Dimension 4 _ CRC_US_Body_of_Knowledge.pdf

DIMENSION 4 - 2 NOTES: DIMENSION 4: ASSESS STRENGTH AND QUALITY OF CLIENT/ SPONSOR CASH FLOW PURPOSE OF DIMENSION 4 The purpose of Dimension 4 is to review skills required to assess business cash flow. Key topics in this Dimension include: Cash cycle analysis. Cash flow statement analysis. Cash flow...

DIMENSION 4 - 2 NOTES: DIMENSION 4: ASSESS STRENGTH AND QUALITY OF CLIENT/ SPONSOR CASH FLOW PURPOSE OF DIMENSION 4 The purpose of Dimension 4 is to review skills required to assess business cash flow. Key topics in this Dimension include: Cash cycle analysis. Cash flow statement analysis. Cash flow statement formats: –– Direct –– Indirect Analyzing cash flow. Alternate cash flow measures: –– EBITDA –– Free cash flow. Comparing cash flow to industry peers. Discovering borrowing causes and repayment sources. Developing cash flow projections. CRC US Body of Knowledge ADDITIONAL SKILL-BUILDING RESOURCES The material in the Body of Knowledge provides an overview of knowledge related to topics covered by the Credit Risk Certification exam. Mastery of topics reviewed here is essential preparation for the exam, but no amount of reading and study can substitute for lending skills that must be acquired through formal classroom and on-the-job training. In addition to reviewing the Body of Knowledge, consider taking the following RMA courses to support your Dimension 4 skillbuilding: UCA I: Cash Flow Analysis UCA II: Credit Risk Analysis for Commercial Bankers Cash Flow Refresher for Experienced Bankers DIMENSION 4 - 3 CASH CYCLE ANALYSIS The term cash cycle, sometimes called the asset conversion cycle, describes how cash moves through a business as its assets and liabilities shrink and expand in a fairly regular pattern. Cash typically moves to inventory, then to receivables, then back to cash. The amount of cash actually required to support the inventory portion of the cycle is reduced by the amount of trade credit available in accounts payable. NOTES: The flowchart below illustrates a simple cash cycle. CASH CYCLE INVENTORY ACCOUNTS PAYABLE ACCOUNTS RECEIVABLE The duration and predictability of a company’s cash cycle affect its need for working capital. You can measure the average length of a company’s cash cycle by analyzing its days’ sales in receivables and days’ COGS in inventory and payables. When a company has inadequate working capital (too little and not liquid enough) to get through a cash cycle, it will need to borrow. That borrowing will be long term if it is caused by a permanent lengthening of the cash cycle (declining efficiency) or by a permanent increase in the amount of cash needed daily (sales growth). The borrowing will be short term if it is caused by a temporary lengthening of the cash cycle or a temporary increase in the amount of cash needed daily. Cash cycles vary with the type of business. For example, manufacturing companies that must invest in raw materials, work-in-process inventory, and finished goods usually have a longer cash cycle than companies that are able to convert purchased merchandise inventory directly to accounts receivable. Companies that can convert inventory directly to cash, by selling for cash or accepting national credit cards, have a shorter cash cycle than companies that offer their customers extended payment terms. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow CASH DIMENSION 4 - 4 NOTES: HOW TO MEASURE THE CASH CYCLE To measure a company’s average cash cycle, calculate average turnovers. Then add the average days’ sales in receivables to the average days’ COGS in inventory and subtract the average days’ COGS in payables. Average days’ sales in receivables + Average days’ COGS in inventory – Average days’ COGS in payables = Average days in cash cycle Example: The turnover calculations for a wholesaler of abrasives products are days’ sales in receivables—107; days’ COGS in inventory—76; and days’ COGS in payables—72. Therefore, for this company, it took an average of 183 days (107 + 76) for cash to move through inventory and receivables and back to cash. For 72 days of that period, on average, cash was provided by accounts payable. Therefore, the average cash cycle for this company was 111 days (183 – 72). As a wholesaler, this company is a good example of the concept of adding and subtracting “days in” to calculate the cash cycle. When calculated for a manufacturer, purchases of raw materials are less than the full cost of goods sold and certainly less than sales. Thus, the subtracting and adding of days derived from these different items gives us only a rough idea of the cash cycle. CRC US Body of Knowledge The wholesaler in our example is a relatively nonseasonal company, so using year-end balances for receivables, inventory, and payables is the best way to measure the average cash cycle. But remember that the calculation is an average, and even a nonseasonal company will experience actual cycles that are longer or shorter than the average during a year. When working capital is just adequate to support average cycles, a slightly longer cycle—created, for example, by a large receivable being just a few days late—can create a borrowing need. DIMENSION 4 - 5 BENEFITS OF CASH CYCLE ANALYSIS NOTES: Measuring the cash cycle helps you analyze the adequacy of a company’s working capital and evaluate if it may need to be permanently increased with a long-term loan or temporarily supplemented with a short-term loan. In addition, the cash cycle concept helps you distinguish three reasons why cash can become available for loan repayment: 1. Because it is temporarily freed up in the cash cycle. Example: Cash can be available temporarily when a large receivable pays early or when management decides to defer payment to trade creditors for a few days to allocate cash to other needs. Cash also can be available on a temporary but regular and fairly predictable basis when a business has seasonality. 2. Because the cash cycle becomes permanently shorter or requires less cash when sales have a permanent decline. This is another way to express permanent improvement in current asset and working capital efficiency, permanent increases in trade credit terms, or lower asset requirements as a result of lower sales. Example: Cash becomes available for loan repayment on a relatively permanent basis when the cash cycle shortens and does not need to extend again. Also, cash becomes available when sales decline so that each average day’s sales and COGS are less, provided the company does not incur losses that absorb any cash released from the cash cycle. 3. Because profit is generated and retained and the cash cycle is not expanded to absorb it. Unlike the first two sources of repayment (from cash already available within the cash cycle), profits (adjusted for noncash expenses, such as depreciation) introduce net new cash into a company. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow This source of repayment depends only on the company’s ability to turn cash into inventory, receivables, and back to cash without incurring losses. No new cash, such as from profits retained, needs to be injected. DIMENSION 4 - 6 NOTES: LIMITATIONS OF CASH CYCLE ANALYSIS Cash cycle analysis has two limitations: 1. All cash cycle calculations are averages, which can: –– Mask irregularities that are inevitable for all companies. –– Mislead you when analyzing seasonal companies. To compensate for this limitation, you should realize that every company will experience actual cycles that are longer and shorter than the calculated average. For seasonal companies, you must distinguish between a company’s shortest cash cycle, or period of lowest daily sales with a base level of cash need, and its longest cash cycle, or period of highest daily sales with a seasonally high level of cash need. 2. The cash cycle calculation excludes cash requirements for payments other than cost of goods sold. CRC US Body of Knowledge Most companies periodically make other sizable cash payments for dividends, taxes, and selling expenses. The most precise way to estimate all those cash needs is to prepare a cash receipts and disbursements budget. DIMENSION 4 - 7 VARIATIONS IN CASH CYCLE BY TYPE OF BUSINESS NOTES: Businesses that must make a substantial investment in current assets to produce goods or services have a longer cash cycle and need more working capital than do businesses that require little investment in current assets. The opposite is true of most manufacturing companies and wholesalers, which depend on turning inventory to generate sales and which usually have to offer their customers payment terms. These companies have longer cash cycles and cannot operate successfully with negative working capital. Here are some calculations of average cash cycles taken from the all-sample median of industry composites in a recent RMA Annual Statement Studies: Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Example: Hotels, restaurants, airlines, and utilities all generate revenues without substantial investments in inventories (in relation to their other assets). They also have minimal cash tied up in accounts receivable since they sell mostly for cash, use national credit cards, and have short-term billing. Consequently, they have relatively short cash cycles and little need for working capital. Many companies in those industries have negative working capital. DIMENSION 4 - 8 DAYS OUTSTANDING INDUSTRY NAICS NO. ACCTS. REC. DAYS 71111 1 Airlines 481111, 481112 30 Hotels 72111, 72112 30 Supermarkets 44511, 44512 1 Manufacturers (Computers) 334111 69 Wholesalers (Computers) 42143 Retailers (Computers) Computer Processing Services Restaurants + + - ACCTS. PAY. INV. DAYS 13 – 25 CASH = CYCLE = (11) 30 N/A – N/A N/A – N/A 23 – 13 + 99 – 45 = 123 36 + 57 – 38 = 55 44312 34 + 59 – 32 = 61 51421 51 + N/A – N/A = 51 + + + = = = 30 11 Among those industry examples, restaurants have the shortest cash cycle and therefore the smallest need for working capital. The longest cash cycle in those examples, 123 days, belongs to manufacturers of computers because they require a lengthy investment in manufacturing inventory and must also offer terms to their customers (distributors, wholesalers, or retailers of their products). CRC US Body of Knowledge Note: Airlines, hotels, and computer processing sources have no inventory and accounts payable. Therefore those calculations are not applicable to their cash cycles. DIMENSION 4 - 9 NET WORKING CAPITAL CONCEPTS Net working capital is defined as current assets less current liabilities. NOTES: Current assets - Current liabilities = Net working capital When an increase in current assets is supported by an equal increase in current liabilities, there is no change in net working capital. If a reduction in current liabilities is accomplished by an equal reduction in current assets, there is no change in net working capital. The two ways to increase working capital are 1) to support an increase in current assets with something other than an increase in current liabilities and 2) to finance a decrease in current liabilities with something other than a reduction of current assets. To increase working capital, a company must: Increase net worth. Decrease long-term assets. To decrease working capital, a company can: Decrease long-term liabilities. Decrease net worth. Increase long-term assets. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Increase long-term liabilities. DIMENSION 4 - 10 NOTES: Examples of transactions that do or do not affect net working capital include: If a company collects accounts receivable and uses the cash to pay a current liability, there is no change in working capital. If a company collects accounts receivable and uses the cash to pay down long-term debt, purchase fixed assets, or pay dividends, working capital decreases. If a company increases net worth or long-term debt and uses the proceeds to support higher levels of inventory, working capital increases. If the proceeds of increases in net worth or long-term debt are used to acquire fixed assets, working capital is unchanged. Working capital is a quantitative measure of liquidity, but its weakness as an analytic tool is that its existence is not proof of convertibility to cash. A company with low net working capital but with a healthy cash position and inventory and receivables turning over regularly is more liquid than a company with high net working capital but illiquid current assets. Example: A company has a large amount of working capital, but its current assets consist entirely of unsellable inventory and uncollectible receivables. Therefore, it does not have cash available to pay current liabilities as they become due. CRC US Body of Knowledge If two companies of the same size have assets of equal quality and equally stable current liabilities, the one that has higher net working capital (or a lower net sales-to-net working capital ratio) provides lenders a greater margin of protection in liquidity. That logic often leads analysts to the false conclusion that an increase in net working capital is always a sign of improved creditworthiness and that a decrease in net working capital always weakens creditworthiness. DIMENSION 4 - 11 When analyzing working capital, you must keep in mind these two concepts: NOTES: 1. An increase in the noncash portions of working capital is a use of cash. If the company cannot at least temporarily get the cash back out of working capital (by collecting receivables or selling inventory), the added quantity of working capital has not improved liquidity. 2. The liquidity of current assets, measured by asset quality and receivables and inventory turnover, is a key factor in how much working capital a company needs. The higher the quality and the more rapid the turnover (the closer current assets are to cash), the less working capital a company needs. Example: A company with a high percentage of current assets in cash and accounts receivable (a high quick ratio and low reliance on inventory to cover current liabilities) needs less of a working capital cushion to be sure of having cash available to meet current liabilities than does a company that has little cash on hand, has low receivables, and must convert inventory to cash to pay its current obligations. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Example: If receivables or inventory turnover declines and the resulting increase in current assets is supported by increases in long-term debt or net worth or by decreases in long-term assets, net working capital has grown, but liquidity has not improved because the new working capital cannot be reconverted to cash unless current asset turnover improves (shortening the cash cycle). DIMENSION 4 - 12 NOTES: IMPACT OF SEASONALITY ON THE CASH CYCLE Many businesses have seasonal variations in sales, inventory accumulation, receivables collection, or disbursements. To measure those variations, you must analyze interim financial statements that report on financial condition and performance monthly or quarterly during the fiscal year. By analyzing interim statements, you can determine the cash effects of seasonality and distinguish between permanent base levels of assets and liabilities and temporary levels caused by seasonality. That way, you can estimate whether outstanding loans can be repaid in the short term and whether seasonal borrowing will be needed in the future. Seasonality can alter cash requirements in two ways: 1. By temporarily lengthening the cash cycle. 2. By increasing daily average sales or cost of goods sold (COGS). You might encounter these seasonal business patterns that can cause seasonal borrowing: Seasonal sales that increase daily average sales or cost of sales and sometimes cause a mismatch of cash receipts and disbursements. Level sales and cash receipts but uneven seasonal cash disbursements that lengthen the cash cycle. CRC US Body of Knowledge Level sales and cash disbursements but uneven seasonal cash receipts that lengthen the cash cycle. DIMENSION 4 - 13 SEASONAL SALES NOTES: Recognizing inventory as a significant use of cash, many businesses try to reduce the length of time they must carry it. Before buying, they encourage their suppliers to hold materials and merchandise for as long as possible, and they look for suppliers who offer quick turnaround between orders and delivery. This practice of strict inventory management—in effect, getting suppliers to carry some of their customers’ inventory burden—has been called “just in time” inventory, or production management. Manufacturers with seasonal sales can respond with their own inventory management strategies, keeping levels of raw materials as low as possible. But each also must select a production strategy, and that strategy will affect levels of work-in-process and finished goods inventory and seasonal borrowing requirements. Manufacturers can use either level production or peak period strategies, or a combination of the two, to prepare for seasonal sales. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Seasonality of sales, an increase in daily average sales, is the most common and most obvious seasonal business pattern. It increases cash requirements and can cause a need to borrow even when there is no change in the length of the cash cycle. Seasonal sales are usually preceded by a period of inventory buildup and are usually accompanied and followed by a period of higher receivables. In such a pattern, the company’s seasonal need for additional cash begins with the inventory buildup and lasts until the receivables have dropped back to lower levels. During that period of seasonal cash needs, average daily sales increase and if receivables or inventory grow faster than sales (such as during inventory buildup), the cash cycle lengthens. DIMENSION 4 - 14 NOTES: LEVEL PRODUCTION Companies engaging in level production produce a consistent amount each period and gradually build up the finished goods they will need for their peak sales. Cash disbursements for production costs are spread out evenly throughout the year, but cash required to support inventory builds when production exceeds sales. PEAK PERIOD PRODUCTION During their season or immediately before it, companies engaging in peak period production produce all the goods needed for peak sales by working overtime, adding a second or third shift, or subcontracting peak orders to other manufacturers. Inventory buildup and borrowing requirements occur much closer to the peak sales and tend to overlap the period of receivables buildup. Therefore, borrowings may not last as long, but may reach higher levels than if the company used level production. SEASONAL CASH DISBURSEMENTS The second seasonal business pattern that often causes seasonal borrowing is cash disbursements that are not level throughout the year, even when sales are level. Remember that expenses may be accrued evenly during the year, but cash payments may be uneven. Examples of cash disbursements that may not be level throughout the year include: Dividends CRC US Body of Knowledge Estimated or final tax payments. Bonuses Expenditures for an annual catalog. DIMENSION 4 - 15 SEASONAL CASH RECEIPTS NOTES: The third and least common seasonal business pattern that contributes to seasonal borrowing is uneven cash receipts despite fairly level sales. This situation occurs in some businesses when it is customary to allow customers to have special payment terms based on their seasonal ability to pay (often described as dating of receivables). Such companies might need to borrow to carry the higher receivables they will have as a result of offering extended terms to their customers. Situations in which receipts might not be level throughout the year include the following: Suppliers to farmers may sell throughout planting and growing seasons, but are not paid until farmers harvest and sell the crops. Suppliers to educational institutions may sell throughout the term, but are paid when students pay tuition. DISTINGUISHING BETWEEN SEASONAL AND BASE-LEVEL ASSETS Current assets are either permanent or temporary. A permanent base level of current assets, such as receivables and inventory, is required to support the relatively low level of sales that occurs during nonpeak periods. That base level of current assets is just as permanent as, although more liquid than, a company’s investment in fixed assets, such as plant and equipment. A temporary, incremental level of receivables or inventory is required to support the higher level of sales that occurs during peak periods. Only that incremental level of current assets is temporary or seasonal; the base level of current assets is permanent. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Suppliers to government agencies may sell throughout the year, but are paid as the agency receives funding allocations. DIMENSION 4 - 16 NOTES: The graph that follows depicts incremental current assets building up in addition to permanent current assets and fixed assets for a manufacturer of submersible pumps used in decorative fountains, waterfalls, and birdbaths. When you look at the graph, take note of the following: The company begins its fiscal year in November with no seasonal assets; total assets are approximately $200,000. By May, incremental assets needed for seasonal sales have increased total assets to almost $300,000 (probably inventory increased in February and March and has begun to subside by May as receivables are increasing rapidly with seasonal sales). By the fiscal year-end at October 31, incremental assets have been liquidated (inventory sold and receivables collected), and the company has shrunk back to its low point of base-level assets. CRC US Body of Knowledge SEASONAL AND BASE-LEVEL ASSETS This concept of seasonal and base-level assets is significant because: Permanent base-level current assets should be supported by net worth or long-term debt. If they are supported by current liabilities, those current liabilities cannot be reduced through asset conversion. Only the temporary seasonal assets will liquidate and provide cash to repay loans. DIMENSION 4 - 17 The following graph depicts a liability structure that is appropriate to support the pump manufacturer’s base-level and seasonal asset requirements: Temporary current debt supports temporary current assets. NOTES: As you study the graph, notice the following: Only the temporary current debt (which is truly seasonal) will be repaid from shrinking assets from seasonal to base levels. The permanent current debt, such as revolving bank loans, and such long-term debt as term loans with scheduled payments, will be repaid only from profits and cash benefits of depreciation and other noncash charges. November April/May 0 0 Temporary current debt 100 100 100 Permanent current debt or LTD +100 100 October +100 +100 200 300 200 Equity TOTAL LIABILITIES AND EQUITY Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow SEASONAL AND PERMANENT LIABILITIES DIMENSION 4 - 18 NOTES: To quantify the amount of temporary current assets that you can expect to shrink and repay temporary current liabilities, compare receivables and inventory balances on interim and year-end statements. The difference between the low and high points of combined receivables and inventory is the temporary current asset requirement, the amount that can be soundly supported by temporary current liabilities. Example: Company A’s quarterly interim financial statements illustrate temporary asset and liability patterns similar to those in the preceding graphs. 