Commercial Lending for Lenders 2015 Just how do you think you ll be paid back on this loan, anyway? Alan Whitecross awhitecross@gmail.com
What repays a loan?????????? Guess we need to understand Cash Flow!
Remember, the first task is to underwrite the transac>on Where s the primary source of repayment?! It should be from?! Does your Bank test the affordability of the transac>on?! Do you calculate the supportable loan amount in every term loan?
Understanding of Cash Flow All cash flow is a dynamic, living, thing:! It needs to be reviewed and analyzed regularly! This requires, therefore, new informa>on regularly Make sure that you understand what stage in the company s evolu>on you are reviewing:! New company! Growing company! Mature company
Quick Summary of Differences between Fast Growth and Mature Firms Growing firms borrow more than mature firms So if our customer base is comprised of growing firms, we need to find a cash flow measure that works in growth scenarios The cash flow measure must determine??
Cash Flow Fantasies Every borrower has a core cash flow! Predictable and reliable! Stable and consistent Borrowers always pay back bank debt first! Before they pay taxes and CAPEX?! Before they pay their personal living expenses?! Before they pay themselves draws and dividends?! Before they pay unexpected costs accidents, fires, floods, tornadoes, hurricanes, illness, etc.?
How Does Your Bank Determine Cash Flow? Tradi>onal! EBITDA! FAS 95 Global
So what cash flow to use? What cash flow measure will incorporate legitimate needs for:! Working capital to acquire inventory and receivables to support sales growth! CAPEX to acquire fixed assets to support growth! Payment of income taxes! Repayment of debt principal and interest! Stockholders expectations for dividends and share price appreciation
Tradi>onal Cash Flow Consequences of using Traditional Cash Flow (TCF) to measure cash flow : TCF = CFO (cash from operations) only if:! But what if company does grow?! Sales growth requires assets to support growth! Additional NWC and fixed assets usually means additional borrowing to acquire assets
Tradi>onal Cash Flow Consequences of using Traditional Cash Flow (TCF) to measure cash flow (cont. d): NWC and CAPEX investments compete with debt repayment, particularly for cash in growing companies Adding back depreciation expense means no dollars available to replenish fixed assets! Depreciation usually covers only about 50% of replacement costs TCF ignores NWC and CAPEX investment, so it overstates CF available to repay debt Now, looking at EBITDA
EBITDA Defined EBITDA spelled out: Sample Co. ($M) E profit after taxes 20 B before... I + interest expense 7 T + taxes 10 D + depreciation 7 A + amortization 1 = EBITDA 45
But TCF and EBITDA add up to the same problem... E 20 B +I 7 +T 10 +D 7 +A 1 = EBITDA 45 E 20 +D 7 +A 1 =TCF 28 +T 10 +I 7 = EBITDA 45
EBITDA s Appeal Why It s Used Easy to calculate! Uses only P&L data, no balance sheet needed Bigger, positive number! Offers larger number for value multiples! Positive, stable number Investment banker mystique and cache Borrowers like EBITDA-based covenants! Easy to calculate! Hard to violate
EBITDA s Drawbacks It s not all available to service debt because:! It ignores sales growth demands for o NWC o CAPEX! It ignores taxes! It ignores dividends Its use induces aggressive accounting tactics Its overstated CF leads to bad credit decisions EBITDA based covenants don t work
Quick Fixes to EBITDA Two solutions to EBITDA! FASB-based cash flow from operations (CFO) o Accurate... o...but harder to calculate than EBITDA o Several variations on CFO " NCAO " NCI " CADA
Comparison of NCAO, NCI, and CADA NCAO, NCI, & CADA ($MM) 2008 2009 2010 Cash collected from sales 566 616 666 -production costs -460-526 -537 -operating costs - 82-104 -123 -other income (expenses) 5 22 25 net cash after operations (NCAO) 29 8 31 -existing interest expenses - 7-11 - 16 -dividends - 3-4 - 8 net cash income (NCI) 19-7 7 -existing principal repayment - 10-5 - 14 cash after debt amrtzn (CADA) 9-12 - 7 -CAPEX for existing net fixed assets - 37-102 - 91 NCAO surplus (deficit) avail - 28-114 - 98 for new debt
What Does This All Mean? Talk with your Customer! Understand what your Customer s future plans are map See how that matches to what the numbers tell you i.e., can the reach their goals with their reality?? What would you do?
