Properly Analyzing Schedule E Business Cash Flow
As part of our procedures at the conclusion of each loan review at a bank, we provide a detailed list of findings, recommendations and best practices. We base most of these comments on what we saw in certain the credit files versus what we would expect to see in a perfect world scenario.
There is one item that we often mention: using K-1s to perform complete and accurate cash flow analysis.
A common inaccuracy identified in bank-prepared financial spreads is that Federal Income Tax Schedule E, for Corporations and Partnerships, use flow-through income numbers as cash flow and not properly calculated actual cash flow. In order to ascertain actual cash flow amounts, Schedule K-1s need to be obtained for each entity showing activity on Schedule E, to determine what cash activity has occurred. K-1 information provides the loan officer with distributions and contributions to the various entities and, if these activities are cash in nature, then distributions should be included in cash flow and contributions should be excluded from cash flow. The use of the gross number flowing through to the front schedule of the individual’s tax return is not indicative of actual cash flow. It is also important to analyze the relationship on a global basis.
We have observed that many credit files lack complete information necessary to conduct a comprehensive cash flow analysis. For those corporations and partnerships that provide income to their owners, distributions need to be subtracted from the respective entities cash flow and contributions need to be included in the respective entities cash flow.
We encourage loan officers to educate their borrowers to provide complete financial information annually. Not only personal financial statements and tax returns should be requested and analyzed, but any additional schedule(s) that is critical in the proper and accurate calculation of cash flow.