Using UCA Cash Flow to determine debt service coverage

How to determine Business Cash Flow with greater accuracy "Using UCA Cash Flow".

As discussed in a previous article, most lending institutions use traditional cash flow to determine the repayment capability of the borrower. This particular method is a favorite of lending officers since its primary component is net income. Therefore, it is much easier for a growing company to show enough debt service coverage since most growing companies can show positive net income even though they might be in dire need of cash.

However, using traditional cash flow ignores some of the most important inflows and outflows of cash into a company. Lets go item by item so that I can show you how UCA cash flow is calculated.

CALCULATING CASH COLLECTED FROM SALES

Sales are not the same as cash collected from sales.

If you sell on credit (give terms to your customers), chances are that your balance sheet has an entry called “accounts receivable”. Small business owners looking for sales usually provide very lenient terms to their customers. Sometimes large customers will take longer than the specified terms to pay. When your accounts receivable increase during the year, this means that the money is not actually coming into the business, and is only reflected as an accounting entry in your books.

For example: Selling $1,000,000 worth of merchandise during 2002, but having your accounts receivable account grow from $100,000 at 12/31/01 to $300,000 at 12/31/02 results on cash collected from sales of only $800,000.

CALCULATING CASH PAID TO SUPPLIERS

Deduct your Cost Of Goods Sold (COGS)

This is pretty much self explanatory. If you are a shoe retailer, you would deduct the price that you pay for the shoes to the manufacturer

Increasing Inventory is an outflow of cash, while reducing it is a source of cash.

Think about this one for a minute. If you increase your inventory during the year that means more of your money tied up in materials. This is not much of a problem for established companies that have already achieved optimal levels of inventory and have the experience to be able to determine the needs of the business. On the other hand, growing companies might find themselves having to use a lot of their cash to finance higher levels of inventory. A prime example of situations where higher inventory levels affect cash flow is when wholesalers decide to introduce new product lines.

Change in accounts payables affect cash flow. This time higher is better!

This is exactly the opposite of accounts receivable. As a business owner it is in your best interest to take advantage of the terms that your supplier provides to you. This is called vendor financing and when used smart can be the cheapest money you can find. (When I say used smart, I mean do not upset your vendor to the point that he requests payment up front before he sends you anymore merchandise).

CALCULATING CASH PAID FOR OPERATING COSTS

Operating expenses affect cash flow

Operating costs is another easy one. In this particular section you deduct all of your operating expenses such as wages, rent, insurance, taxes etc. At the same time you will account for those expenses that have not resulted into an actual cash outflow, but have instead created an accrual. For example, your business has $20,000 worth of tax expense, but you only pay $5,000 and end up with $15,000 worth of taxes payable. You will deduct $20,000 from the cash flow and label it “tax expense”, but at the same time you will add $15,000 to the cash flow and label it “Taxes payable”.

TAKING INTO ACCOUNT OTHER INFLOWS AND OUTFLOWS

Making sure everything is accounted for.

Here you will add or subtract those inflows and outflows that are not part of the above. Among the items that come to mind are:

a) Interest income

b) Other income (which is not related to the main business of the company.

c) Changes in other asset or liability accounts not involved in the main business of the company.

THE RESULT IS YOUR NET CASH FLOW FROM OPERATIONS (NCAO)

The resulting number after accounting for the above will be the NCAO, If your lender uses this type of cash flow calculation he will take this number and divide it by the amount of debt service that your loan request needs to come up with a ratio. If the ratio is within the lender’s guidelines then it will be a favorable factor to arrive to the decision to grant or deny your request.

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