9/30/X0 12/31/X0 3/31/X1 6/30/X1 9/30/X1 Receivables $ 495 $ 434 $ 263 $1,717 $ 522 Inventory 1,120 1,333 1,756 1,085 1,302 $1,615 $1,767 $2,019 $2,802 $1,824 Total Peak temporary current assets of $2,802,000 occur at 6/30/X1; by 9/30/X1 assets have shrunk to their base level of $1,824,000. Company A could repay $978,000 in temporary current liabilities through asset conversion (inventory and receivables converted to cash). CRC US Body of Knowledge It is possible that combined receivables and inventory peaked earlier in the quarter ended 6/30/X1 and had started shrinking by quarter-end, or they continued to rise until sometime in the fourth quarter and then fell to the low level by 9/30/X1. If you cannot obtain monthly statements, which many companies do not prepare because they can be time consuming and expensive, confirm the actual peak with management. Notice that the lowest level of combined receivables and inventory in Fiscal Year X1 actually occurred at 12/31/X0. However, since that amount was higher than the balance at the preceding fiscal year-end, we do not believe it is the low point. Instead it reflects an increase in the base level of current assets as a result of either sales growth or declining efficiency. In other words, Company A experienced an increase in combined receivables and inventory equal to $1,187,000 ($2,802,000 $1,615,000) but was able to repay only $978,000 ($2,802,000 $1,824,000) from shrinkage of seasonal assets back to base levels. The rest, $209,000 ($1,187,000 - $978,000), has become a part of baselevel assets and could be repaid only from profits. DIMENSION 4 - 19 When sales are increasing annually as well as seasonally, or when the cash cycle is lengthening owing to permanent as well as seasonal declines in receivables or inventory turnover, the distinction between temporary and base-level assets is more difficult to see. It is important to isolate them so that you can properly assess the borrowing cause and repayment source and therefore the loan’s risk and realistic maturity. NOTES: When increases occur both in temporary current assets and in permanent base-level assets, it may help you to think of the pattern in the graph below. The permanent increase in base-level assets may be the result of sales growth or declining efficiency. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow SEASONALITY AND GROWTH BASE-LEVEL ASSETS DIMENSION 4 - 20 NOTES: CASH FLOW STATEMENT ANALYSIS Cash repays debt. The income statement and beginning and ending balance sheets for a period provide the information necessary to calculate cash flow. In cash flow analysis you need to: Distinguish between profit and cash flow. Understand the three categories of cash flow: –– Operating –– Investing –– Financing Recognize the benefits and limitations of the statement of cash flow. Analyze the quality of the cash flow. Identify operating and extraordinary demands on cash flow. Isolate historical cash flow available for debt service. CRC US Body of Knowledge Project cash flows that will be available for future debt service. DIMENSION 4 - 21 CASH FLOW STATEMENT FORMATS NOTES: You must determine how the statement of cash flow assists in reconciling the results of a company’s financial performance for a year to the change in cash from beginning to end of the year. The Statement of Financial Accounting Standards (SFAS) allows, under SFAS No. 95, either the direct or indirect method. Regardless of the method, the primary purpose of SFAS No. 95 is to provide managers, investors, lenders and other interested constituents with additional information about the financial health of a company. When the accounting profession issues an audit, it usually includes the indirect cash flow in the financial statements. You are able to construct the direct cash flow statement when the income statement and balance sheet are spread using one of the software packages available in the market today. Topics included in this discussion are: Direct versus indirect cash flow. Cash flow terminology for the direct method. Analyzing cash flow. Cash flow ratio analysis. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow There are different methods of calculating or measuring cash flow. Each financial institution has its preferred method of analyzing and presenting cash flow. Some institutions use the direct method and some use the indirect method, yet others use a hybrid method developed for their particular purposes. Short-term lenders may favor the direct method of cash flow analysis while long-term lenders may prefer the indirect method. DIMENSION 4 - 22 NOTES: DIRECT VS. INDIRECT CASH FLOW What are the differences between direct and indirect cash flow? Direct cash flow is known as the top down” approach, while the indirect cash flow is known as the bottom up approach. The starting points are different. Direct cash flow starts with the top line on the income statement (net sales) whereas the indirect cash flow starts with the bottom line on the income statement (net income). Direct cash flow starts with the income statement (net sales) and methodically adjusts the corresponding balance sheet accounts (sometimes referred to as the buddy accounts) to highlight which changes in the working capital assets are affecting the cash flow generated from operations. Direct cash flow breaks out interest expense. Interest expense in the indirect cash flow is included in the net income figure, so you can’t tell how comfortably the company can pay its interest. CPLTD (current portion long term debt) is broken out as a claim against the operating cash flows of a company in the direct method. The indirect method combines CPLTD with other changes in long-term debt to arrive at a net number for an increase or decrease in long-term debt. It is not as easy to determine from the indirect method how maturing long-term debt has been financed, either from new long-term debt or from operating cash flow. The direct cash flow statement does not include net income, and, as a result, it is harder to determine the sustainable profitability and, ultimately, the long-term debt-service capacity of your customer. CRC US Body of Knowledge Both methods of presenting cash flow facilitate the analysis of the internally generated sources of cash flow that are available to service debt. DIMENSION 4 - 23 The primary purpose of SFAS 95 is to provide the many different interested parties with information about the financial performance of a business. Your analysis should focus on how a company is positioned to handle its institutional debt relationship: NOTES: Can it pay interest? Can it pay CPLTD? How much external financing does the company require? How have these external financing needs been met? Cash flow analysis also provides answers to the following four basic questions: Is cash flow from operations sufficient to repay scheduled maturities of LTD (Long Term Debt)? What are the company’s financing requirements (or financing surplus) after capital expenditures and other long-term investments? How has the company financed it activities? Is it through additional debt or equity, or the draw-down of cash balances? The cash flow statement provides a picture of the company’s functions broken down by current (operating activities) and long-term (investing activities) requirements, and the funding (financing activities) necessary. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Is cash flow from operations sufficient to pay interest on all debt? DIMENSION 4 - 24 NOTES: BASIC CASH FLOW CONCEPTS The sources or inflows of cash are from: Revenues Decreases in assets Increase in liability Increase in equity The uses or outflows of cash are from: Expenses Increase in assets Decrease in liability Decrease in equity Only by understanding the underlying reason for the change in these categories, can you determine the true effect on cash flow. For funding purposes, the primary sources of cash for operating and investing activities will be: Cash from operations. Cash from external financing (either debt or equity). Drawing down on existing cash balances. CRC US Body of Knowledge DIRECT AND INDIRECT CASH FLOW STATEMENT FORMATS The following exhibits illustrate the direct and indirect cash flow statement formats. DIRECT CASH FLOW STATEMENT The following is an example of a direct cash flow statement worksheet: DIMENSION 4 - 25 CASH FLOW WORKSHEET (PAGE 1 OF 2) Net Sales Revenue–Y2* Accounts Receivable–Y1 Accounts Receivable–Y2 ( ) CASH FROM SALES Cost of Goods Sold–Y2 (______________________ ) Depreciation in Cost of Goods Sold (if any) ________________________ Inventory–Y1 ________________________ Inventory–Y2 (______________________ ) Accounts Payable–Y1 (______________________ ) Accounts Payable–Y2 ________________________ Other Accounts Payable–Y1 (______________________ ) Other Accounts Payable–Y2 ________________________ CASH PRODUCTION COSTS GROSS CASH PROFITS Operating Expenses (SG&A)–Y2 (______________________ ) Depreciation and/or Amortization in SG&A (if any) Prepaids–Y1 Prepaids–Y2 ( ) Accruals–Y1 ( ) Accruals–Y2 ________________________ CASH OPERATING EXPENSES( ) CASH AFTER OPERATIONS (+/-) Miscellaneous Income Miscellaneous Expense (______________________ ) Other Current Assets–Y1 Other Current Assets–Y2 ( ) Other Current Liabilities–Y1 ( ) Other Current Liabilities–Y2 Other Noncurrent Assets–Y1 Other Noncurrent Assets–Y2 ( ) Other Noncurrent Liabilities–Y1 ( ) Other Noncurrent Liabilities–Y2 TOTAL MISCELLANEOUS (+/-) ( ) Tax Provision–Y2 ( ) or Tax Benefit–Y2 Taxes Payable–Y1 (______________________ ) Taxes Payable–Y2 ________________________ Deferred Taxes–Y1 (______________________ ) Deferred Taxes–Y2 ________________________ Tax Refunds Due–Y1 ________________________ Tax Refunds Due–Y2 (______________________ ) CASH TAXES PAID (+/-) ( ) NET CASH AFTER OPERATIONS (+/-) Interest Expense–Y2 ( ) Interest Payable–Y1 ( ) Interest Payable–Y2 Dividends–Y2 ( ) Dividends Payable–Y1 ( ) Dividends Payable–Y2 FINANCING COSTS ( ) NET CASH INCOME *Y2 is the year for which the cash flow is being constructed: Y1 is the previous year. ___________________ (___________________ ) (___________________ ) ___________________ ___________________ ___________________ (___________________ ) Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. DIMENSION 4 - 26 CASH FLOW WORKSHEET** (PAGE 2 OF 2) 52. Current Maturities Capital Lease Obligations–Y2 (_____________ ) 53. TOTAL DEBT AMORTIZATION( ) ( 54. CASH AFTER DEBT AMORTIZATION(+/-) 55. Net Fixed Assets–Y2( ) 56. Net Fixed Assets–Y1 57. Change in Net Fixed