In credit analysis, we obtain peoples’ tax returns to evaluate their income. However, we know that the tax return fails to tell us everything we need to know about someone’s cash flow to repay debt, because the IRS taxable income does not necessarily tax income on a cash basis.
For starters, we need to understand that taxable income is not necessarily cash income. Therefore, many taxable sources of income that appear on the first page of a tax return do not indicate with certainty that the person received cash from that source. Whether the source of income is business related, interest income, farm income, etc., the amount reported is simply the “taxable” part of their income and not the actual cash received, which may vary greatly.
For people who own companies and partnerships (for which this income is reported on Schedule E of the tax return), they will annually receive a K-1 form that tells the individual how much taxable income to report. A unique feature of these K-1s is that they also include distributions and contributions made from/to the company, regardless of taxable income. Because of this, it has become industry practice to ignore the taxable income, but to focus on whether money was received via a distribution, or lost via a contribution.
While this would seem a good way to evaluate cash flow, there is still information not being conveyed on K-1s, and distributions and contributions can still oversimplify cash flow in many ways.
First, consider that all distributions and contributions are not necessarily cash. If a person transfers property to or from a company, that too will be counted as a contribution or distribution. If I own a piece of land and transfer that to the company’s name, I have just made a contribution. This did not impact my cash position, so it would be wrong to count this as a cash event, but my K-1 may not reflect the type of contribution made. Likewise, if I transfer the company’s private jet to my personal name, the company has just made a distribution to me, but again my cash position was unaffected.
Now, consider if we knew whether a contribution or distribution is actually cash, the K-1 still does not indicate other key information needed for analysis. A distribution can be made, even if a company had negative income or negative cash flow. A company does not need to be profitable or strong to make distributions. A company can borrow money and then distribute those borrowings to owners.
Likewise, a cash contribution isn’t necessarily the sign of a weak company. A company with strong profitability and cash flow may still receive a cash contribution for a variety of reasons. If the company doesn’t need the cash and has a cash surplus, does it make sense to penalize someone’s personal cash flow for having moved cash into that company?
The point I’m driving at is the K-1 tends to be a red herring of sorts. While at first it seems a tool that captures the actual movement of cash to and from a company, it really may not be capturing cash events at all. And, in the cases where we can definitively demonstrate cash was distributed or contributed, it is still unclear what the actual cash flow of the company was.
Really, the only way to tell whether a company truly had recurring cash flow to distribute would be to obtain a P&L and evaluate how much cash flow is remaining after all of that company’s debt service was paid. And, if there is a cash flow shortage, it would seem logical to reflect that as negative cash flow when evaluating global cash flow.
K-1s ignore the internal cash flow and debt service of each company, so to only track distributions and contributions treats each company like a black box and misses the key details that indicate how dependable the company is as a source of income.