Cash Flow Analysis - RMA U

1 IThe RMA Journal April 200684 2006 by RMA. James Miller is a vice president at Wells Fargo Bank NA, in Phoenix, Flow Analysisby James C. MillerVarious spread systems may be used to track cash flow. This article focuses on an adaptation of one such system Uniform Credit Analysis to a format that theauthor calls lender s cash flow, which helps bring more light to lendingopportunities. This format is shown using a real-life THE UCA CASH FLOW FORMAT ON LENDING OPPORTUNITIESn 1987, RMA moved credit Analysis from thehorse-and-buggy days of traditional net-profit-plus-depreciation cash flow to the jet-age Uniform CreditAnalysis (UCA) format, a variant on the FinancialAccounting Standards Board s FASB95 cash flowformat. The UCA format, which calculates real cashflow, is probably the best thing RMA has done forlenders since it started collecting and publishingcomparable peer , over the years, experienced commerciallenders at large and small banks have told me that theUCA cash flow is ignored in certain situations.

2 It is notrequired in some banks loan approval write-ups. It isnot used by some vendor programs, such as LaserPro (which produces loan documents), that use net profitplus depreciation in lieu of the UCA cash flow. Mostimportant, though, it is not used by some lenders who,instead, go directly to companies financial statementsto make eyeball estimates using net profit my experience, such informal estimates workbest when the situation is simple and obvious, andless well in complex and marginal situations. First,accurate cash-flow calculations can be too complexfor most lenders to do off the top of their , most financial statements show periods ofonly two years not enough to establish the impor-tant trends and patterns. Third, the customers mostlikely to leave one bank for another tend to havecomplex and often marginal financial situations,which require a more formal and detailed , they may be open to leaving their currentbanks because their current lenders calculate cashflow off the top of their heads, which may result inan opinion that is less accurate and less favorablethan that of company management.

3 I suggest that thelimitations of the widely used informal eyeballing techniques are a disadvantage, because most com-mercial lenders face aggressive loan-growth goals andneed a reasonably precise and easily used tool tohelp them identify lending opportunities quickly andavoid wasting time on candidates that ultimately endup being Cash FlowTo solve that problem, I suggest a reorganizationof the UCA/FASB95 format, which I ll call lenders cash flow(LCF). LCF focuses on and directly dis-plays precisely the lending opportunities for whichexperienced lenders look. This reorganization of theUCA format is not the first to be suggested1, and itdoes not attempt to address subtle accounting ortheoretical nuances for obscure kinds of , I believe it is the first to result in a sim-ple, easily used format designed specifically to helpcommercial lenders in the real world focus quicklyon lending do experiencedlenders look for?In general,lenders tell me they look for threethings in the financial statement: approximation of cashflow for debt repayment, tofind net profits and thenmentally add back interest,taxes, depreciation, opportunities inreceivables and inventory,because these assets are whatthe loan supports most of thetime.

4 They look at the mag-nitude and estimated changein these assets to get an ideaof the size of any loans tocover the change. When youthink about it, these elementsconstitute the asset part ofthe trading asset or workingcapital cash opportunities in capi-tal expenditures by examiningthe size and changes in fixedassets, , the asset portion ofthe capital expenditures cashcycle (CAPEX). These lendersknow that financing fixedassets is a time-honored way tobuild large interest-income-generating outstandings quick-ly. Very savvy lenders havefound that sometimes termingout high-equity fixed assetsprovides the cash to solvemany business UCA with Three NewFocused SectionsFigures 1 and 2 show how Ireorganized the UCA format tocreate three new sections thatfocus on and present what thelenders look theinterest repayment incomestream, , cash flow approxima-tion, I chose interest, taxes,depreciation, and amortization(EBITDA) and accordinglymoved revenues, cash cost ofsales, and cash operating expens-es to a section called New EBITDA / NOI InterestCoverage.

5 I chose EBITDA,sometimes referred to as net oper-ating income(NOI), over the alter-natives for four closely resembles the quickmental calculations experi-85 Focusing the UCA Cash Flow Format on Lending OpportunitiesFigure 1 Current UCA FormatNew Lending Opportunities in Receivables &Inventory New Lending Opportunities inCAPEX New EBITDA/ NOII nterest Coverage RevenuesChanges in ReceivablesCost of Goods SoldChanges in InventoryChanges in Trade PayablesChanges in Costs/Billings >Bills/CostsOther Operating Revenues & Non-Trade ReceivablesOperating ExpensesChanges in Operating Balance SheetItemsCash Payments for Income TaxesChanges in Flooring LineNet Cash from OperationsCash CPLTD Payments(Current Portion of Long-term Debt)Cash Interest PaymentsDividendsCash After Debt AmortizationNon-Operating Income (Expense)Fixed Assets ChangedCash Used for InvestmentsOther Asset TransactionsChanges in IntangiblesAsset Sales/ExtraordinaryChanges in Short-term Bank DebtChanges in Long-term DebtChanges in Subordinated DebtChanges in Other Liabilities andAffiliated LiabilitiesChanges in Other Liabilities & Gray AreaChanges in Net WorthNet Change in CashBeginning CashNet Change in CashEnding CashRevenuesChanges inReceivablesCOGSC hanges inInventoryChanges in Trade PayablesOperatingExpensesFixed Assets ChangedChanges in Short-term Bank DebtChanges inLong-term Debt86enced commercial lendersmake and that, in actual prac-tice, tend to be quicklyaccepted.