Assets (+/-)( ) (_____________ ) 58. Depreciation–Y2( ) (_____________ ) 59. ( ) CAPITAL EXPENDITURES( ) ___________ 60. Intangibles–Y1 ____________ 61. Intangibles–Y2( ) ____________ 62. Investments–Y1 ____________ 63. Investments–Y2( ) ( ) 64. TOTAL LONG-TERM INVESTMENTS (+/-)( ) ( 65. FINANCING SURPLUS/REQUIREMENT( ) 66. Short-term Debt–Y1( ) ( ) 67. Short-term Debt–Y2 68. Change in Short-term Debt (+/-) ______________ 69. Current Maturities Long-term Debt–Y2 ____________ 70. Long-term Maturities Long-term Debt–Y2 ____________ 71. Total Long-term Debt–Y2 ____________ 72. Long-term Maturities Long-term Debt–Y1( ) ( ) 73. Change in Long-term Debt(+/-) ( ) ( ) 74. Subordinated Debt–Y1( ) CRC US Body of Knowledge 75. Subordinated Debt–Y2 76. Change in Subordinated Debt Obligations (+/-) 77. Equity–Y1*** 78. Equity–Y2*** 79. Change in Equity (+/-)*** ______________ 80. TOTAL EXTERNAL FINANCING (+/-) 81. CALCULATED CHANGE IN CASH (+/-) ___________ 82. ACTUAL CHANGE IN CASH (+/-) ___________ ** *** ) Write results of column 1 calculations in column 2, and results of column 2 in column 3. Reflect only the change in common stock, not retained earnings ) DIMENSION 4 - 27 INDIRECT CASH FLOW STATEMENT The following is an example of an indirect cash flow statement worksheet 1. Net Income (after tax) 2. Plus: Depreciation & Amortization Income Statement Cash Flow 3. Accounts Receivable–Decr. (Incr.) 4. Inventory–Decr. (Incr.) 5. Miscellaneous Current Assets–Decr. (Incr.) 6. Accounts Payable–Incr. (Decr.) 7. Accrued Expenses–Incr. (Decr.) 8. Income Tax Payable & Deferred Tax–Incr. (Decr.) 9. Other Current Liabilities–Incr. (Decr.) 10. Other Noncurrent Liabilities–Incr. (Decr.) 11. Marketable Securities–Decr. (Incr.) 12. Long-term Investment–Decr. (Incr.) 13. Fixed Assets–Decr. (Incr.) 14. Nonrecurring Gain (Loss) 15. Intangible & Other Noncurrent Assets–Decr. (Incr.) Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow OPERATING CASH FLOW INVESTING CASH FLOW Cash Flow before Financing 16. Short-term Debt–Incr. (Decr.) 17. Long-term Debt–Incr. (Decr.) 18. Subordinated Debt–Incr. (Decr.) Debt Financing Cash Flow 19. Capital Stock–Incr. (Decr.) 20. Dividends Paid 21. Adjustments to Retained Earnings 22. Minority Interest–Incr. (Decr.) Equity Financing Cash Flow FINANCING CASH FLOW 23. Beginning Cash 24. Operating Cash Flow 25. Investing Cash Flow 26. Financing Cash Flow COMPREHENSIVE CASH FLOW 27. ENDING CASH DIMENSION 4 - 28 NOTES: CASH FLOW TERMINOLOGY: DIRECT METHOD The indirect cash flow is generally provided in the auditor’s financial reports and is self-explanatory. The direct cash flow must be constructed and the resulting presentation requires further explanation. If you choose to use the direct cash flow method in your analysis, the following terms will be helpful: Cash from sales: That portion of the present year’s sales collected in the present year, plus any amounts from previous years’ sales collected during the present year. Cash production costs: Cash expended during the present year to produce goods for sale (manufacturer) or to acquire merchandise (wholesaler or retailer). In the case of a manufacturing company, this figure may be adjusted for depreciation as well as for changes in inventory, accounts payable, and other payables. Gross cash profit: The difference between cash from sales and cash production costs. Cash operating expenses: CRC US Body of Knowledge Actual cash spent during the present year for selling, general, and administrative expenses. SG&A will be adjusted for depreciation as well as for changes in prepaid and accrued expenses. Cash after operations: Computed by subtracting cash operating expenses from gross cash profit. DIMENSION 4 - 29 Net cash after operations: NOTES: Cash remaining after adjusting cash after operations to reflect net cash outlays (or inflows) arising from changes in income taxes and in miscellaneous assets and liabilities. It is the amount of cash available for servicing interest on bank debt. Investigate large miscellaneous sources and uses of funds. Net cash income: Computed by deducting financing costs (interest, dividends, or withdrawals) from net cash after operations. Computed by subtracting the current maturities of term debt outstanding at the end of the previous year from net cash income. If, after this deduction, there is still a positive figure, it could mean that a company has been able to generate sufficient cash from its internal operations to meet all its current obligations to its debt holders, including interest and principal payments on your institution’s debt. If the figure is negative, your customer must resort to external sources of financing to meet these obligations and make any capital expenditures. Financing requirements or surplus: Computed by subtracting fixed-asset purchases and expenditures for long-term investments from cash after debt amortization. This measures either the magnitude of external financing needed or the cash generated in excess of all needs of the business. Calculated change in cash: External financing refers to the provision of additional cash to a company from new debt or equity. This entry will result in an excess or shortfall of cash after adjusting the financing requirement or surplus by the amount of any external financing. Actual change in cash: This represents the change in the cash account on the balance sheet from the preceding year to that of the current year. The change in cash includes changes in other cash equivalent accounts, such as marketable securities classified as current assets. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Cash after debt amortization (CADA): DIMENSION 4 - 30 NOTES: ANALYZING CASH FLOW Whether using the direct or indirect methods, the overall approach to measuring cash flows is to: Adjust accrual revenues and expenses to a cash basis, by measuring changes in related balance sheet accounts and determining whether each balance sheet change was a source or a use of cash. Eliminate noncash expenses, such as depreciation and amortization, from operating activities in determining cash flow from operations. Combine depreciation and amortization with changes in noncurrent assets, and measure their effect on investing activities. Measure changes in short and long-term debt and paid-in equity to determine their effect on financing activities. Once you have constructed a cash flow statement (or prepared one using an automated financial statement spreading program), the most important cash flow analytical step is to use the statement to assess the quality of the customer’s cash flow. CASH FLOW QUALITY Cash flow quality depends on the source and repeatability of the cash flow. Cash flow sources important to you are those that: Are sustainable and reasonably predictable over the ensuing three to five years. CRC US Body of Knowledge Increase your margin of protection and indicate your customer’s economic viability. Analyzing cash flow means determining if there are sufficient highquality and continuous sources of funds to meet all the financial demands placed on the cash flow, while still leaving enough cash to repay your customer’s obligations. Your customer can have positive cash flows but be in a declining financial condition—a scenario that does not bode well for debt repayment over the long-term. The opposite is also true, in that a growing company can have negative cash flow but exhibit profitable operations. In this case, you need to understand the nature of the growth and assure yourself that management has control of the expanding business. If a company is too successful, it can put strains on the banking relationship by requiring large amounts of external financing. DIMENSION 4 - 31 ASSESSING QUALITY OF CASH FLOW The most desirable cash flows are those from authentic and repeatable revenues and related noncash expenses. They are the cash flows that improve margins of protection because they are repeatable and they are the result of the company’s economic earning power. NOTES: The least desirable sources are flows from additional debt or from the sale of assets. Additional debt, while it may have benefits for your customer, increases leverage, can reduce profitability by adding to the interest burden, and can reduce liquidity by adding to annual principal debt service (all of which weaken your margin of protection). Sale of an asset may also have immediate onetime benefits, but if it is an operational asset, it can reduce the future earning power of your customer. To analyze the demands on cash flow you should: Look carefully at the statement of cash flows and identify the negative flows within each category. Consider whether each negative cash flow is a one-time, irregular event or if it is likely to be recurring. Consider if the amount of each negative cash flow is typical for that transaction or if it is unusually low or high. Decide if the event or transaction producing the negative cash flow is within the control of management. Compare historical demands with historical sources, and expected future demands with expected future sources. In both the direct and indirect cash flow formats, analyze operating and investing activities and the effect of the resulting surplus or deficit on financing activities. There are three levels of analysis: Analyzing operating cash flows. Analyzing investing cash flows. Analyzing financing cash flows. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow The second most desirable sources are improvements in asset efficiency and the proceeds of additional equity. Improved efficiency might not be repeatable, but it is a sign of good management and enables the company to improve its return on assets while maintaining the same profit margins. The proceeds from additional equity are not usually a predictable recurring source of cash. DIMENSION 4 - 32 NOTES: ANALYZING OPERATING CASH FLOW When using an indirect method cash flow statement, focus on the operating cash flow section of the statement. If you are working with a direct method cash flow statement, focus your analysis on the portion of the statement that ends with net cash after operations. Using either method, it is important to distinguish between the two types of cash flows included in this category: earnings and cash cycles. Cash flow derived from earnings is dependent on business fundamentals, whereas the cash cycle is driven by swing factors. By business fundamentals, we mean management of the company’s gross profit and its operating expenses. By swing factors, we mean management of the company’s trading accounts: accounts receivable, inventory, and accounts payable. Positive operating cash flow can be attributable to strong fundamentals. A company that generates sustained gross profit and succeeds at controlling its operating expenses has not only strong accrual profit in each sale dollar, but also great potential for cash profits. Changes in the swing factors reflect a company’s ability to manage its working capital assets, and these changes can have a significant influence on cash flow. For example, growth in accounts receivable and inventory consume company cash, but growth in accounts payable is a source of cash. CRC US Body of Knowledge Keep in mind that the cash benefits of strong fundamentals can be erased by poor management of the swing factors. Conversely, if there is a temporary strain on fundamentals—perhaps