts sales growth

We’ll address two basic issues: 1) The need for and components of Basics of Operational Cash Flow (OCF) – the source for repaying term debt; and 2) A look at determining basic liquidity

requirements (How Much Basic Working Capital is Needed to Be A Viable Operation).


- Bankers & Lenders Want Loans…without loans, the bank has few earning assets!

- Made to credit-worthy relationships – meaning: The borrower repays as agreed… From the intended repayment source… And the business continues to be “adequately profitability”… And it maintains “reasonable equity” in their assets… And it provides adequate and timely financial information so

the lender can monitor performance of those issues… And the loan is structured in a way that is appropriate to the

borrower’s cash flow as well as the bank’s loan administration abilities & lending culture…

And it provides a reasonable profit for the bank.

Understand What Your Lender Wants …A Growing Loan Portfolio of Creditworthy Borrowers that Pay As Agreed

One of the first things the lender wants to know is the reason for needing a loan.


Businesses borrow for one of only two reasons …everything traces back to these two:

The Desire/Need to Build Assets (permanent or temporary) – Short-Term “Trading Assets” (help fund accounts receivable &

inventory or finance a project, construct a building or plant a crop) – Long-Term “Fixed Assets” (finance permanent, long-term fixed

assets like real estate & equipment)

The Need to Fund Losses (Replace Equity) – Fund SG&A Expenses when Gross Profits are insufficient.

What Causes The Need to Borrow?

Since loan proceeds typically are used to acquire or fund assets, it’s important to recognize what type of asset generates the revenue or sales that creates the cash flow to repay debt.


Service (PEOPLE): 1) Veterinarian, Consultants, Trainers, etc.

Distribution (AR & INV): 2) Marketing Co-ops & Retail/Wholesale Input Suppliers

Manufacturing / Production (AR & INV): 3) Protein production – cow-calf, dairy, poultry, swine & hog, beef, eggs,

breeding stocks, honey, etc. 4) Permanent Plantings – vineyards & orchard 5) Natural Resource Extraction – mining & timber 6) Grain & cash crop production – grains, vegetables, soy beans, alfalfa,

corn, cotton, wheat, etc. 7) Processing – milling, canning, dehydrating, slaughtering, curing,

cleaning, sorting, packaging, etc.

Service (REVENUE PRODUCING FIXED ASSETS): 8) Equipment Service Providers – grading, crop dusting, custom

cultivating, trucking, controlled atmosphere/warehousing, etc.

In making a loan request for any type of business, it’s helpful for the borrower to recognize the type of lending culture or philosophy with which they are dealing.

The Four Basic Business Types …Differentiated by their ‘profit-making’ asset


A Comparison of Two Lending Cultures The focus will be on cash flow or the value of the collateral

Summary of Lending Philosophies Some Subtleties worth Considering When Evaluating Loan Choices

Classic Example – Line of Credit Classic Example – Mortgage “RELATIONSHIP LENDER” “TRANSACTIONAL LENDER” ● Considerable Analysis ● Little Analysis ● Process Differs Depending on Financials ● Very Standardized Process ● Need for Funds is an On-Going Activity ● Relates to a One-Time Event ● Analysis is Not Very Conducive To Forms ● Analysis Process is Often ‘Form-Oriented’ ● Future Payment Capacity is a Key ● Payment History is a Key ● Proportion of True Equity is Necessary ● Equity is Not Always Necessary ● Financial Info is Complete & Adequate ● Financial Info is Limited ● Loan Volume is Often Small – Large $$ ● Loan Volume is Often Large – Lesser $$ ● Semi-Customized Structure and Terms ● ‘One Loan Fits All’ Orientation ● Always Some Form of Follow-Up ● Limited or No Follow-Up ● Cash Flow is Key to Loan Decision ● Collateral’s Value is Key to Loan Decisions

We will focus our discussions on repayment ability…not collateral value.


– Some loans are made based on the borrower’s ABILITY TO REPAY in the ordinary course of business – we’ll describe those as CREDIT decisions – based upon:

FINANCIAL INFORMATION

– Some loans are made based on the VALUE OF THE COLLATERAL and the rights to that collateral – we’ll refer to those as LOAN decisions – supported by appraisals, guarantors, budgets, reputation, past history, a credit score, etc., but with heavy reliance upon:

CONTROL OF & VALUE OF THE COLLATERAL

A Difference in Lending Philosophies Loan documentation looks the same, but the differences are subtle!

A lender that focuses on repayment wants and needs to understand how the loan will be repaid….as should the borrower!


Cash Flow is What Repays Loans It Can Be Generated 3 Ways…Only 2 are Reliable!

LIQUIDATE ASSETS at their Net Book Value (NBV)

(↓Assets)

CLAIM FUTURE PROFITS (NOP) (After Taxes!) (↑Equity)

INCREASE DEBT (↑Debt)

(Not sustainable. . . for Work- outs!) (Finding a Greater Fool is NOT SUSTAINABLE)

FUTURE PROFITS

(Short-Term Loans) …This type gets repaid from the PURPOSEFULLY LIQUIDATION of

the COLLATERAL that supports the loan.