6 Has long been recognizedthat interest repayment comesfrom the profits earned on thesale of the assets funded bybank debt and that principalrepayment comes from the liq-uidation of the funded , EBITDA is the appro-priate income stream that cov-ers the interest portion. is widespread accept-ance2of EBITDA in the gen-eral financial community,including commercial lendersand prospective customers, sobankers and borrowers usual-ly speak the same language. the line items needed forcalculation are already presentin the existing UCA Opportunities inReceivables & ,I isolated the major elements thatcapture the trading asset cashcycle, , changes in receivablesand inventory, the changes intrade payables, and the short-termbank debt that funds those oppor-tunities. I moved this cycle s ele-ments from their location in thecurrent UCA format to a new sec-tion, Lending Opportunities inReceivables & Opportunities inCAPEX. Finally, I isolated themajor elements that capture theCAPEX cash cycle , thechanges in fixed assets and thechanges in the long-term debtthat should fund most of thegrowth in fixed assets andmoved them to a new section,Lending Opportunities in CapitalExpenditures (CAPEX).

7 Other in the Operating Cash Flowsection of the UCA format includemiscellaneous operating cash flowelements mostly cash paymentsfor income taxes. I grouped theseline categories together inMiscellaneous Operating CashFlow. In actual practice, movingthese items out of LendingOpportunities in Receivables andInventory allowed for clearer focuson the trading assets cash cycle. Inaddition, collecting these items inthis new section made it easier toexamine them and catch anom-alous amounts that influencedcash left intact the classic UCADebt Coverage section, whichincludes the Cash After Operations(CAO) and the Cash After DebtAmortization (CADA) means the subtotals and debtcoverage ratios are identical tothose of the current UCA took the remaining miscella-neous items and put them into theproposed LCD in a RemainingSources and Uses section. In actu-al practice, this section proves veryuseful in tying up loose ends andanswering some questions thatarise from the other It WorksFigures 3 and 4 show an exam-ple from real life.

8 Figure 3 containsthe income statement for the lastyear and the balance sheet for twoperiods, , what is required to cal-culate cash flow. Figure 5 shows thecash flow derived from Figures 3and 4 with the existing UCA formatin the two columns to the left andthe proposed Lenders Cash Flowin the two columns to the that the existing UCA for-mat and the Lenders Cash Flowuse identical line items and identi-cal Cash After Operations and CashAfter Debt Amortization / NOI s start at the topsection in Figure 7, EBITDA /NOI Interest Coverage, theLenders Cash Flow format letsus look at the cash flow approxi-mation section. In this case, theLenders Cash Flow presentedthe $ million in revenues andthen subtracted $ million incash costs of sales3and $ in cash operatingexpenses4. The result wasEBITDA, or NOI, of $846, EBITDA covered $284,000in interest times. My experi-ence is that this is strong for anykind of EBITDA does notadjust for changes in receivables,but for some companies, this canbe significant.

9 As a result, theLenders Cash Flow also adjustsfor changes in receivables to pres-The RMA Journal April 2006 Figure 2 UCAP roposed Lenders Cash Flow (LCF)Operating Cash FlowInterest CoverageLending Opportunities in Receivables & InventoryMiscellaneous Operating Cash FlowDebt CoverageDebt CoverageInvesting Cash FlowLending Opportunities in CAPEXF inancing Cash FlowRemaining Sources & Usesent Cash EBITDA (which wecould call CEBITDA). In thiscase, CEBITDA was a positive$758,000 to cover the $284,000 ininterest for a coverage ratio of format makes both optionsavailable so the lender can chosewhich is more Opportunities inReceivables & Inventory in theOperating Cash 7shows the lending opportunitiesin receivables and inventory inthe Lending Opportunities inRec & Inv section of the we see changes in the twotrading assets the receivablesand inventory and then we seehow those assets are funded bytheir normal sources of funds,which are increases in short-termbank lines of credit and tradepayables.

10 There is only a smalllending opportunity to supportreceivables because they onlyincreased $88,000. However,there is a substantial lendingopportunity in inventory, whichincreased $ million this year,certainly a portion of which expe-rienced lenders would want , note that trading assets(inventory and receivables) grew ata combined rate of , asopposed to revenue at revenues and tradingaccounts should move at roughlythe same rate, the faster growth intrading assets is a potential prob-lem. On a dollar basis, the LCFshows that of the total $88,000growth in receivables, $89,000 wasrequired by the revenue growth5;however, only $601,000 of the $ of inventory growth wasattributable to sales growth. TheLCF will help us find what causedthe portion of inventory growthnot attributable to sales we need to lookat the two fundingsources trade payablesand short-term bank linesof credit. Trading accountsincreased $ million,but only a tiny portion ofthat was covered by the$85,000 increase in tradepayable, leaving $ mil-lion to cover.