Can Your Business Actually Afford That Loan?

Need a loan? Maybe. But the more important question is: Can you afford it? The answer lies in your financial statements, and you can conduct a borrowing analysis to get the answer by implementing a few commonsense measures.

EBITDA

A cursory examination of your company’s income statement reveals this basic metric. Better known as EBITDA-which is earnings plus interest, taxes, depreciation, and amortization-this metric assesses your ability to service existing and new debt. Simply divide EBITDA by total loan payments, and you have your debt coverage ratio.

The reasoning is that depreciation and amortization are expenses calculated on purchases made in the past. They do not require cash in the current period. Interest expense is part of debt service. Taxes are income tax only, which likely changes when newly borrowed money is spent. Overall, EBITDA provides a reasonable measure of assurance that you can-or cannot-afford the loan and will be able to avoid taking on crushing debt and endangering your business’s survival.

Projection

The objective of increased borrowing is income growth. When you expect higher sales as a consequence of incurring new debt, your forecast is assessing accrual of new sales. But rising sales require a collection period. All the revenue does not arrive at once. Likewise, all the borrowed money is not necessarily spent right away. Some may pay bills in the future.

When you’re already accurately tracking income through the accrual accounting method, sales are the amount your enterprise has invoiced, and expenses are the bills received. The beauty of accrual accounting is that it states sales and matching expenses in specific periods. Unfortunately, estimates of future sales and expenses in an accrual accounting framework depict an EBITDA that is far removed from actual cash available for debt service in upcoming months.

Cash flow

To avoid extrapolating cash availability from too little information, use the cash flow statement. This piece of financial data is vital when you’re assessing your ability to borrow. It adjusts for sales invoices that are pending collection, and bills that remain unpaid. A statement of projected cash flow translates a projected accrual basis income statement into expected money on hand.

Operating cash flow is a conversion of net income into cash realized by subtracting increases in accounts receivable and decreases in accounts payable… or alternatively, adding decreases in accounts receivable and increases in accounts payable. The figure also considers an increase or decrease of inventories. And non-cash items-depreciation and amortization-are added to operating cash flow.

Assessment of the cash flow that’s free to service debt doesn’t end there; investments in new equipment or other fixed assets are subtracted because they require cash.

Finally, add the borrowed money. The resulting cash at the end of each future period is available to repay debt principal. For simplicity, add interest expense and income tax to the cash flow figure. The resulting cash basis EBITDA is available for total loan payments-principal and interest.

Now, contact lenders with confidence. You can afford it.

Buying Out a Partner Can be ‘Taxing’: Let the Experts Handle it

Yes, you may miss your partner. But more to the point, when a part owner of your business departs, acquiring his or her ownership interest can trigger complex tax accounting rules.

The predicament in a buyout is deciding whether you’re purchasing your departing partner’s interest or the partnership you formed is redeeming the interest. With either path, the departing partner receives the same amount of money, and you end up owning the entire business. But the paths may differ in the tax implications.

A common misconception is that using company cash to buy out a partner is an expense. A partnership interest is generally considered an asset-although an intangible one. Purchasing your partner’s business share is therefore simply trading one asset for another-handing over money for a partnership interest.

Allocating the partnership’s taxable income in the buyout year

The partnership ends when your partner conveys his entire business interest. Bookkeeping is closed for the year-to-date, and profit or loss up to the buyout is split between you and the departing partner. Subsequent income is taxable to you alone as sole proprietor.

Exceptions arise if the buyout entails tangible assets. When the business buys a partner’s share of business assets, a bookkeeping adjustment to the company’s cost basis in those assets may be needed.

This may require you to consider a full range of possibilities for various asset types. But there’s a better (and safer) way: Leave this and other complexities involved in the tax consequences of a buyout to your accounting pro.