Capacity: The Right Loan for the Right Purpose

To recap, I have recently been writing about the 5 Cs of Credit. The world is full of infinite reasons why a loan could go bad, and we try to classify all those risks into 5 buckets: Character, Capacity, Capital, Collateral and Conditions. Generally speaking, if all the 5 Cs are strong, then risk should be well mitigated. In reality, some of the Cs will have weaknesses and others will have strengths, and a team of people will need to debate whether the balance is appropriate.

We have looked at Character and discussed why it is important to know your borrower personally, as well as conduct background checks and other independent investigations. We also discussed Capacity and the importance of making sure a loan matches borrowing cause and the timing of the asset conversion cycle.

The assessment of Capacity gets a little more complicated because the asset conversion cycle has both short-term and long-term components. Generally speaking, all business operations can be broken into the “operating cycle” and “capital investment cycle.”

The operating cycle tends to be a short-term cycle of production that generates cash or profit. An example of the operating cycle would be buying raw materials for widgets, stamping the widgets, packaging and selling the widgets, and repeating the process all over again.

The capital investment cycle is a long-term cycle of providing and replacing the means of production. An example would be purchasing the widget stamping machine. Recovering the expense of the machine will take several operating cycles; but that is okay, because the machine should last for several cycles.

Now that we have these key principles spelled out, we can really address how to assess capacity accurately! Borrowing cause that arises from the operating cycle will almost always be coupled with short-term credit facilities; whereas, borrowing cause tied to the capital investment cycle usually calls for long-term debt.

Commercial & Industrial Lines of Credit 

Let’s start by looking at borrowing cause associated with the operating cycle. For example, Widget Inc. invests all their cash into making widgets for a single order. Widget Inc. delivers the widgets and is waiting to get paid. Meanwhile, Widget Inc. gets a second order and needs to borrow cash to start production since they haven’t been paid yet from their first order.  The best type of loan to solve this problem is a line of credit. Think of this as a credit card with a high limit, but there is a catch.

The limit will always be determined by the amount of sales (accounts receivable) that are waiting to be collected; therefore, if there are no sales, Widget Inc. will not be allowed to borrow. To control the credit limit, Widget Inc. will need to send a report to the lender every month showing what sales (receivables) are outstanding and for how long they have been waiting to collect. The only payment required for the line of credit is interest on the outstanding balance. Actual repayment of the debt hinges on the expectation that the principal will be repaid once the sale is collected, which will be verified with the monthly report of sales (accounts receivable aging report) sent to the lender.

Because the operating cycle is likely to repeat several times, it would be a hassle to constantly get a new loan each time the company needs to start a new order and doesn’t have the cash. A solution is to allow the customer to repay their line of credit and re-borrow as the need arises. We call this a “revolving” line of credit. Again, it works just like a credit card with a high balance, except it is well-monitored.

Real Estate Construction

Not all lines of credit should revolve, because not all short-term needs are recurring or easily justified. For example, construction of an office building will require a short-term demand for funds. Because the building will not generate rent until it is constructed, it is not practical to require principal to be repaid in the short run. In this case, it makes sense to extend a line of credit for construction as well. In this way, the owner will only be charged interest on the amount of money they are currently borrowing until construction is complete, but once construction is complete, principal must be repaid.

The important concept to bear in mind is lines of credit are usually repaid from the conversion of an asset to cash. In real estate, this means permanent financing (which requires payment of principal) can replace short-term financing, or hypothetically, the building could be readily sold to an end user. In this case, if debt is fully repaid, it does not make sense to allow the customer to re-borrow for the same purpose. Why not? It is difficult to identify how real estate will be repaid, and before the project is started, there is substantial analysis of the market and/or end user of the real estate. This level of analysis should be completed for each real estate project because the market changes and/or the end user may be different. It is too risky to invest a large sum of funds into a single project to see it fail. A non-revolving line of credit is appropriate in this circumstance.

Term Debt and Useful Life

When machinery or equipment is needed, it is understood that cash received in one operating cycle is likely not enough to make the needed purchase. Since these assets will likely last for years, it is permitted to take years to repay them. All long-term assets have a “useful life,” and the loan for a long-term asset should not exceed its useful life. Ideally, a loan term should be shorter than the useful life of the asset to provide added protection to the lender.