(Long-Term Loans) …This types gets repaid from the GENERATION of, and

ALLOCATION of FUTURE AFTER-TAX PROFITS.


Operational Cash Flow Starts with Sales NOP (for permanent assets) and NBV (for self-liquidating assets)

ALL cash flow and loan repayment relies on TURNOVER Selling a product (turning over Inventory), and/or Providing a service (utilizing a Fixed Assets).

Doing so produces two different types of cash flow….

SALE PROCEEDS = COST OF GOODS SOLD + GROSS PROFIT

SALE ⇒ NBV + NOP Lenders become concerned if profits (NOP) are not adequate, but…

Having ADEQUATE PROFITS sufficient to repay the prior period’s principal

portion of long-term debt (CPLTD) does NOT mean there is cash flow! Let’s look at how the turning-over of inventory creates these two basic cash flow components, and

how the profit portion ultimately becomes realized cash….aka: operational cash flow. This perspective can be helpful in understanding your company’s performance.

Here is an animation of how the pieces fit together.

(SG&A) (Dep Exp) (Tax Prov)

Recovery of Inventory’s ( )


Balance Sheets

Provides a GREAT

PLATFORM for

Understanding Cash Flow

Issues

The Fixed Asset (Profit-Enhancing) Group

Current Portion LTD 50 Prop & Equip 1,000 $ 100 Long Term Debt 230 (Accum Dep) ( 600) (FAE) Def Tax Liab 20

Net Fixed Assets $ 400 Total Long-Term Debt $ 300 (NFA) (Total LTD)

The Trading Asset (Profit-Making) Group

Excess Cash ---- Bank Loan - A/R 70 $ 150 Bank Loan - Inv Accts Rec 100 (TC) Accruals (Dir Labor & OH) Accts Pay 130 Inventory 250 Trading Assets $ 350 Trading Liabilities $ 200 (TA) (TL)

Non-Productive Asset Group: Net Worth’s Basic Components: Other (Intangibles, Trading Capital (TC) 150 Deferred, etc.) Fixed Asset Eq (FAE) 100 $ 300 Assets 50 Other Assets (OA) 50 (Total Equity) TOTAL ASSETS $ 800 TOTAL LIAB & EQ $ 800

350

500 = SALES =

$ 350 COGS (NBV)

$ Op Cash Flow (OCF)

( )

Recognize the difference between

NBV & NOP dependent loans.

+ 150 + Gross PROFIT

$ 50 NET PROFIT

X

X X A funnel, overlaid on the balance sheet is a simple ways to understand Op Cash Flow.


Short-Term Loans the NBV-dependent loan requires liquidity (loan margin)

The Trading Asset (Profit-Making) Group [Annual Sales of $1,000]

Excess Cash ---- Bank Loan - A/R 70 $ 150 Bank Loan - Inv Accts Rec 100 (TC) Accruals (Dir Labor & OH) Accts Pay 130 Inventory 250 $ 350 $ 200 (Trading Assets) (Trading Liabilities)

Creditors are Spontaneous Asset is Self-Liquidating Customer CREATES the cash flow for the bank Repayment cycle is easily measured – DAYS Relatively short time horizon to repay debt Relatively liquid equity that re-liquefies each cycle Debt is repaid with pre-tax dollars (not true if taxes are reported on a cash-basis) Repayment source is the NET BOOK VALUE of the collateral


Long-Term Loans the NOP-dependent loan requires future profits

The Fixed Asset (Profit-Enhancing) Group [Annual Sales of $1,000]

Fixed Assets 1,000 Current Portion LTD 50 $ 100 Long Term Debt 230 Accum Dep ( 600) (FAE) Def Tax Liability 20 $ 400 $ 300 (Net Fixed Assets) (Total Term Debt)

Creditors are NOT Spontaneous Assets are NOT Self-Liquidating Customer may NOT NECESSARILY CREATE the cash flow Revenue ≠ cash flow Repayment cycle is NOT easily measured Relatively LONG time horizon to repay debt Very ILLIQUID equity that stays illiquid Debt is repaid with AFTER-tax dollars (2 exceptions) Repayment is from the PROFIT portion of sale proceeds; not NBV

Both the long and short-term loans have common factors that create cash flow.


( )

Key Factors for Creating Cash Flow Both Short & Long-Term Loans Have Common Credit Issues

Short-Term Loan Require Repayment ultimately comes from the PURPOSEFUL Liquidation of the NBV of the Collateral (AR & INV)…unless there’s a greater fool!

• REASONABLE TURNOVER (On-Time) • SUFFICIENTLY ABOVE the NBV (On-Budget)

• WITHOUT DIVERSION (of Sale Proceeds)

Long-Term Loan Require ( Repayment Comes from Normal, Operational After-Tax Profits )

• ADEQUATE PROFITS (‘A-1’) • REASONABLY ALLOCATE (‘A-2’)

The ONLY way to determine these issues is to obtain FINANCIAL STATEMENTS


Financial Statements are the ‘Tools of the Trade’ …for a ‘CREDIT DECISION’ – NOT a ‘LOAN DECISION’!

Farmers, Ranchers, Growers and all of production agriculture need land, sunshine, water, power & equipment to operate.