a year in which a company decided to buy its way into a new market through aggressive price competition—astute management of the swing factors can help compensate for the cash flow lost to poor margins. Whenever the combination of fundamentals and swing factors produces positive operating cash flow, there is an added margin of protection for you. Carefully consider the components of operating cash flow to form your opinion of the quality and sustainability of cash flow. Cash from continued operating activities is higher quality than cash from discontinued operations. Cash from the sale of operating assets is generally neither predictable nor repeatable, so is of lesser quality than cash from operating activities. A key entry to look at is the magnitude of the miscellaneous income/(expense), as this category reflects nonoperating cash flows and is suspect in terms of sustainability. DIMENSION 4 - 33 The accountant-prepared direct method cash flow statement does not provide these two interim sections (Net Cash Income and Cash after Debt Amortization). In a traditional direct method statement, interest expense is included in operating expenses, and debt service is incorporated in the financing cash flows section. Similarly, there is no explicit measure of debt service from operating cash flows on the indirect method cash flow statement. The UCA format has been adapted by banks from the traditional direct method statement largely to enable you to evaluate debt service coverage from operating cash flows. Although you certainly can interpret cash flow coverage using an indirect method statement or the traditional (non-UCA) direct method statement, consider the advantages of using the UCA format to isolate debt service coverage from operating cash flows. Most of the vendors of automated financial statement spreading programs provide the UCA report option in addition to the indirect method statement. ANALYZING INVESTING CASH FLOWS When using an indirect method statement, focus on the Investing Cash Flows section. On a direct method statement you should focus on capital expenditures and long-term investments. Investing cash flows include cash flow from investment activities, such as buying and selling plant and equipment, rental properties, and stock in affiliates or subsidiaries. Changes in marketable securities are also classified as an investment when the securities are held for long-term investment rather than as cash equivalent. When a company has not disposed of any long-term assets, investing cash flow will include only expenditures to acquire long-term assets. Investing activities are negative for most companies until they enter a declining stage in their life cycle, i.e., they reinvest less than they dispose. If a company has positive investing cash flows, you should determine if this is a one-time event or a trend. If the investing cash flow is negative, ask questions to determine future requirements. NOTES: Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow If you are analyzing a Uniform Credit Analysis (UCA) direct method cash flow statement, you have the additional benefit of being able to determine whether debt service—principal and interest payments—has been provided by operating cash flow. On the UCA statement, look to see if Net Cash after Operations is adequate to cover financing costs, which include interest expense and dividends. If so, the next subtotal on the statement, Net Cash Income will be positive. Then, check to see if Net Cash Income is adequate to cover the company’s debt service, or current portion of long-term debt. If so, Cash after Debt Amortization will be positive. If either Net Cash Income or Cash after Debt Amortization is a negative number, it is likely that your customer’s interest and/or debt service was covered by additional debt (perhaps drawing on your line of credit) or by an equity infusion. DIMENSION 4 - 34 NOTES: ANALYZING FINANCING CASH FLOWS With an indirect method cash flow statement, focus on the Financing Cash Flows section of the report. Using a direct method or UCA statement, focus on the reported changes in external debt and equity. For both methods, these changes tell you how the company financed its total cash requirement or how it disposed of (invested) any cash surplus. The direct method looks at changes in short-term debt, long-term debt, and equity less the current portion of long-term debt (CPLTD) that has already been considered in the operating cash flows. The indirect method first combines new borrowing and repayments of short-term debt and discloses the net change. Then, it combines that number with separate figures for advances of long-term debt, repayments of long-term debt, and increases and decreases in net worth (other than from profits or losses). Lenders prefer to see sources of cash flow that increase net worth because that increase represents a margin of protection. On the other hand, positive cash flow from increased debt can increase the leverage of the company. The netting of increases and decreases in short-term debts limits your ability to understand how much total debt the company might have placed or repaid during the year, or the high and low borrowing points. You need to refer to the footnotes included in the financial statements to get more information. CASH FLOW RATIO ANALYSIS There are several ratios that will help you evaluate cash flow: CRC US Body of Knowledge CASH MARGIN RATIO (DIRECT OR UCA DIRECT CASH FLOW) Using the direct method cash flow statement, compute this ratio by dividing gross cash profit by net sales. The result is an indication of the percentage of each sales dollar that remains as cash after payment of all production (for a manufacturing company) or acquisition (for a wholesaler or a retailer) costs. Cash gross profit Net cash from sales DIMENSION 4 - 35 DEBT SERVICE COVERAGE RATIO (INDIRECT CASH FLOW) NOTES: Net income + Depreciation + Amortization CPLTD This ratio is commonly used based on an indirect method cash flow approach, but it has severe limitations: It implies that all net income has equal cash potential. It does not account for major demands on cash flow such as capital expenditures, dividends or working capital changes caused by sales growth or declining efficiency. FIXED CHARGE COVERAGE RATIO (INDIRECT CASH FLOW) Earnings before Interest and taxes (EBIT) + Lease and rental expense Interest expense + Lease and rental expense + CPLTD This measure also uses an indirect approach to measuring cash flow and has the same limitations as the debt service coverage ratio. This measure recognizes that the borrower may have recurring charges, such as for an operating lease, which competes with loan payment for the company’s cash flow. CASH COVERAGE RATIO (UCA DIRECT CASH FLOW) Net cash after operations Financing costs + CPLTD This ratio addresses the question of whether the borrower is able to meet its debt obligations, both principal and interest, and any dividend payments, from internally generated cash. Calculated by dividing net cash after operations by financing costs plus scheduled payments on long-term debt. A ratio of greater than 1:1 indicates no reliance on external financing to make the required payments. A ratio of less than 1:1 means that a company must raise external financing elsewhere (under its short-term line of credit, from new long-term debt, or from shareholders) to service its obligations to lenders and to stockholders and to fund its capital expenditure requirements. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow It implies that loan repayment will have a first claim on cash flow. DIMENSION 4 - 36 NOTES: ADJUSTING CASH FLOW ANALYSIS FOR OFF-BALANCE SHEET EVENTS In Dimension 3, we discussed the need to incorporate certain balance sheet adjustments in your ratio calculations, such as the leverage calculation. The adjustments in question included capitalizing operating leases, adding off-balance sheet commitments and contingencies, estimating pension liability, and estimating recourse liability for securitized receivables. If you have made these adjustments to fine tune your evaluation of a customer’s leverage, you should also consider determining if any of the adjustments are likely to result in cash outlays in the intermediate term. In other words, if you are using financial projections to assess repayment ability in the next three to four years, consider the potential cash impact of the guarantees or other contingencies. In the very near term, you generally do not need to be concerned about cash impact of these adjustments. If you are receiving audited financial statements, and if the company’s CPA identified a reasonable probability that the company would need to satisfy a contingent liability, that amount would be recorded as a current liability in the statements you are evaluating. However, in the second year and beyond of your projection, you should consider the likelihood of outlays to satisfy these contingencies. CRC US Body of Knowledge You also do not need to be concerned about adjusting for operating leases in your cash flow analysis because the statement of cash flows already reflects the actual cash outlay for lease payments. However, remember to consider the operating leases when identifying cash flow coverage using the fixed charge coverage ratio. DIMENSION 4 - 37 ANALYZING FINANCIAL EFFICIENCY: CASH FLOW DRIVERS NOTES: By understanding the quality and demands of cash flow, you can use the following cash flow-related ratios to fine-tune the analysis and stress test the company’s ability to repay debt. Not surprisingly, ratio analysis focuses on the business fundamentals and the swing factors. In combination, they are the primary determinants of cash flow. Together, business fundamentals and swing factors are sometimes called cash flow drivers. These are the critical ratios that require “what if ” analysis when reviewing any projections for the company. We analyze business fundamentals using four ratios that evaluate the company’s key profitability components. We analyze swing factors using three turnover ratios that relate to the company’s efficiency in managing its working capital assets. With the exception of sales growth, the following ratios are accrual accounting measures of performance: Sales growth Gross profit margin. Operating expense percent. Operating profit margin. SALES GROWTH Sales Year 2 – Sales Year 1 x 100 (%) Sales Year 1 Sales growth usually causes an increase in a company’s working capital investment because each new sales dollar creates a receivable dollar (if sales are all on credit), and new sales are supported by new inventory, of which purchased components are financed using new trade credit. To estimate the cash impact of sales growth based on working capital growth, multiply the growth percentage times each working capital component. The following table illustrates a worksheet to estimate this cash impact. