In consumer lending, it is relatively straightforward how a loan will get repaid. Someone has an income and a credit report that summarizes what other debts need to get paid. We compare how much income they have with how much debt they have, and make a decision whether they can afford the new loan.
Business lending has effectively the same method for determining repayment. We compare a business’s income with all the debts it has to determine if it can afford more debt. However, we know a business’s income differs from personal income in many ways. The income is likely to change up and down every year, and a business has different types of expenses to worry about. But, we are still focused on their income, which is what will repay the debt. Particularly, we focus on their cash income, which we call cash flow.
How we look at a business’s cash income can create some unique debates at times. Even personal income could be open to interpretation. Say someone has a salary of $40,000 a year. Okay, we can expect various taxes to take away about 1/3 of that income, so someone is actually left with $26,666 to live off and pay debts. But say the person also sells a used car for $5,000. Is the person’s cash income really $26,666 + $5,000 = $31,666? In that particular year, yes, they seem to have an extra $5,000. But that was an unusual situation. If the person is coming in to get a new loan, should we use the income of $26,666 or $31,666 to make the decision? I’m inclined to use the lower amount, unless the person can demonstrate they have a used car to sell for every year the loan is outstanding into the future.
For businesses, we can look at their regular income with a method we call EBIDA, which stands for Earnings Before Interest Depreciation and Amortization. In other words, how much cash income a business has before it pays any debts and ignoring non-cash expenses. We can then look at a business’s historical EBIDAs and reasonably project what income to expect in the future.
There is another method for counting a business’s cash income called UCA cash flow. The UCA stands for “Universal Credit Analysis.” This tries to capture all cash events related to the business. So if the business has an EBIDA of $26,666, and it sells a piece of equipment for $5,000, then the UCA cash flow is $31,666. Once again, which way of calculating income do you think makes more sense to evaluate when considering a loan?
In the past year, I’ve heard a lot of murmuring about the need to use UCA cash flow, and I think there is a belief it is superior based on its name alone. After all, it is the Universal Credit Analysis cash flow, right? Well, I would argue strongly that it is not “universal” in its application, nor should it be. Maybe it is called “universal” because it looks at all cash events? Maybe it should be renamed the “comprehensive” or “everything” cash flow?
Believe it or not, UCA cash flow is actually a copyrighted method of calculating cash flow created by RMA back in 1987. I believe they had the best intentions in trying to look at cash flow arising from changes in the balance sheet, which are undoubtedly important to how a business is run and managed.
But regardless of what moves on or off a business balance sheet, it’s sales that we ultimately care about, and whether those sales can cover operating expenses. UCA cash flow is important for large companies, like publicly traded companies that have a more unique balancing act that doesn’t just involve management of bank debt, but the expectations of shareholders and bondholders. As for small business and the middle market, EBIDA is a more powerful tool for predicting tomorrow, since we don’t expect rearranging the balance sheet will be integral to our repayment.