Lenders need ACCRUAL financial statements!

Not every borrower’s financial statements need to be CPA prepared…but they do need to balance and make sense.

A set of financial statements contains three basic items:

A Balance Sheet A Profit & Loss Statement

A Reconciliation of Net Worth (Equity)

From these three documents, a fourth can be derived;

A Statement of Cash Flow (CPA prepared financial statements should always provide one)

We will cover CASH-BASE accounting a little later, but the framework for ALL financial issues are rooted in accrual concepts, so everything we discuss is relevant to all borrowers.


What is A Statement of Cash Flow ? It shows where a business generated and spent its money.

It is derived from the differences between the beginning and ending values of balance sheet accounts.

SOURCES ( USES ) Decrease () Increase () Increase () Decrease () Increase () Decrease () In three areas of the balance sheet, those differences are replaced with the

detailed activity of what caused the change. • FIXED ASSETS (purchases of new & sale of old)

• LONG-TERM DEBT (payments made & new borrowings) • RETAINED EARNINGS (profits, gains, dividends & adjustments)

In its “raw” form, this information is called a SOURCE & USE OF FUNDS.

When organized in a ‘readable format’ it’s called a

STATEMENT OF CASH FLOW

∆ ASSETS ∆ LIABILITIES

∆ EQUITY


The CPA Organizes Cash Flow Information into Three

Areas The Fixed Asset (Profit-Enhancing) Group

Current Portion LTD --- Prop & Equip --- Long Term Debt --- (Accum Dep) (---) Def Tax Liab ---

Net Fixed Assets $ --- Total Long-Term Debt $ ---

The CURRENT Asset (Profit-Making) Group

--- Bank Loan ST Loan – A/R --- Accts Receivables --- Accts Pay --- Inventory --- Bank Loan ST Loan – INV --- Prepaid Exp (SG&A) --- Accrued Expenses --- Taxes Payable --- Current Assets $ ---- Current Liabilities * $ ---

$ Op Cash Flow (OCF)

( )

OPERATIONAL

CHANGE IN CASH

NET NON-CASH PROFIT CHARGES +

• FINANCIAL

•

INVESTMENT

Other Long - Term Assets : Net Worth: Other (Intangibles, Common & Pfd Stock --- Deferred, etc.) Retained Earnings --- A ssets --- Total Equity $ ---


NOP & Dep Expense

“Traditional” Cash Flow

$ (Pay CPLTD & DTL)

Acquire New LTD & DTL (Buy) / Sell Fixed Assets

(Pay DIV / DRAWS) or Inject New Equity

(Buy) / Sell Other LT Assets

∆ in Cash

This “$” represents BASIC OPERATIONAL CASH FLOW (OCF). It is the amount of “traditional cash flow” (NOP + Depreciation Expense) that was allowed to pass through the operational portion of the balance sheet during the accounting period. The changes (∆) in these selected balance sheet accounts represent the sources or uses of funds that are needed to convert ‘traditional cash flow’ into OCF. Operational Cash Flow is the amount of NOP and Depreciation Expense that was NOT USED to increase the equity in the Trading Assets (A/R & INV) that supports sales growth.

Using a Funnel is a Simple Way to Understand How

NOP & Dep Becomes OCF...

…or Doesn’t!

The Components

of Operational Cash Flow

(OCF) "Minor -2” -

∆ Prepaids ∆ Accruals

* “NBV-Dependent Operating Loan -

∆ Bank Op Loan

“Uncle Sam” - ∆ Taxes Pay

"BIG-3” - ∆ A/R ∆ INV ∆ AP

* Included in Operational Activity when structured to fund AR & INV


The ‘TARGET’ of What

OCF Should Be

∆ A / R ∆ INV ∆ A / P ∆ Prepaids ∆ Accruals

∆ Bank Op Loan *

∆ Taxes Pay

NOP & Dep Expense

“Traditional” Cash Flow

$ (Pay CPLTD & DTL)

Acquire New LTD & DTL (Buy) / Sell Fixed Assets

(Pay DIV & D RAW S ) or Inject New Equity

(Buy) / Sell Other LT Assets

∆ in Cash

Target OCF A) Enough NOP to pay the

prior year’s CPLTD. B) Enough DEP EXP to fund the

FA purchases not coming from new LTD…called UNFUNDED

CAPEX

A) Profits fund CPLTD

Know WHY it needs to be more than just enough

to pay CPLTD.

"Minor -2” -

"BIG-3” -

“Uncle Sam” - “NBV-Dependent Operating Loan -

B) Dep Exp funds UNFUNDED

CAPEX


($ 20) ($ 50)

Inadequate

PROFIT & ALLOCATION PROBLEMS

OP CF ⇒ $ 50 ($ 50)

Adequate - NOT

Sustainable PROFIT

PROBLEMS

The Four Possible Cash Flow Scenarios …a combination of Adequacy (A-1) and Allocation (A-2)

“A-1” If PROFITS (the

intended source to repay CPLTD) are

adequate

“A-2” If there is CASH

from OPS

Description of Op Cash Flow

$ 50

Adequate PROFITS $ 65

∆ AR ∆ INV ∆ AP

∆ Prepds ∆ Accrls

Inadequate PROFITS $ 35



$ 20

($ 50) Inadequate

ALLOCATION PROBLEMS

Inadequate PROFITS $ 35





(15) ∆ AR ∆ INV ∆ AP


15 ∆ AR ∆ INV ∆ AP


(55)

Adequate PROFITS $ 65





(45)

(CPLTD) ⇒

($ 50) Adequate & Sustainable

IDEAL SITUATION

Evaluating “A-1” and “A-2” is relevant for virtually all borrowers…except those whose working capital investments are small, like real estate and fixed asset businesses. That’s why using “traditional cash flow” and NOT adjusting for changes in the “Big-3” and “Minor-2” works for them.


