How to calculate and analyze global cash flow
For most small business owners, there’s a very fine line between their personal and business financial affairs. That’s because most small businesses are established as pass-through entities (S-corps, LLCs or partnerships), with some items of business income and expenses passing through to the owner’s personal tax return.
In addition, many owners are now financing their businesses via personal credit cards and home equity lines of credit, further blurring the line between personal and business finances. As a result, there is a significant interrelationship between the income, expenses and cash flow of most small businesses and the owner’s personal finances.
The importance of global cash flow
When analyzing small business loan requests, lenders need to carefully examine a borrower’s complete business and personal financial situations and integrate them into global cash flow. Otherwise, there’s a good chance of getting an incomplete (and possibly very inaccurate) picture of the business’s and owner’s true financial situation.
How to calculate global cash flow
Global cash flow should include all of an owner’s business and personal income/salary, debt and other financial obligations, and liquidity.
On the business side, cash flow is fairly straightforward:
net income
+ depreciation/amortization and interest
– dividends/distributions
On the personal side, the calculation is as follows:
Salary + interest/dividend income +/- rental cash flow
+ Cash distributions from Schedule K-1 (for S-corps, LLCs, partnerships)*
– Contributions from Schedule K-1 (for LLCs and partnerships)
*Some cash distributions are required, and some are discretionary.
This total is multiplied by a percentage that excludes taxes and personal living expenses — 40%, for example (allowing 60% for taxes and living expenses).
Personal debt service (typically figured as the debt revealed on the owner’s personal credit report, cross-checked with the borrower’s loan application) is then subtracted from this to arrive at net personal cash flow. Note: Personal debt obtained on the corporate side of the bank (e.g., owner-occupied real estate) is typically not disclosed on the personal credit report.
To arrive at a bottom-line figure for global cash flow, add business cash flow and net personal cash flow. The next step is to determine an owner’s global debt service capability, which is global cash flow divided by business debt service.
The repercussions of ignoring global cash flow
Why does global cash flow matter to your financial analysis?
It could skew your review. For one thing, the owner may be taking significant sums of money out of the business in distributions, which may cause the cash flow of the business to appear weak. However, if the money isn’t needed in the business and the owner is investing it in liquid assets, this shouldn’t be a problem.
Conversely, the business may have strong cash flow, but the owner may have assumed an excessive amount of personal debt (perhaps even to finance the business itself) that requires him or her to take too much money out of the business, thus weakening global cash flow.
However, if the owner has other sources of income outside the business (such as ownership in income property or another business), this could strengthen the global cash flow position. Similarly, if the owner invested heavily in liquid assets, this could also improve the global cash flow picture.
Analyzing global cash flow
Here are a few more important points to keep in mind when determining global cash flow:
- For small businesses that operate via multiple pass-through entities and have significant income and expense items flowing through to the owner’s personal tax return, the adjusted gross income on Schedule 1040 will likely bear no relationship to the actual cash generated.
- It’s critical to obtain the owner’s Schedule K-1 to identify pass-through items and the amount of cash the owner is taking out of the business. This cash won’t show up anywhere else on the owner’s personal tax return.
- From the lender’s perspective, net personal cash flow is the all-important amount of personal cash that would be available for business debt service.
- In today’s environment, liquidity — especially personal liquidity — is king. Unfortunately, many small business owners have little or no personal liquidity outside their retirement accounts, which by law cannot be liquidated or attached, even in bankruptcy.
Servicing debt
When calculating global cash flow, your primary goal is to determine a borrower’s ability to generate cash to service debt. Remember, not all business cash flow will be available for personal and business debt service; a portion of it must also be used to support the daily operations of the business (working capital, replacement capital expenditures, etc.).
How Wipfli can help
Need help determining your true financial situation? Or finding the best way to secure financing for your small business? Wipfli’s seasoned tax and financial analysts can help you create an ideal business structure and financial strategy to grow your business and protect your personal interests. To learn more about our tax and financial services for businesses, contact us today.
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