By: David Dalessandro, Senior Consultant
In the summer of 1987, the savings and loan I was working for at the time sent me to a “cash flow” seminar in Norman, OK. I had graduated from Penn State a few years before and had recently accepted my first of what would prove to be many positions in banking as a credit analyst. At that point, my experience at financial analysis was limited to what I had absorbed from two accounting firms I had worked for and studying for (and passing) the CPA exam. The seminar topic was “The Implications of FASB 95.”
FASB 95, for those of you asking, was issued in November 1987 and was to be utilized in all financial statements finalized in fiscal years ending after July 15, 1988. The requirement replaced the famous APB 19, Statement of Changes in Financial Position, which we all knew and loved as a pretty worthless financial statement at the time, because no one without a CPA attached to their name understood it, and most CPAs had difficulty explaining it.
The seminar turned out to be one of the most beneficial events in my life. As it was explained, the Statement of Cash Flows, as required by FASB 95, was a financial disclosure that would trace every dollar of cash through an accounting period. How awesome, I thought, because only cash pays back loans. So now if I have a tool to trace every dollar of cash, credit analysis would be a cinch.
Well, fast forward 30 years…and the Statement of Cash Flows is still not a household name in Credit Analysis. Most financial institutions, even the largest, still hang onto EBITDA for “cash flow” or multiples of EBITDA for “value.” The EBITDA analysis may approximate real cash flow for real estate rental properties, but for those thousands of enterprises that carry Accounts Receivable, Accounts Payable, Inventory, Other Assets, and Other Liabilities, pay distributions, report gains and losses on sales of assets, take charge downs on intangibles, write off bad debts, and enter into other “non-cash” transactions, the Statement of Cash Flows is the only real way to “follow the money.”
The question here is, why would any financial institution NOT at least include FASB 95/UCA in cash flow analysis when it was appropriate? EBITDA, or even EBITDA adjusted for one-time items, may give the analyst an estimate of total cash flow, but true operating cash flow can only be obtained from a properly and timely prepared Statement of Cash Flows. The Statement separates the movement of cash into three primary categories: Operations, Investment, and Financing. From a bank or financial institution standpoint, if there is positive cash flow from the Investing segment or from the Financing segment, then the enterprise is selling assets or obtaining more loans or selling stock in order to make its loan payments. Are those sources sustainable? Are those sources where you want your customer to come up with the funding to make your loan payments? Is the quality of cash flow from Investing or Financing equal to that of Operating Cash Flow? Probably not. But if the cash flow from operations is positive, and it has been positive for a number of years and it is sufficiently positive to fund all loan payments, then that should be a sustainable source of cash flow far into the future. If the Operating Cash Flow is positive enough to fund loan payments, pay distributions/dividends, AND fund capital expenditures, then that enterprise is more than likely to enjoy a very strong financial condition with relatively easy debt coverage.
If your underwriting protocols do not include UCA/FAS 95/Statement of Cash Flow analysis, then you risk being surprised when a borrower who had “good” EBITDA coverage shows up past due or comes to you needing more money. Use this tool in conjunction with your standard analysis and it will enable you to rethink loan structures where the expected cash flows do not match up.
If you would like to discuss incorporating UCA/FAS 95/Statement of Cash Flow analysis in your institution, please contact me at 330.422.3487 or firstname.lastname@example.org.