Pay CPLTD, LTD & DTL

Pay Div & Draw

∆ NFA

∆ Other Assets

∆ Cash

$

Acct Rec BK Op Loan

Inventory Acct Pay

Trading Assets Trading Liab

Why “Traditional Cash Flow” Coverage Works for Fixed Asset Businesses – Not for Others

“Traditional” Cash Flow and OCF are nearly the same…see why!

Most Manufacturing & Distribution Businesses

The Emphasis is on the Short-term, Self-Liquidating, Profit-Making Assets funded by NBV-Dependent

Operating Loans

Little reason to keep “Money in the Funnel”… That’s not the asset group producing the

profits that results in operational cash flow!

$

∆NFA Pay CPLTD LTD & DTL

Pay Div & Draw

∆ Other Assets

∆ Cash

Revenue Producing Fixed Asset Businesses The Emphasis is on Long-term, Permanent, Profit-Making

Assets funded by NOP-Dependent Term Loans


Debt Coverage Ratios (DCR) A common and useful concept…but it’s not the whole picture


Pay Div & Draw

∆ NFA

∆ Other Assets

∆ Cash

$

Acct Rec BK Op Loan

Inventory Acct Pay

Trading Assets Trading Liab

SOME VARIATIONS:

THE OFTEN-MISSING ‘OTHER’ COVERAGE RATIO

Op Cash Flow CPLTD + Unfunded CAPEX + Div/Draw

NOP + Dep Exp + Interest Exp Pymts + Dividends

NOP + Dep Exp + Interest Exp - Draw Pymts + Dividends + Replcmt CAPEX

NOP + Dep Exp + Interest Exp - Draw Pymts + Dividends + Unfunded CAPEX

NOP + Dep Exp CPLTD

> 1.XX ‘Traditional’ Debt Coverage Ratio


Common Cash Flow Concepts

and Their Differences

Be cautious relying on EBIT and EBITDA …they are NOT DEBT-LENDER

TOOLS!

They are tools for INVESTMENT BANKERS

and INVESTORS

Long-Term Debt is repaid with AFTER-TAX

PROFITS…not pre-tax!

Financial Components The PERSPECTIVE at Each Level

NET SALES $ 1,000 Less: COGS ( 700) Gross Profit $ 300

Less: SG&A Expenses (excl interest) ( 120)

$ EBITDA (1) $ 180

Less: Dep & Amortization Expenses (50)

$ EBIT (2) $ 130

Less: Interest Expense ( 30)

Net Profit B4 Taxes $ 100 Less: Income Tax Provision ( 40)

$ NOP (3) $ 60

Add Back: Dep & Amortz Expenses 50

$ NOP & Dep Exp (4) $ 110 “Traditional” Cash Flow Lenders [“Traditional” & Historical View of Cash Flow]

(Inc) / Dec Accounts Rec ( 30) (Inc) / Dec Inventory ( 70) Inc / (Dec) Accounts Payable 25

(Inc) / Dec Prepaid Expenses (8) Inc / (Dec) Accrued Expenses 5 Inc / (Dec) Taxes Payable 3

$ Operational Cash Flow (5) $ 35 “Relationship-Oriented” Lender (Before Including Changes in Bank Op Line of Credit)

∆ Short Term Bank Loan 21 (Represents a 70% incremental advance on added A/R)

$ Adjusted Cash Throw-Off (6) $ 56 “Relationship Lender” (AFTER Including Changes in Bank Op Line of Credit)

BIG-3

Minor-2

‘Uncle’

The net changes in these current balance sheet accounts represent the amount of NOP & Dep Exp which DID NOT FLOW THROUGH the operation, and were therefore NOT AVAILABLE to fund CPLTD. This amount is the change in ‘core’ equity in the working capital area. Using funds here funds sales growth, a slowdown in asset turnover, or a reduction in short-term asset leverage.

‘Transactional Investor’ – Appropriate for investors who can chose between debt & equity CAPITAL, ignore taxes, see no need to replace FA or consider sales growth’s impact on CPLTD repayment.

'Relationship Investor’ – Similar to ‘Transactional’ Investor, but acknowledging that depreciation is not available for CPLTD repayment (isn’t a source or that it is used to keep NFA constant).

All Lenders – Basic Component of All Term Loan Repayment & Coverage Ratios: If NOP is less than zero, there is no sustainable source to fund CPLTD or fund sales growth.