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow BUSINESS FUNDAMENTALS DIMENSION 4 - 38 SALES GROWTH A/R $ end of Year 1 Times Year 2 sales growth % = Cash Impact1 Inventory $ end of Year 1 Times Year 2 sales growth % = Cash Impact A/P $ end of Year 1 Times Year 2 sales growth % = Cash Impact Total cash impact of growth GROSS PROFIT MARGIN********* Gross profit x 100 (%) Net sales Changes in the gross profit margin impact cash flow. A higher profit on each sale means the customer keeps more of each sale dollar; a lower profit means the customer keeps less of each sale dollar. Although the gross profit is calculated from the accrual income statement, and thus there is not a direct correspondence between gross profit dollars and gross cash profit dollars, a change in the profit percentage of each sale nonetheless drives the ultimate cash collection from each sale. You may estimate more accurately if you eliminate any depreciation expense in cost of goods sold before calculating the gross profit margin. To estimate the cash impact of a change in the gross profit margin, first calculate the change in the gross margin (i.e., 45% in year 2 minus 44% in year 1 = a 1% improvement). Then, multiply the change percentage times the second year’s sales. GROSS PROFIT MARGIN CRC US Body of Knowledge Change in gross margin % Times Year 2 sales dollars = Cash Impact2 OPERATING EXPENSE PERCENT Operating Expense x 100 (%) Net Sales 1 Receivable and inventory growth consumes cash, so their cash impact should be recorded in brackets. Payable growth provides cash, so its cash impact should be recorded as a positive number. 2 If the gross margin increased, show the cash impact as a positive number. If it decreased, show the cash impact in brackets because a decrease in the gross profit margin reduces cash from each sale. DIMENSION 4 - 39 Very similar to the gross profit margin, changes in operating expenses as a percent of sales either provide or consume cash. To make a more accurate estimate, eliminate any depreciation expense from operating expenses before calculating the operating expense percent. To estimate the cash impact of a change in the operating expense percent, first calculate the change in this ratio (i.e., 22% in year 2 minus 20% in year 1 = a 2% increase in expenses). Then, multiply the change percentage times the second year’s sales.****** OPERATING EXPENSE % Change in operating expense % Times Year 2 sales dollars = Cash Impact3 Swing factors, measured by turnover ratios, are also called efficiency ratios and relate to how efficiently the company manages its accounts receivable, inventory, and accounts payable. Loss of efficiency consumes cash, and increases in efficiency provide cash to the company. The swing factors are: A/R days outstanding. Inventory days outstanding. A/P days outstanding. ACCOUNTS RECEIVABLE (DAYS) Accounts Receivable x 365 Net Sales If a company has collected its receivables faster than in the prior year, it has shortened its cash cycle. The reverse is true if collections have taken longer. To estimate the cash flow impact of a change in the number of days’ sales in accounts receivable, first calculate the change in A/R days (i.e., 38 days in year 2 less 36 days in year 1 = a 2-day improvement). Then, multiply the change in days times one day’s average sales for year 2. 3 If the operating expense percent decreased, show the cash impact as a positive number. If it increased, show the cash impact in brackets because an increase in operating expenses reduces operating cash flow. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow SWING FACTORS DIMENSION 4 - 40 ACCOUNTS RECEIVABLE DAYS ACCOUNTS RECEIVABLE times Year 2 sales dollars 365 Change in A/R Days INVENTORY (DAYS) = Cash Impact4 ******* Inventory x 365 Cost of Goods Sold If a company has reduced its inventory days on hand compared to the prior year, it has shortened its cash cycle. The reverse is true if inventory days on hand have grown. To estimate the cash flow impact of a change in the number of inventory days on hand, first calculate the change in inventory days (i.e., 63 days in year 2 less 59 days in year 1 = a 4-day loss of efficiency). Then, multiply the change in days times one day’s average cost of goods sold for year 2. For a more accurate estimate, eliminate any depreciation from cost of goods sold before calculating inventory days each year. ACCOUNTS PAYABLE Change in Inventory Day times Year 2 COGS dollars 365 = Cash Impact5 ACCOUNTS PAYABLE (DAYS)******** Accounts Payable x 365 CRC US Body of Knowledge COST OF GOODS SOLD OR PURCHASES If a company is receiving less trade credit and thus has reduced its accounts payable days compared to the prior year, it has lengthened its cash cycle. The reverse is true if payable days have grown. To estimate the cash flow impact of a change in the number of accounts payable days, first calculate the change in payable days (i.e., 45 days in year 2 less 41 days in year 1 = a 3-day loss of efficiency). Then, multiply the change in days times one day’s average cost of goods sold for year 2. For a more accurate estimate, eliminate any depreciation from cost of goods sold before calculating inventory days each year. Also, if you have enough detail to isolate purchases from cost of goods sold, using purchases instead of cost of goods sold will be more accurate, as trade credit is extended only for purchased goods, not for the many other components of cost of goods sold typical of a manufacturer. 4 5 If A/R days decreased, show the cash impact as a positive number. If it increased, show the cash impact in brackets because an increase in the A/R portion of the cash cycle reduces cash flow. If inventory days decreased, show the cash impact as a positive number. If it increased, show the cash impact in brackets because an increase in the inventory portion of the cash cycle reduces cash flow. DIMENSION 4 - 41 ACCOUNTS PAYABLE Change in A/R Days times Year 2 COGS or purchases 365 = Cash Impact6 ANALYZING THE CASH FLOW DRIVERS******** It is useful to look at all the cash flow drivers together, to be able to see which of the three driver families (sales growth, fundamentals, or swing factors) had the most influence over cash flow trends during the years you are analyzing. Construct a worksheet similar to the following to see the cash flow drivers for one year. Replicate the worksheet for multiple years of analysis. A/R $ end of Year 1 times Year 2 sales growth % = Cash impact Inventory $ end of Year 1 times Year 2 sales growth % = Cash impact A/P $ end of Year 1 times Year 2 sales growth % = Cash impact Total cash impact of growth OSS PROFIT MARGIN Change in gross margin % times Year 2 sales dollars = Cash impact times Year 2 sales dollars = Cash impact OPERATING EXPENSE % Change in operating expense % Total cash impact of fundamentals 6 If payable days increased, show the cash impact as a positive number. If it decreased, show the cash impact in brackets because a decrease in the payables portion of the cash cycle reduces cash flow. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow SALES GROWTH DIMENSION 4 - 42 A/R DAYS Change in A/R Days times Year 2 sales dollars 365 = Cash impact INVENTORY DAYS Change in Inventory Days times Year 2 COGS dollars 365 = Cash impact A/P DAYS Change in A/R Days times Year 2 COGS or purchases 365 = Cash impact Total cash impact of swing factors As you analyze cash flow driver trends, focus on the changes that made the largest impact on cash flow. These are the result of management decision-making, and your analysis should suggest to you the particular variables to which the company’s cash flow is most sensitive. Your discussions with management should focus on whether they are purposefully managing the most important cash flow drivers, or if outside influences (such as suppliers or competitors with aggressive price strategies) are most influencing the cash flow drivers. You can easily use these worksheets to estimate future cash sensitivity to changes in the cash drivers. For example, if you are concerned that a customer might risk extending too generous terms to secure additional sales, you can use the A/R days portion of the worksheet to test the cash impact of an additional few days’ receivables. Similarly, you can use the sales growth portion of the worksheet to test the cash impact of sales growth your customer is hoping to achieve. CRC US Body of Knowledge Being able to perform sensitivity analysis on key variables in this fashion helps you quantify a range of potential management decisions, enabling you to estimate debt service and of course, to engage in a productive discussion of growth options with your customer. DIMENSION 4 - 43 ALTERNATE CASH FLOW MEASURES NOTES: Two alternate methods lenders often use to measure cash flow are: Earnings before interest, taxes, depreciation, and amortization (EBITDA). These measures are often incorporated in loan agreement financial covenants, because they are simple to calculate and, in the case of EBITDA, well understood by most borrowers. Neither tool measures cash flow as accurately as the direct method statement of cash flows, however. In a perfect world we might wish to specify a measure such as net cash after operations from the UCA direct method cash flow statement when defining the numerator of a debt service coverage measure. Unfortunately, few borrowers and their CPAs prepare a UCA direct method cash flow statement, and it is generally not wise to specify a loan covenant that requires a measurement that only the bank has access to. For this reason, lenders are generally constrained to using the traditional cash flow measure—usually EBITDA—to communicate cash flow requirements to borrowers, even while using the more accurate direct method cash flow statement to analyze creditworthiness. In this section of Dimension 4, we will briefly discuss each alternate cash flow measure, noting its limitations. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Free cash flow. DIMENSION 4 - 44 NOTES: EBITDA Earnings before interest, taxes, depreciation and amortization is calculated just as the tool’s name implies: Net profit before tax, plus interest expense, plus depreciation expense, plus amortization expense. This measure is often the numerator for a debt service coverage ratio, which divides EBITDA by interest expense plus current portion of long-term debt. As mentioned earlier, the value of this tool is in its ease of calculation, and because it is the near-universal language of cash flow. However, EBITDA has many flaws. In the earlier presentation of cash flow ratios, we included the measure net income + depreciation + amortization] / current portion of long-term debt. We noted the limitations of that debt service coverage ratio, which also apply to interpreting EBITDA as a proxy for cash flow: It implies that all net income has equal cash potential. It does not account for major demands on cash flow such as capital expenditures, dividends or working capital changes caused by sales growth or declining efficiency. It implies that loan repayment will have a first claim on cash flow. CRC US Body of Knowledge If your customer has few non-operating income sources and very little sales growth, and if its swing factors remain very constant over time, and if capital expenditures are generally similar to annual depreciation expense, it is possible that an EBITDA measure of cash flow will provide a reasonably accurate assessment of cash flow. However, these four ifs are significant conditions not likely to be true for most companies. The cash flow consumption of even modest sales growth will not be reflected in an EBITDA measure, nor will EBITDA reflect the cash consumed by efficiency losses that cause the cash cycle to lengthen. In all likelihood, you are constrained to use EBITDA