Net Income versus Cash flow (Using Traditional Cash Flow to determine debt service coverage)

Earnings, including profits, and cash flow, although related, are two distinctly different concepts. Profits and earnings are created by accounting conventions and include non-cash items such as depreciation. Cash flow, on the other hand, is an analysis of the timing of cash receipts and cash disbursements over a specific time period.

Many financial analysts define operating cash flow as net income exclusive of depreciation. However, it is necessary to understand other income statement items in order to fully understand cash flow management. For example, depreciation and amortization are accounting conventions for expensing (in the case of depreciation) and allocating (in the case of amortization of a loan) the cost of an asset over an arbitrary time period and, as such, affect annual net income. Cash flow, however, is not directly affected by these items. Moreover, prepaid items such as insurance, supplies, maintenance contracts, etc., are cash payments which are typically made in advance. While they impact cash flow, they are charged against earnings in a subsequent period.

The easiest way to explain how a lending institution comes up with your business cash flow is to take a look at an example. The following is one of the tables used to determine debt service coverage using traditional cash flow. Please take into consideration that traditional cash flow is considered by many as a very limited tool to determine the repayment capability of a business. The formula does not take into account certain accounts and the impact of the cash conversion cycle

DEBT COVERAGE ANALYSIS

Traditional Cash Flow Coverage In US$
Net Income	$100,000
Plus:
Interest Expense	70,000
Depreciation	20,000
Amortization	10,000
EBIDA	$200,000
Existing CPLTD	50,000
Proposed CPLTD	30,000
Interest of Existing Lines of Credit	10,000
Dividend Payments	10,000
Total Debt Service	$100,000
Debt Service Coverage	2.00X

As you can see by the table above this particular borrower shows sufficient debt coverage using traditional cash flow. The resulting EBIDA (Earnings Before Interest Depreciation and Amortization) is enough to cover the interest expense and CPLTD (Current Portion of Long Term Debt).

However, as you will see in my next update, the traditional cash flow while still in use in many lending institutions does not take into account certain key factors such as changes in trading accounts (accounts receivable, inventory and accounts payable).