[Earnings Before Interest, Taxes, Depreciation & Amortization ]

[Earnings Before Interest & Taxes]

[Net Profit After Taxes]


Depreciation Doesn’t Always Function as A Source Relying on it for Debt Repayment Can Be Problematic

A B C D E

Sales 1,000 1,000 1,000 1,000 1,000COGS (750) (800) (825) (825) (850) Gross Profits 250 200 175 175 150

Sell, Gen & Admin (100) (150) (155) (175) (200) Profit B4 Dep Exp & Taxes 150 50 20 0 (50)

DEPRECIATION EXPENSE (50) (50) (50) (50) (50) Taxable Profits 100 0 (30) (50) (100)

Provision for Taxes (40%) (40) 0 Cr 12 Cr 20 Cr 40 Cr

Net Profit AfterTax 60 0 (18) (30) (60)

Traditional "Cash Flow" 110 50 32 20 (10)(Cash IF UNCLE SAM 'Invests")

Actual CASH from Operations 110 50 20 0 (50)

IMPORTANT PRINCIPLE: Depreciation Expenses is NOT a source…it is a NON-USE! Understanding this is especially important for those overseeing loans or lending cultures that evaluate or approve loans relying upon depreciation expense as a source or partial source of repayment. When profits turn negative, some or all of that depreciation expense will fail to function as a source. That is why it generally is better to rely on normal operating profits (NOP) as the primary source for long-term loan repayment, and look only to depreciation expenses as a back-up source when profits fall short of what is needed --- but are not negative!


…then see if profits were ‘ADEQUATE’

Year-1 Year-2 ∆B/S Year-1 Year-2 ∆B/S

Cash 45 28 -17 Notes Payable - Bank 150 185 +35 Accounts Receivable 225 256 +31 Accounts Payable - Trade154 204 +50 Inventory 300 396 +96 Accruals 50 44 -6 Prepaids 50 42 -8 Taxes 6 2 -4 Total Current Assets 620 722 CPLTD 60 74 +14 Total Current Liab. 420 509 Net Fixed Assets 1060 1140 +80 LTD 517 538 +21

Other Assets 80 73 -7 Net Worth 823 888 +65 $1,760 $1,935 $1,760 $1,935

Year-1 Year-2

Sales $1,561 $1,910 Cost of Goods Sold 1,051 1,274

Gross Profit 510 636

Selling & General Admin Exp 345 480 Depreciation Expense 40 49

Net Profit Before Tax 125 107 Provision for Income Taxes 51 42 Net Operating Profit After Tax 74 65 1. What is this company's basic operational cash flow in Year-2 (HINT: It is composed of three

groups of elements: "traditional cash flow", plus changes in the balance sheet accounts of the "Big-3" and the "Minor-2"! The changes in taxes payable are generally not very significant, so by excluding that and changes in the bank’s operating line of credit, you are seeing what this company is doing to help their own cause, before they rely on the bank.)

Basic Operational Cash Flow (BOCF) $ ________ (Before relying on the Bank!)

2. Was this company adequately profitable? Was its operational cash flow sufficient to service its long term debt?

An Exercise to Determine the Basic

OCF

…and if enough were

‘ALLOCATED’ to pay CPLTD


The TWO Ways to Present OCF Indirect (NOP + Dep Exp) or Direct (Components of NOP & Dep)

The DIRECT method essentially converts an accrual statement into a cash-based INCOME &

EXPENSE statement.

Accrual Profit & Loss Statement

Sales 1,000 COGS (750) Gross Profit 250

SG&A Expenses (100) Depreciation Exp (50) Taxable Profits 100

Provision for Taxes (40%) (40) Net Operating Profit After Taxes (NOP) $ 60

INDIRECT APPROACH

(Adjusting Accrual to Operational Cash Flow) Net After Tax Profits 60 Depreciation Expense 50

∆ Accts Receivable (30) ∆ Inventory (80) ∆ Accts Payable 25 ∆ Prepaid Expenses (20) ∆ Accrued Expenses 15 ∆ Taxes Payable 5 Basic Operational Cash Flow 25

DIRECT APPROACH (Converting Accrual Profits to a Cash P&L) Sales 1,000 ∆ Accts Receivable (30) Cash Received $ 970 COGS (750) ∆ Inventory (80) ∆ Accts Payable 25 Cash Pd for Inv Purchases (805) SG&A Expenses (100) ∆ Prepaid Expenses (20) ∆ Accrued Expenses 15 Cash Pd Op Expense (105) Provision for Taxes (40%) (40) ∆ Taxes Payable 5 Cash Pd Income Taxes (35)

Basic Operational Cash Flow 25

= 90

INDIRECT

DIRECT


Comparing an Accrual P&L Statement to a Cash I&E Statement

Accrual-Basis Cash-Basis Sales 1,000 1,000 Sales -- ( 30) Inc in A/R 970 CASH RECEIPTS COGS ( 750) ( 750) COGS -- ( 80) Inc in INV -- 25 Inc in A/P ( 805) CASH PD FOR INV Gross Profit $ 250 $ 165 GROSS INCOME SG&A Expenses ( 100) ( 100) SG&A Expenses -- ( 20) Inc in Prepaids -- 15 Inc in Accrued Exp (105) CASH PD OP EXP Depreciation Expense ( 50) ( 50) Depreciation Expense

Taxable Accrual PROFITS 100 10 TAXABLE CASH INCOME

Provision for Taxes (at 40%) ( 40) ( 4) At 40%, the deferred amount is $ 36

NET PROFIT AFTER TAXES $ 60 $ 6 NET CASH INCOME AFTER TAXES

Profit & Loss (P&L) Profit & Loss (P&L)


Seeing How Cash & Accrual Differ In CASH accounting ALL debt is repaid with AFTER-TAX dollars!

