Global cash flow analysis – common mistakes & helpful hints
Global Cash Flow analysis is used by financial institutions to assess the combined cash flow of a group of people and/or entities to get a global picture of their ability to service the proposed debt.
When performing a Global Cash Flow (GCF) analysis, there are several mistakes that financial institutions make that could be the difference between approving and denying a loan request:
1. Obtaining business and personal financials, but not combining them into a single cash flow
It may seem obvious that the above isn’t even a GCF analysis by definition, but this mistake happens. The lender believes they are performing a ‘Global’ analysis by obtaining and analyzing all of the people and businesses involved in the loan request, but it is not truly Global until all of these cash flows are combined into a single GCF. Linda Heath, president of Financial Holographix 1, emphasizes the importance of thinking “net” cash flow. “Owners and guarantors may be sources of business capital, but in down economies they become users of business cash flow, depending on their personal and other business obligations. Analysts must dig for potential indirect demands on resources that could prevent the borrower from repaying as agreed,” says Heath.
2. Not analyzing (or requesting) all of the necessary tax forms
Tax returns and their supporting schedules are vital to performing a GCF analysis correctly. Without the necessary tax schedules, cash flow numbers can be greatly skewed due to using paper transactions that change ‘income/expenses’ for tax purposes but have nothing to do with actual cash flow. For example, the K-1 forms are crucial for obtaining the distributions and contributions applicable to the individual, which provide an actual cash flow amount. As the OCC’s Internal Guidance from April 9, 2008, explains:
An analysis of the guarantor’s global cash flow should consider inflows, as well as both required and discretionary cash outflows from all activities. This may involve integrating multiple partnership and corporate tax returns, business financial statements, K-1 forms, and individual tax filings. Anything short of a comprehensive global cash flow analysis diminishes confidence in the assessment of guarantor strength, even in the face of significant liquid assets since that liquidity may be needed to fund contingent liabilities and global cash shortfalls.
Learn how to book loans faster while managing risk.
3. Double-counting income
Again, it may seem obvious to remove portions of income that are counted twice (once by the business and once by the individual, for example), but this is a point that is often overlooked by less experienced analysts when performing their GCF analysis. The most common error starts when the business borrower is given full credit for EBITDA without subtracting distributions to shareholders. It is compounded when shareholder/guarantors are given full credit for 1040 Schedule E part II “earnings” rather than distributions. The error increases if shareholder K-1 earnings are added to their 1040 E part II amounts. “When cash flow is accurately reflected between the business and shareholders, bankers will be able to evaluate whether they can rely on the primary source of repayment, or must lean on a secondary source of repayment and have a defensible GCF,” says Heath.
4. Inconsistencies between employees in GCF analysis
This key point is often unnoticed by financial institutions. Each employee performing GCF needs to execute it in the same way to create consistency at the bank. Different people calculating GCF in different ways will result in poor loan, pricing, and risk rating decisions. Microsoft Excel can cause several issues in credit risk management practices, including creating inconsistencies by employees using dissimilar spreadsheets or entering data incorrectly. A consistent approach to global cash flow should be a top priority for banks once they decide on a standard and accurate GCF method. Heath has observed firsthand how regulators pick up on these inconsistencies and exploit them during reviews: “Regulators are taking a hyper-cautious approach to risk rating your loans. Once they find inconsistencies in your calculations they dig deeper. Every $1 million loan that is downgraded can cost your bank tens of thousands in ALLL reserves.”
Whitepaper: Risk Rating
Whitepaper: The Definitive Guide to Global Cash Flow
Sageworks offers lending, credit risk and portfolio risk software to help commercial lenders lower costs and improve the borrower experience. By automating business loan operations with Sageworks, banks and credit unions make good loans faster and optimize risk. Sageworks stands alone with a fully integrated life-of-loan solution, product and industry experts, exclusive benchmarks, patented technologies and an engaged client base of financial institutions.