Continuing on with our series on “where is that box”, today I wanted to add the “why” to the items for cash-flow analysis. Working on underwriting for so many years I got used to just adding up the numbers from the proper forms and moving on. But when I was training underwriters or taking calls from the loan officers they would often ask a great question… “WHY”? I think the easiest way to explain the cash flow analysis is by saying this.
There are three types: real money spent, one-time money spent, and non-cash expense.
What does each one of these mean?
1) Real Money Spent – no explanation needed here, the business spent the money so it comes out of their bottom line causing a net result of profit or loss.
2) One-time Money Spent – This name is actually a bit deceptive, it does not mean “one time ever” it really means expenses that do not normally occur, for example in a business if you spend $1,000 on an insurance deductible for a fire it is reasonable to assume that will not happen every year, so those are deemed one-time expenses.
3) Non-cash expense – Because very few assets last forever, one of the main principles of accrual accounting requires that an asset’s cost be proportionally expensed based on the time period over which the asset was used. Both depreciation and amortization (as well as depletion) are methods that are used to prorate the cost of a specific type of asset to the asset’s life. So in English, not accounting geek speak, no one writes a check for these types of expenses!
So let’s go over the items again for schedule C cash flow and see which of three categories each item falls into! (Note make sure to read Part One of this blog series if you need the reference on the items)
Line 6 Other Income – Real Money (can be Earned or Spent)
The reason you have to adjust for this number is line 6 is reserved for income not earned in the normal course of business. Example: I own a popcorn business so my schedule C is all about my popcorn business, BUT line 6 is income I get from a fuel credit for using propane from the government. This income is NOT from the normal course of business of selling popcorn but an income that ANY business can get if they qualify from the government. So if I want to leave it in my cash flow I have to separately document what the income is, has the borrower received it for two years, and is it likely it will continue for three years!
So if the answer is YES and you can document it all… do nothing to the numbers. If the answer is NO (either due to lack of documentation or not meeting history/future requirements) you must SUBTRACT this income from the borrower’s cash flow. On the other hand if the income in line 6 is NEGATIVE or a loss you can add back in that loss IF you can document it is NOT likely to continue in the future (that is trickier!!)
Line 12 Depletion – Noncash Expense
Refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well’s setup costs are spread out over the predicted life of the oil well. Since FNMA/FHLMC understand that a business did not write this check to anyone, it is added back on line 31.
Line 13 Depreciation – Noncash Expense
Refers to prorating a tangible asset’s cost over that asset’s life. For example, an office building can be used for a number of years before it becomes run down and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year. Just as with depletion it is not a check your write to anyone so FNMA/FHLMC tell you to add it back into line 31
Line 24B Meals and Entertainment – Real Money
The IRS allows you to write off 50% of the full amount of receipts turned in for this category. For example if you turn in $1,000 of receipts on line 24B it will show and “expense” of $500. Because FNMA and FHLMC know the IRS only allows 50% you are required to subtract the “other” 50% from the profit.
Line 30 At Home Business Expense – Noncash Expense
Simply put the IRS allows you to “expense” or write down the portion of your home that is dedicated to your business. What in theory you are doing is stating that instead of renting an office I am portioning off a part of home to running my business and therefore have an “expense” to the space. Again no business owner is writing them or their business a check for this amount so therefore FNMA/FHLMC have you add it back to your cash-flow
Line 27A (Transferred from Page 2 Part 5) – “One Time” Expenses OR Noncash depending on the item
On part 5 this is the section where all of a business “other” items are put because they don’t fit into lines 8 thru line 27B on the schedule C. In this section if you see either amortization or causality loss expenses these can be added back in.
For causality loss, this is real money spent on an insurance deductible but because items like this are not expected to reoccur year after year, you can add them back in. Note: if you add back in anything but casualty loss or amortization you must clearly document why you added the item back in because it is non standard.
Amortization is similar to depreciation, EXCEPT is it a non-tangible asset. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent. Just as with depreciation this is not a check written so FNMA/FHLMC allow it to be added back into the cash flow.
Line 44A Business use of vehicle – Noncash Expense
The IRS allows borrowers one of two methods in factoring the costs of transportation in their business. These methods are actual expenses (only reported on line 9 of the schedule C) and “standard mileage rates” reported on line 44A then moved to line 9. If you see the borrower has filled out part 4 on page 2 this means they are using the standard mileage rate of 56.5 cents in 2013 or 55.5 cents in 2012. Per IRS notice 2012-72, part of that mileage is deprecation of 23 cents per mile for both 2012-2013. If you take the mileage reported in 44A and multiply it by 0.23 this will give you depreciation for the vehicle. This depreciation can be added back into the borrower’s cash flow.
Apologies for the length, but this topic requires a bit of thought so I hope you found it helpful! Okay, stay tuned for part 3 which we will review partnerships (form 1065) and part 4 which is corporations (1120S and 1120). As always we like to remind you about using our free online income tool to get your income fast, documented, and accurate for FREE! Check out www.blueprintio.wpengine.com to see how the tool works!