← DEBT COVERAGE RATIOS DIFFER → NOP this yr CPLTD last yr

NI this yr CPLTD last yr

ACCRUAL CASH-BASIS

$100 - - - - - Taxable Accrual Profits B4 Income Taxes - - - - $100 ( 40) - - - - - Provision for Income Taxes (40%) - - - - DEFERRED! $ 60 - - - - - Net Operating Profit - - - - - -

( 30) (INC)/DEC IN ACCOUNTS RECEIVABLE ( 30) ( 80) (INC)/DEC IN INVENTORY ( 80) 25 INC/(DEC) IN ACCOUNTS PAYABLE 25

(20) (INC)/DEC IN PREPAID EXPENSES (20) 15 INC/(DEC) IN ACCRUED EXPENSES 15

($ 30) ← Op Cash Flow (Available NOP) TAXABLE CASH INCOME $ 10 TAX PROVISION (40%) (4) NET CASH INCOME $ 6 (after taxes)

(90) (90)

“A-1” “A-2”


You are a cash-based borrower and you reported pre-tax cash income of $30,000 last year but that is after you prepaid expenses (increased INV), delayed sending out invoices (increased A/R) and paid down the trade (A/P) all of which totaled nearly $100,000 over that of a year earlier. Your CPLTD on last year’s balance sheet was $84,000. Your income tax rate is 40%.

Let’s compare what your actual cash was to what it should have been were you to fund your debt reduction and living expenses from a sustainable source…accrual profits.

ACTUAL TARGET $ __________ Pre-Tax ACCRUAL PROFITS $ _________ ( _________ ) Prov for Inc Tax (if Accrual) $ __________ Net Operating Profits (NOP)

$ _________ Pre-Tax CASH INCOME $ _________ ( ________ ) Tax Provision (CASH-Basis) ( _________ )

$ _________ “TARGET” Net Inc $ _________ ( _________ ) Pay CPLTD ( _________ )

1) What was the minimum “Target” amount of pre-tax CASH INCOME ?

2) What was the

minimum “Target” amount of pre-tax

ACCRUAL PROFITS ?

3) What is the likely repayment source if

profits or cash income is inadequate ?

An Exercise to

Determine the ‘TARGET’

Level of Profits for a Cash-Based

Taxpayer

An example of why cash income must comes from accrual profits to be sustainable

This diagram may help you under-stand that for NET CASH INCOME to be sustainable, it must come from PRE-TAX ACCRUAL PROFITS….provided it doesn't gets ‘stuck in the funnel’ (USED to increase working capital assets). If the business pays taxes on a cash-basis, the recognition of income taxes is deferred until those funds flow out of the operation. For a cash-based taxpayer, growing working capital (excluding cash) is a way to defer income taxes. Liquidation of AR & INV creates the tax liability. What the bank thinks is the NBV of an asset, the taxing authorities will view as taxable income!


Cash & Accrual Based Borrowers Have the Same Responsibilities

Regardless whether a business pays income taxes BEFORE considering changes in the ‘Big-3’ and ‘Minor-2’ (Accrual Based), or AFTER those balance

sheet changes are considered (Cash Based), the only sustainable source for repaying CPLTD roots back to after-tax accrual profits.

Relying on Depreciation Expense or Additional Borrowings collateralized by increased levels of short-term assets (Prepaid Inventory and/or Accounts

Receivable) funded by untaxed accrual profits is not a viable long-term source of repayment.

EVERY BORROWER, regardless of how it pays income taxes, needs to be:

ADEQUATELY PROFITABLE (“A-1”) …and they also needs to deploy their ‘ALREADY COMMITTED PROFITS’

as agreed, meaning profits need to also be:

ADEQUATELY ALLOCATED (“A-2”)

These are critical issues that prudent lenders will be looking to find.


The Fixed Asset (Profit-Enhancing) Group

Current Portion LTD 50 Prop & Equip 1,000 $ 100 Long Term Debt 230 (Accum Dep) ( 600) (FAE) Def Tax Liab 20

Net Fixed Assets $ 400 Total Long-Term Debt $ 300 (NFA) (Total LTD)

The Trading Asset (Profit-Making) Group

Excess Cash ---- Bank Loan - A/R 70 $ 150 Bank Loan - Inv Accts Rec 100 (TC) Accruals (Dir Labor & OH) Accts Pay 130 Inventory 250 Trading Assets $ 350 Trading Liabilities $ 200 (TA) (TL)

Net Worth’s Basic Components: Trading Capital (TC) 150 Fixed Asset Eq (FAE) 100 $ 300 Other Assets (OA) 50 (Total Equity) TOTAL ASSETS $ 800 TOTAL LIAB & EQ $ 800

$ ( )

NOP $ 50

$150 180

$250

D/W = 3.00 D/W = 1.67

$200 $130

$200

D/W = 1.0 Leverage within the fixed

assets is constantly decreasing.

