Understanding Commingled Entities Through Global Analysis
The main philosophy behind a global cash flow (GCF) is to spread all parts of a relationship (people, businesses and related real estate) to measure their financial health and cash flow individually, then collectively on a “global” level.
The important takeaway here is to try and view individuals, businesses and their real estate as a holistic, singular “net” cash flow from which the bank or credit union can determine the borrowers’ ability to pay debts.
But this practice can be complicated and doesn’t come without challenges.
Double counting and analyzing items that relate to income rather than net cash are common mistakes that often occur when businesses’ and people’s financials are commingled. What is double counting? When the same item is counted twice, thus creating double the amount of incomes, debts, assets or liabilities.
Basic example: Business A turns a $500K profit in 2014 and pays $150K as a dividend to the shareholder. The tax form documentation should be left as is; however, during the GCF calculation, $150K should be removed as a double counting adjustment. In this scenario, the $150K reflects on both business and the individual, creating $650K total income to the group, instead of $350K and $150K being appropriately divided. As you can imagine, this can create serious inaccuracies.
Ultimately, we’re trying to view individuals, businesses and their real estate as a singular “net” cash flow from which we can determine their ability to pay debts.
A major area contributing to mistakes is how business investment incomes are documented – do you use schedule E Part II or the corresponding K-1? While what we want and what we get can be two different things, entering a K-1 instead of the E Part II is a best practice. The E Part II can inaccurately reflect distributions as income while failing to show the actual cash flow to the individual. With a K-1, the credit analysis sees the distributions, capital gains, and interest income – which are critically important for making accurate, double-counting adjustments and generating a realistic debt service coverage ratio (DSCR).
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K-1s can create other specific challenges, with respects to their content (distributions, interest income, and capital gains):
Distributions: These capture the part of a business’s cash flow that is paid back to the owner or shareholder. A common error is crediting the business’s full EBITDA without adjusting the distributions to the shareholder (see example above) for double counting. On a more granular level, line 16d on Schedule K shows this amount flowing out of the business. Line 19 or 16d on the K-1 will reflect this coming into the individual. This would be subtracted from the Global Total Income as a double-counting adjustment – as it has already been accounted for by the business on schedule K and the individual on the K-1.
Interest Income: Net Personal Income before Debt Service is one half the formula for calculating DSCR for a person. A common mistake here is not double counting or using interest income found on line 5 or 4 of a K-1, with respect to the Taxable Interest Income from line 8a of the 1040. Example: Person A’s 1040 shows $7,500 on line 8a. The individual receives $150K as a distribution from his business on the K-1 and $2,500 of that amount is interest income from line 4 of the K-1. Because that $2,500 of interest income is not cash flow as described in the $150K credited to the individual from the business as cash flow, we will subtract it in our calculation of Other Regular and Dependable Sources of Income to leave Net Cash Distribution to the individual.
Capital Gains: Very similar to the “Interest Income” example above, Capital Gains (or Losses) of an individual are accounted for in line 13 of the form 1040. In the same fashion, we would subtract (or adjust for double counting) short and/or long term Capital Gains or Losses on line 7 or 8a of our K-1 from line 13 of 1040 – as cash distribution is the main point of interest.