or a derivative measure such as EBIT in your loan documents. Keep in mind its limitations as you establish covenant levels. Try to identify minimum EBITDA-based coverages that will trigger a loan default before or at the same time that net cash after operations from the UCA direct cash flow statement is no longer sufficient to cover financing costs and principal payments. Your best strategy for understanding the EBITDA/ NCAO correspondence is to use an automated spreadsheet program to run projections that sensitize sales growth and the swing factors. The spreadsheet programs provide EBITDA-based ratios as well as NCAO-based coverage ratios, and you can work with a variety of sensitivity scenarios until you determine how much sales growth, or how many days’ change in the swing factors, appear to cause NCAO to significantly diverge from EBITDA. DIMENSION 4 - 45 FREE CASH FLOW There are many variations of the free cash flow model in use by financial institutions today. All free cash flow variations attempt to measure the amount of annual after-tax cash flow generated by internal operations, after making required investments. In other words, it is the annual cash flow available to repay debt, pay dividends, and buy back stock. NOTES: One measure of free cash flow begins with the indirect method cash flow statement’s net cash provided by operating activities (NCPOA). Because companies that provide a cash flow statement almost always choose this format, this measure is generally available. Free cash flow is calculated as: Less: Capital expenditures Less: Other investments (investment sales) Plus: Interest expense net of tax benefit (interest expense times (1-tax rate)) = Free cash flow available to service debt The advantages of this cash flow measure are that it is easy to calculate, available to bankers and borrowers alike, and that it explicitly accounts for both capital expenditures and any cash consumed by sales growth or working capital efficiency losses. The model’s principal limitation is that it assumes all capital expenditures are required investments, when indeed most companies have a mix of replacement and growth capital expenditures. Growth capital expenditures may be discretionary, and if removed from the calculation would more accurately portray funds available for debt service. Other variations of free cash flow may be based on net profit after tax, net operating profit after tax, or EBITDA. In most cases, the measures adjust for working capital increases and capital expenditures to acknowledge those required cash outflows. However, some models do not correct for the complications of income tax. That is, for tax-paying corporations, interest is paid in pre-tax dollars while principal is paid in post-tax dollars. If the calculation uses net profit after taxes, interest should be adjusted to post-tax dollars. If the calculation uses net profit before taxes (or EBITDA), then principal should be adjusted to pre-tax dollars (i.e., grossed up by dividing by 1 minus the tax rate). There is no standard calculation of free cash flow. If your bank has a version specified by loan policy, of course that is the version you should use in your analysis. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Net cash provided by operating activities DIMENSION 4 - 46 NOTES: COMPARING CASH FLOW TO INDUSTRY PEERS Just as you use peer analysis to gauge a borrower’s financial performance in terms of similar-sized companies in the same industry, you should review industry-specific cash flow indicators. There are no particular benchmarks or rules of thumb for cash flow measures, but it is very good practice simply to note whether your customer exhibits liquidity similar to peers, or diverges significantly enough to prompt a closer analysis. RMA’s Annual Statement Studies provides you with both traditional debt service coverage ratio comparisons and UCA direct method cash flow statement measures. DISCOVERING BORROWING CAUSES AND REPAYMENT SOURCES In this Dimension we have discussed analyzing your customer’s cash cycle and how to understand and interpret overall cash flow using a variety of cash flow analysis tools. Now it is time to apply that cash flow analysis to the problem of identifying your customer’s financing needs. In this section, we will relate your understanding of cash flow sources and uses to discovering your customer’s borrowing causes and repayment sources. Borrowing causes are not always the same as stated loan purposes. By identifying the borrowing cause, you can: Determine if the borrowing needs will be long term or short term, thereby establishing a realistic repayment period. Estimate the amount of borrowing that will be needed, thereby avoiding surprises and an underestimation of risk. CRC US Body of Knowledge Identify what must happen for the company to repay, thereby assessing more accurately the risks of repayment and the need for secondary sources of repayment. DIMENSION 4 - 47 You can categorize most borrowing causes in five groups: NOTES: 1. Current-asset growth resulting from sales growth. 2. Current-asset growth resulting from declining efficiency. 3. Fixed-asset expenditures. 4. Changes in trade credit. 5. Decreases in net worth. For each borrowing cause you identify, decide if it will: Reverse and free up cash for repayment. Stabilize, requiring repayment to come from other sources. IDENTIFYING BORROWING CAUSES Here is a review of the five common borrowing causes, how to identify them, and how they should be funded. CURRENT-ASSET GROWTH RESULTING FROM SALES GROWTH When sales increase, so does the need of most companies for assets. When the sales increase is permanent rather than temporary or seasonal, the asset increase, even the increase in current assets, is permanent. Analyzing the cash flow drivers enables you to quantify the cash impact of sales growth. Borrowing that results from long-term sales growth will be needed long term. You can use the asset turnover ratios to measure the relationship of a company’s sales to its assets. For example, the ratios can help you determine asset growth due to sales increases and/or asset growth because of changes in efficiency. Cash required for investment in higher permanent levels of current assets can be obtained from decreases in other assets, from increases in net worth, or from increases in liabilities. The soundest way for a company to fund permanent increases in current assets is with permanent or long-term sources of funds, such as increases in net worth, higher permanent levels of accounts payable, or loans that can be repaid over a long period. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Continue or accelerate, absorbing more cash and requiring repayment from other sources. DIMENSION 4 - 48 NOTES: To identify how a company has met its need for funds in the past, look for the largest increases in liability or net worth accounts and the largest decreases in asset accounts. Examine each source to decide if it is temporary, such as temporary shrinkage of an asset that will need to be replenished or long term, such as increases in retained earnings. When long-term borrowing causes have been met with temporary cash sources (such as loans that require short-term repayment), anticipate additional borrowing to replace liabilities as they become due or to replenish depleted assets. CURRENT ASSET GROWTH RESULTING FROM DECLINING EFFICIENCY This category includes the growth of current assets caused when receivables and inventory turnover slow down. To identify the efficiency declines: Use the asset turnover ratios and isolate the increases from lower turnover. Remember that the cash flow drivers tool enables you to estimate the cash effect of changes in the swing factors—in this case, accounts receivable and inventory management. These cash effects closely mirror the asset growth required to support changes in efficiency. Decide if asset increases are temporary or permanent. Increases that will not shrink to former levels quickly or that will have to be replenished immediately if they do shrink are permanent. CRC US Body of Knowledge Find the sources of cash the company has used to meet the needs and determine whether they are temporary or permanent. Permanent increases should be funded with sources that do not have to be reduced in the short run; otherwise, additional borrowing will occur to replace liabilities that must be reduced. DIMENSION 4 - 49 FIXED-ASSET EXPENDITURES Fixed-asset expenditures merit special attention because: NOTES: The need to make fixed-asset expenditures is often what motivates a company to seek bank loans. Fixed-asset financing often requires large loans and long repayment periods, both signs of higher risk. Fixed-asset expenditures often trigger related but unanticipated borrowing requirements. Astute lenders anticipate additional cash needs related to fixed-asset expenditures, such as: Costs of equipment set-up and installation, relocation expenses, and lost production time. Increases in inventory associated with new storage space or more work-in-process. Working capital requirements if higher sales result from added capacity. Increased expenses of maintaining the property. Fixed-asset expenditures usually must be supported by increases in net worth or by loans that allow a long-term repayment schedule. CHANGES IN TRADE CREDIT Increases in accounts payable to the trade can be temporary or permanent, providing short-term or long-term sources of funds to a company. Decreases in payables can also be temporary or permanent, causing short-term or long-term borrowing needs. Think of accounts payable as the first place to look for funds to support increases in current assets, especially inventory. To measure cash supplied or used by changes in trade credit, use either days’ COGS in payables or days’ purchases in payables, and measure the impact on cash of a change affecting one day’s COGS or one day’s purchases. Your cash flow drivers tool will help you measure this impact. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Possible distraction of management from other tasks. DIMENSION 4 - 50 NOTES: DECREASES IN NET WORTH Decreases in net worth pose special risks for lenders if the decreases are permanent, such as they are when dividends exceed profits, when there are losses, or when the company repurchases stock. These risks are: The company’s resources (and earning power) are diminished. Repayment usually requires change rather than continuation of a trend. Replacing net worth with debt has a double impact on leverage and decreases the lender’s margin of protection in asset values. Net worth decreases that are temporary, such as regular dividend payments that are covered by profits, sometimes cause borrowing to finance timing differences between cash receipts and disbursements within the same year. Those loans are less risky because they do not require a long period or a change in the company’s operation to be repaid. USING CASH CYCLE ANALYSIS AND THE CASH FLOW STATEMENT TO INTERPRET BORROWING CAUSES CRC US Body of Knowledge The UCA direct cash flow statement provides a format that is particularly useful for interpreting borrowing needs. The statement is organized so you can evaluate, first, sources and uses of cash flow for operating needs, then for capital expenditures and long-term investments, and then sources or uses related to external financing and net worth changes. The statement format enables you to easily see if sources of operating cash flow are adequate to meet operating cash requirements or if there is a borrowing need to satisfy unmet operating cash flow uses. While the cash flow statement quantifies any operating cash flow need, to understand its underlying causes requires secondary analysis that we have discussed in this Dimension. That is, cash cycle analysis and the related swing factor cash flow drivers enable you to drill down on operating cash flow needs by quantifying cash consumed by sales growth and any efficiency changes. The earlier discussion of seasonality should help you understand how to distinguish between temporary and permanent working capital financing needs caused by sales growth. Understanding borrowing causes is key to appropriately structuring loans, which is the subject of Dimension 6. DIMENSION 4 - 51 DEVELOPING CASH FLOW PROJECTIONS The purpose of a projection is to help determine whether your customer can repay your institution’s debt based on reasonable estimates about the company’s future operating strategy and management’s ability to implement it. NOTES: Cash flow projections are a: Quantitative assessment of the future financial performance and financing needs of a company. Forecast of a company’s ability to repay debt from its internallygenerated cash. Test of the vulnerability of a company to possible risks that may affect its repayment capacity. Provides a range of possible outcomes based on how a company may perform under a variety of economic and competitive conditions. Determines whether possible outcomes, or results, are within acceptable ranges for lenders. Provides the foundation for identifying the key drivers for a company and how much fluctuation creditors can tolerate. Identifies the factors that will assist you in determining the best loan structure. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow A set of cash flow projections: DIMENSION 4 - 52 NOTES: KEY PROJECTION REFERENCE POINTS There are four key reference points that are used to build a projection: Past operating results of a company. Objectives and goals of a company for the future as defined by management and outlined in a business plan. Likely impact of economic, competitive, and regulatory factors on a company. Supplemental action plans and alternatives available to help management meet performance projections. Of these four reference points, the first one represents hard data: the historical record of a company’s operating results. The other three points represent a subjective assessment, assumptions used to derive it, and the ability of you and your credit committee to interpret the results of what is likely to happen. Information available to you to reduce the amount of uncertainty involved when making a set of projections can include: Historical records of a company’s financial position, including past years’ financial statements, relationship manager reports and client interviews (when available), credit reports, etc.—in short, your customer’s credit file. Management reports: business plan, strategic objectives, mission statements, management forecasts, and projections. CRC US Body of Knowledge Industry reports such as those prepared by RMA and applicable industry associations (see Credit Considerations and Industry Study Packs by RMA). Economic reports, analyses, and forecasts on both the macroeconomic, and the microeconomic level (see DRI industry outlook reports published by RMA). DIMENSION 4 - 53 KEY PROJECTION ASSUMPTIONS A cash flow projection is only as good as the assumptions made by you in conjunction with the company’s management. The key to developing assumptions is to focus on the cash flow drivers: NOTES: Sales growth percent. Gross profit margin percent. Operating expense percent. Operating profit margin percent. Accounts receivable (days). Inventory (days) There are other income statement and balance sheet variables that must be established in the process of developing projections, but they will not have the magnitude of influence on the projections that these cash flow drivers will. Most suppliers of financial spreadsheet software have a projection module that you can employ in analyzing projections. In developing a credible set of assumptions for the cash flow drivers, they must be constantly tested for reasonableness, given the company’s historical financial performance, industry forecasts, the capacity of the company’s PP&E, and the depth and strength of the management team. USING SENSITIVITY ANALYSIS Once a realistic set of projections has been developed, do a sensitivity analysis or stress test on one or more of the variables. The purpose and function of a sensitivity analysis are to: Identify and assess the key/critical financial variables. These variables, when changed, will positively or negatively affect the future financial performance of the company and its ability to service debt. Identify what would cause the change in these critical variables (external factors, management actions, and so forth). Determine the amount of change in the drivers that can occur without materially affecting your customer’s ability to service its debt. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow Accounts payable (days). DIMENSION 4 - 54 NOTES: The primary reasons you should conduct a thorough sensitivity analysis include: The analysis enables you to determine whether your customer can repay its debt in less favorable business and economic circumstances. It shows whether the amount of financing requested is sufficient given all the demands on the company’s cash flow, particularly if there are material adverse changes in some of the underlying assumptions. It indicates whether you have identified all the key areas in your customer’s operations and financial condition that need to be monitored throughout the life of a loan, so that deterioration in these key areas does not adversely affect its repayment. It determines, in light of prospective changes, the most reasonable loan structure. It enables you to say that all the possible developments that might relate to the repayment of your customer’s debt have been considered and therefore the risk has been fully evaluated. To perform a sensitivity analysis, follow these steps: CRC US Body of Knowledge Identify the most critical financial variables that appear to have the most significant potential impact on financial performance, and especially operating cash flow. For clues to critical variables, evaluate the cash flow drivers for recent years. You may either hand calculate the cash flow drivers, using worksheets similar to the one presented earlier in this Dimension, or review your bank’s automated financial spreading software’s cash management report, which provides cash flow driver information. As you examine historical cash flow drivers, identify which drivers seem to have had the most significant influence on cash flow in the past. Then, consider which drivers are most susceptible to change in the future. Drivers that have tended to cause a significant cash impact in the past, and which are also highly susceptible to nearterm change, are critical financial variables. DIMENSION 4 - 55 Once you have identified the critical financial variables, use a series of financial projections to test a range of values for each critical variable, in each projection case holding all other variables constant. Your goal is to answer a double-faceted question: NOTES: –– What is the break-even value for this variable to produce an acceptable financial performance outcome; i.e., a projection outcome that yields acceptable profit, leverage, and cash flow to service the projected debt? To determine the break-even value for each critical variable, you must run a series of projections for the variable, changing values in very small increments until you observe the repay/cannot repay point. For example, if you have determined that the gross profit margin is a critical variable, you must determine the minimum gross margin required to produce a projection that demonstrates acceptable profit, leverage, and generation of sufficient net cash after operations to service the proposed debt. The most reasonable means of performing these projections is to use an automated spreading software program, if your bank uses this technology. Keep in mind that the automated spreading packages balance the projection by assuming any financing requirement will be satisfied through short-term borrowings, such as draw-downs under a line of credit. Therefore, as you check for adequate net cash after operations to service projected long-term debt, you must also check the balance sheet to determine if other variables (notably capital expenditures) incurred a financing requirement that in turn caused projected line borrowings that remain within your line approval amount. If the line has exceeded approval limits, then the sensitivity case you have tested—the gross margin %--is not adequate to produce a satisfactory case for loan repayment. After you have determined the break-even value for each of the identified critical variables, run a projection that incorporates the break-even values for each of the critical variables. It is very likely that this projection will not itself be a break-even projection; and you must then try to find out which of the key variables need to be stronger than their individual break-even values to provide an acceptable repayment outcome when combined with the other critical variables. This process includes some trial-and-error procedure, but with experience you will learn to quickly isolate the combination of minimum performance values of individual variables needed to produce the whole break-even projection. Dimension 4 // Assess Strength and Quality of Client/Sponsor Cash Flow –– How likely is it that the borrower will achieve a value for this variable that achieves the break-even value you have identified? DIMENSION 4 - 56 NOTES: Revisit the second key projection question: having identified breakeven values for key variables individually and in combination, how likely is it that the borrower’s performance will fall within these ranges? What are some scenarios that can realistically interfere with the company’s ability to achieve each break-even variable? How likely are these scenarios to occur? The range of events and circumstances that might interfere with achieving a break-even value for critical variables is different for each borrower, but might include: –– Interest rate changes. –– Competitors’ price changes. –– Supply interruptions –– Labor shortages –– Technological change in the industry. –– Currency exchange rate changes. –– Cost increases for key inputs. The process of conducting a sensitivity analysis should uncover the options or lack of options that are available to a company and a lender in developing a relationship. You might consider doing both a mostlikely case and a pessimistic set of projections to ensure that the debt can be repaid even in the most difficult of times as delineated by that pessimistic set of projections. CRC US Body of Knowledge Once projections have been stress-tested for their reasonableness, they should be shared with management to assess their degree of comfort with the final results. These are the projections against which you will covenant the loan.