Once a LT Loan is made

LEVERAGE is NOT the

issue!

CASH FLOW is the issue.. …but to be

sustainable it must come from PROFITS

Let’s examine how liquidity (working capital) influences the ability to generate profits.


Generating Profits to Repay CPLTD Requires Maintaining A Minimum Amount of “Core Equity”


Pay Div & Draw

∆ NFA

∆ Other Assets

∆ Cash

Influenced by: •A/R Turnover •INV Turnover •COGS%

Influenced by: •COGS % (Efficiency) •SG&A Exp % (Cost Controls) •Depreciation Exp •Income Tax Rates

Influenced by: •Trade Terms •Bank Loan Structure •A/R Loan Adv % •Inv Loan Adv %

By Default…this Trading Capital IS the MINIMUM or CORE EQUITY that must be invested -- enough to be …….

ADEQUATELY PROFITABLE to generate enough NOP to pay CPLTD.

Accts Rec

INVentory

TRADING ASSETS (Profit-Making Assets)

BANK OP LOAN

Accts Pay

TRADING LIABILITIES (Spontaneous Creditors)

TRADING CAPITAL (Equity in A/R & INV)

Net Operating Profits (NOP$)

NET SALES

∆ Accts Rec ∆ Bank Op Loan ∆ INVentory ∆ Accts Pay Trading Assets Trading Liabilities

$ _____ Trading Capital

$ OP Cash Flow

X X X X

X X


Factors that Determine Loan Margin Requirements Trading Capital (‘Core Equity’) is the Focal Point of Liquidity

OCF $

$ 50

(5.0%)

1,000

Accts Rec 100 Inventory 250 Trading Assets 350

Bank A/R Loan 70 Trade Payables 130 Trading Liabs 200

TRADING CAPITAL 150 15% of SALES

Influencing Factors: CPLTD = $50

NOP = 5% AR = 36.5 days INV = 2.5 x AR Bank = 70% AR AP ≅ 50% INV

TC = 15% Sales

With enough Trading Capital,

ANY level of sales can be

achieved!

Pay CPLTD

$______ (SALES)

( $50)

$ (NOP)

Minimum Working Capital will be $50 LESS!....

∆ Accts Rec ∆ Bank Op Loan ∆ INVentory ∆ Accts Pay Trading Assets Trading Liabilities


The “Financial DNA” of Every Business is Different!


Understanding the Basics of Sustainable Growth Reversing These Dynamics Can Remedy Cash Flow Problems

OCF $50

65 (NOP)

(6.5%)

$______ (SALES) 1,000



TRADING CAPITAL 150

15% of SALES

(15)

+ 7 + 13 + 20

+ 10 + 25 + 35

+100

+15

Generating “Uncommitted Profits” is the only SUSTAINBLE way to increase Trading Capital & therefore SALES…when profits are inadequate, it REVERSES!

Pay CPLTD ( $50)

Being more profitable than just sufficient to service

CPLTD provides the opportunity to use the

‘uncommitted profits’ to fund growth…or to build cash, pay dividends or acquire other assets.


Liquidity Needs INCREASE as NOP% DECREASES! …The IRONY of FINANCE…and the importance of being “A-1”

OCF $

$ 50 (NOP)

(2.5%)

$______ (SALES) 2,000



TRADING CAPITAL 150

15% of SALES

Pay CPLTD (50)

When Profitability Decreases, the requirement for Trading Capital

INCREASES …but the normal source to

provide it comes from ‘UNCOMMITTED’

PROFITS…but they are NOT BEING GENERATED!

Bummer!

Growing SALES in this situation is a path to “GROWING BROKE”!


All Businesses Have Two Requirements Adequate Profits and Adequate Loan Margin

All borrower’s must have enough SALES to be… “ADEQUATELY PROFITABLE”

(NOP > CPLTD )

…but not too many sales (assets) so they remain

“ADEQUATELY LIQUID” (Have Sufficient Loan Margin in AR & INV)

The receivables & inventory (livestock & crop) both maintain the MINIMUM required % of equity

Identifying and staying within these “FINANCIAL BOUNDARIES” is what both lender and borrower should be focused upon to maintain a good & viable relationship.

Yr- 2 Yr- 1

One is a PROFIT & LOSS issue… …the other a BALANCE SHEET issue


A Visual Overview of the Financial Boundaries Profitability on the Low Side, Liquidity on the High Side

. . . T I M E . . .