Commercial Lending for Lenders Net Trade Cycle Cash A/R Re Inventory Sales As defined by The Business Ferret, LLC, the net trade cycle or trading cycle is: Net Trade Cycle is a popular metric that new business clients always want to learn more about. The Net Trade Cycle is sometimes known by the name Cash Conversion Cycle. The whole idea of the Net Trade Cycle or Cash Conversion Cycle is how fast it takes for cash to go from the cash balance through the regular trade cycle of the business. Cash, along with vendor payables, are used to purchase inventory, which goes through processes to become a service or product for sale, ultimately to be sold and held as an account receivable balance until eventually being paid off by the customer. The Net Trade Cycle shows how long the cash is tied up in the trade cycle before coming back out as cash again. To calculate the Net Trade Cycle, we start with the number of days, on average; money is held in each of accounts receivable (AR), inventory, and accounts payable (AP). Once the days are tabulated for each, AR days are added to inventory days and AP days subtracted out to come up with a total net trade days. This net number of days can either be positive (usually) or negative. The Net Trade Cycle tells how many days it will take for cash to go through the trade cycle back to cash. When the net trade days are positive, the company needs to funds those days with net income or a line of credit. When the net trade cycle is negative, the firm is being paid for the service or product before the firm pays its vendor AP. While a negative net trade cycle can be very advantageous to a business, it only holds true when a business is increasing the revenues. When revenues start to decline, a negative Net Trade Cycle can be disastrous to cash flow. Basically, a positive Net Trade Cycle uses cash flow as the business grows and a negative Net Trade Cycle produces cash flow as a business grows. The reverse is true of both positive and negative Net Trade Cycles when the business is constricting. The Net Trade Cycle can tell a company how many cycles it goes through in a year and how many total dollars are tied up in each cycle. This indicates how many dollars are tied up in each day in each category whether accounts receivable, inventory, or accounts payable. When days increase in accounts
Commercial Lending for Lenders Net Trade Cycle receivable or inventory, the company is decreasing cash flow and cash balances. When days decline, the company is increasing cash flow and cash balances. With accounts payable it is the opposite: when days are increasing in the accounts payable, the cash flow increases. When the AP days decline, the cash flow declines. If the company knows specifically how much each day in the Net Trade Cycle actually represents in dollar amounts, then management is much less likely to ignore problems in the cycle as a whole. This may be one of the reasons it has such appeal or interest to understand; there is a concrete metric to follow to determine success or failure. There are, however, two more tactical levels of the Net Trade Cycle. Most financial discussions only look at the most basic cycle (explained above). There are two more levels of Net Trade Cycle that should be discussed. Besides accounts payable days, a firm can do the calculation of days for other payables, which could include credit card balances, and unearned income (or, if these amounts are typically substantial, they can be the calculated for days separately). This would be a Level 2 Net Trade Cycle where the first one that was discussed was Level 1. Additionally, the calculation of days tied up in the line of credit is calculated to determine a Level 3 Net Trade Cycle. Level 2 adds the AR days to the inventory days and subtracts out the AP days and the other payable days. Level 3 now subtracts out the line of credit days. The faster a company can turn cash back to cash, the faster it can grow without increasing the investment in working capital. Working Capital is the net difference between the drivers in current assets (not counting cash) and those in current liabilities (not counting any accrued tax liability in order to avoid double counting in the cash flow before financing numbers).