Term debt characteristically has equal payments of principal and interest until maturity, although this does not have to always be the case. It is common for payments to be due monthly or quarterly, but could be due semi-annually or annually. Which is the best payment method? I would direct you to the operating cycle to answer the question. Structure regular payments to be due when you expect the customer to have the best ability to pay, which is when the operating cycle produces cash. It is fairly common to have predictable income on a monthly basis for most businesses, and a business could have several operating cycles complete in any given month.

A good example of matching term loan payments with the operating cycle can be observed in the hotel industry. The useful life of a hotel could be up to 25 years or more, so a good lender will expect the hotel to be able to repay on a 20-year plan (amortization). A hotel in a tourist destination may see a boom in summer months and be flush with cash, but the hotel may not be able to break even in winter months. Some hotel loans require 3 or 4 large payments during the summer months when the hotel has cash, and no payments during the rest of the year when they likely have little cash. In this situation, a hotel could even close down in the winter months to keep from losing cash without worrying about missing loan payments!

Recurring Cash Flow

Now we have established the need for a term loan arises because of the capital investment cycle and will take several operating cycles to repay the debt. We know the payments should retire the debt within the useful life of the asset, and the timing of the payments should coincide with the timing of the operating cycle. Now, how do we know if business is profitable enough to repay debt if the loan is structured correctly? We need to dissect the business’ income to understand this, because not all profits are cash.

Income can be recorded for a variety of reasons. When dealing with accrual accounting, income can be generated from completing a sale before cash is collected, it could be the result of appreciation of the market value of an asset, or a host of other reasons that don’t coincide with the inflow of cash. To truly analyze capacity, it is necessary to examine where cash is coming from and not necessarily income.

The most common way to approach cash flow is by adding non-cash expenses back to net profits - this calculation is called EBITDA (Earnings Before Income Taxes and Depreciation). But, this is problematic for several reasons. Taxes are a necessary expense that must be paid with cash, but it is often mistakenly added back. EBITDA is a business school concept of comparing cash flows of two similar businesses, and adding taxes back is done to filter out the distortions the local tax authority may place on cash flow when comparing two like businesses. When it comes to repayment of debt, taxes should be treated as a necessary expense that must be paid, and really, the focus should start with EBIDA (without T) instead of EBITDA.

EBIDA is still problematic, because it only adds back non-cash expenses and does not subtract out non-cash income. EBIDA also will fail to indicate whether or not the source of cash flow is recurring and misses other accounting distortions. Say you bought a widget-stamping machine for $500,000 and sold it for $300,000. EBIDA will reflect a loss of $200,000. However, the actual cash inflow to the company will be the $300,000 cash received from the sale. But, if we are constructing a pro-forma to demonstrate the recurring ability to repay debt, should we include the $300,000 cash inflow? We don’t want to depend on the constant sale of machinery to repay debt, do we? Really, we want the cash flow from the sale of widgets to repay debt! To make matters worse, say a new widget machine is purchased for $700,000. The entire purchase of the machine will not be reflected as an expense, but rather expensed through depreciation over its useful life. In reality, the company just experienced a $700,000 cash outflow that EBIDA did not catch.

If your head is spinning, that’s okay; it should be. The key takeaway is income does not equal cash flow, and EBITDA or EBIDA isn’t an accurate measure of cash flow for debt repayment. The only way to truly understand cash flow is through careful study of the financial statements and understanding how changes in the income statement and balance sheet are linked to cash accounts. This takes a fair amount of training. In accountant-prepared statements, these interactions will usually be reflected on a Statement of Cash Flow, but not all borrowers will have this quality of financial statements.

Putting it All Together

While this appears to be a large volume of information to digest, important principles should now be easy to identify. For example, term debt should not be provided to finance production of inventory or services, because those are related to the operating cycle and best matched with lines of credit. A revolving line of credit is practical for an operating cycle that constantly repeats, but isn’t appropriate when invested into one large project such as real estate construction. It doesn’t really make sense to measure repayment of lines of credit with cash flow models for term debt, because lines of credit should be repaid from collection of receivables, which should be extensively monitored through monthly reports.

Term debt should be evaluated based on recurring cash flow sources, not necessarily on booked income. Term debt should not extend past the useful life of an asset, and the repayment of the debt should coincide with the timing of the operating cycles. And lastly, EBITDA is not a catch-all for cash flow. The burden is on the analysts and other decision makers to understand what is occurring on the financial statements and where the true cash flow is. A good practice is to determine which sources of cash flow are recurring, and decide if it is acceptable for underwriting purposes.--Trevor Plett