INADEQUATE LIQUIDITY (Core Equity) (Insufficient Trading Capital)

KEY ISSUE: MIN PROPORTION OF EQUITY

INADEQUATE PROFITS (Insufficient NOP to fund CPLTD)

KEY ISSUE: MIN ABSOLUTE AMT OF EQUITY

MINIMUM SALES

The “Field of Play”

MAXIMUM SALES

SALE

S


The Four Basic Causes of Liquidity Problems All Businesses Have Liquidity Boundaries Triggered By “DOGS”

Causes of Liquidity Problems •Diversion of TC (Equity)

•Operating Losses

•Growth – Rapid Growth

•Slowdown in Turnover

Loan Covenants That Address Liquidity Issues • MAXIMUM Dollar Limit on BORROWINGS – Limiting sources constrains asset levels • MINIMUM PROPORTION of ‘CORE’ Equity – Sets a maximum level for asset growth

• MINIMUM AMOUNT of ‘CORE’ Equity – Sets a minimum level to ensure profits are ‘adequate’

Basic Current Ratio

(Trading Ratio)

Basic Debt-to-Worth

(Trading Leverage)

Trading Assets

Trading Liabilities

In All Cases, Basic Net Worth Remains at $50

4.0 : 1

75% $200 $150

$250 $200 80%

$100 $50 50%

1.25

1.33

1.50

2.00

3.0 : 1 2.0 : 1 1.0 : 1

67% $150 $100

‘CORE’ Equity: Trading Capital

Loan Margin Adj Working Capital


PROJECT and CROP

LENDING

TWO Different Needs 1) Fund the project (NBV)

LOAN MARGIN [ $20 Equity ]

$80 LOAN

NBV Dependent Debt

$40 “YET-To-BE-MADE”

Gross PROFIT MARGIN

REQUIRED $20 Initial

Equity

• SG&A Expenses (incl Int Exp)

Dep Exp • • Income Taxes

• CPLTD • Dividends

• Draws • Fund Asset Growth

$ 100

$140

PROJECTED SALE PRICE

$35

SG&A EXPENSE GROSS PROFIT Dependent Debt

$7 $7

$7

$7

$7

80

20

40

60

20

40

60

80

1 2 3 4 5 MONTHS TO COMPLETE THE PROJECT

$ 115 (80 + 35)

2) Fund SG&A Expenses (LOSS)

…because during the production

period there is no gross profit to fund operating expenses

The amount of minimum equity is determined at the PEAK point of the cycle. The available “working capital” needs to be allocated between loan margin & future SG&A Expenses.

They require MORE initial equity

than permanent- level trading asset operations…


The Benefits of Being More than Adequately Profitable When profits are MORE than enough, it funds growth

MINIMUM SALES

MAXIMUM SALES

TIME With PROFITS greater than CPLTD, ‘Uncommitted Profits” are available to

increase Trading Capital (Core Equity or Loan Margin in AR & INV), so sustainable sales growth can be achieved.

The “Field

of Play”

INADEQUATELY PROFITABLE

INADEQUATELY LIQUID


When Profits Diminish, Liquidity Follows Anticipate the CASH FLOW CRUNCH…BEFORE it happens!

MINIMUM SALES

MAXIMUM SALES

TIME

The “Field

of Play”

As NOP% FALLS, the need for more SALES rises, as does the need for loan margin (EQUITY)!

With NOP< CPLTD, and the shortfall is funded from existing loan margin, it causes SALES to diminish.

Once the Trading Capital (CORE EQUITY in the profit-making asset group) falls below what is needed to support the sales needed to be adequately profitable, there are now two

distinctly different, but inter-connected problems: a history of INADEQUATE PROFITS and INSUFFICIENT LIQUIDITY (loan margin) to support the sales needed to create sufficient

profits to repay CPLTD.

Critical Point: “Cinderella’s Midnight”


Quick Review of the Key Issues Being Sufficiently Liquid to Be Adequately Profitable

Net Operating Profits (NOP$)

NET SALES

Accts Rec INVentory

TRADING ASSETS (Profit-Making Assets)

BANK OP LOAN Accts Pay

TRADING LIABILITIES (Spontaneous Creditors)

TRADING CAPITAL (Equity in A/R & INV)

Influenced by: •COGS % (Efficiency) •SG&A Exp % (Cost Controls) •Depreciation Exp •Income Tax Rates

Influenced by: •Trade Terms •Bank Loan Structure •A/R Loan Adv % •Inv Loan Adv %

By Default…this Trading Capital IS the MINIMUM or CORE EQUITY that must be invested -- enough to be …….

ADEQUATELY PROFITABLE to generate enough NOP to pay CPLTD.

∆ Accts Rec ∆ Bank Op Loan

∆ INVentory ∆ Accts Pay

Trading Assets Trading Liabilities

= OP CASH FLOW


Pay Div & Draw

∆ NFA

∆ Other Assets

∆ Cash


$

Copyright 2012 by Deannco Financial Enterprises. All rights reserved. Used by permission @ AAPEX Meeting – February 2012

42

Deannco Financial Enterprises Specializing in Credit Training to the Banking Industry

4790 Irvine Blvd, Suite 105-125, Irvine, CA 92620-1973 www.deannco.com

THANK YOU FOR YOUR TIME AND ATTENTION Profits cure a lot of ills

…but cash flow pays the banker’s bills!

Regardless of the business type, …the strength of the guarantor, …the reputation of the borrower, …the past payment history, or …the collateral supporting the loan… A viable business must be both adequately liquid AND adequately

profitable, and the ‘first fruits’ of profits that have already been “committed” to repay the term debt need to be used to do so.

Commercial Lending An Inside View of How Commercial Lenders Think

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