Determining DSC for Subchapter S Corporations, Limited Liability Companies, and Other Small, Privately Held Companies. (Small Business Lending)
Davidson, Robert B., Larabee, Annette R., The RMA Journal
Earnings reporting practices of smaller, nonpublic companies often result in a lowered or insufficient debt service coverage ratio and the appearance of increased leverage. The numbers can be less than appealing when arrived at through traditional ratio analysis. Authors from "The Biggest Little Bank in Connecticut" suggest the "excess compensation" tool.
Because loans to small businesses make up the vast majority of a community bank's commercial loan portfolio, analysis of these loans had better be accurate. But as any lender to small businesses can tell you, this is easier said than done.
Small businesses are often organized as Subchapter S corporations or, more recently, limited liability companies (LLCs). Both S-corps and LLCs are treated as partnerships for income tax purposes. These companies generally have a limited number of owners (often only one or two) and pay little or no corporate income taxes. The owners' pro-rata share of the company's earnings flow to their personal tax returns as adjusted gross income in one of two ways:
1. The company's net profit is reported on Schedule E of the personal tax return.
2. The earnings become year-end bonuses, which are then reported as wages on the personal tax returns.
The use of either scenario will result in a similar adjusted gross income figure.
If the owner chooses the first option, the company will report a larger net profit figure, and the company's cash flow figure will not be negatively affected. However, the owners of these companies often select the second option and "bonus out" the majority of earnings at year-end, resulting in little or no net profit to report.
Analysis of these companies is made more difficult by the lowered net profit figures. Because the company reports reduced earnings before interest, depreciation and amortization (EBIDA) and net cash after operations (NCAO) figures, its debt-service-coverage ratio is lowered or even insufficient. In addition, lowered earnings result in lower retained earnings, possibly leading to increased leverage.
An insufficient DSC ratio and a high leverage ratio mean a banker may dismiss a strong company as "unbankable." In fact, the more successful a company is, the more the individual owner(s) may take out in compensation, which could further exacerbate the appearance of an unbankable company.
Obviously, these companies are stronger than traditional debt-service-coverage and leverage ratios indicate. In fact, the vast majority are ideal customers for the typical community bank. The challenge is to find an alternative method to analyze these companies.
The simplest way to bypass this concern would be to establish either a maximum officer compensation or minimum net profit figure. However, the owner of the company may (rightfully) feel that the loan officer is trying to "micro--manage" his or her business. A more acceptable way to analyze this type of company would be to calculate the owner's "excess compensation," an amount the lender can derive from a credit report and the complete personal tax returns of the owner.
Determining Adjusted After-Tax Income
The first step is to determine the owner's total income. Total income from all sources is located on line 22 of the 2000 1040 individual tax return. This income figure includes wages, interest income, capital gains (losses), Schedule E income, IRA distributions, and so forth.
Next, any nonrecurring income should be subtracted and any nonrecurring losses should be added. Including any one-time income items would artificially inflate excess compensation. The lender might approve a loan that normally would not qualify. Capital gains and losses are generally the most common nonrecurring items.
Tax obligation, located on line 40 of the 2000 return, is the next item to be deducted from total income. The individual owner must be able to satisfy personal tax obligations from personal income. …