Comparing K-1 Contributions and Distributions vs. EBITDA in Global Cash Flow Analysis

Kirsten Asks:

I am seeking material that compares the use of K-1 contributions and distributions versus EBITDA in global cash flow analysis. Our bank currently uses the K-1 method and rarely calculates a full global cash flow, including income from partnerships and contingent debt obligations. This approach often complicates loan approvals for commercial real estate investors who reinvest into new assets, as these show up as contributions from partners.?

We are reconsidering our methodology, and I believe the K-1 method may not be the most comprehensive. Could you compare these methods for their effectiveness in risk reduction? What resources do you have available?

Linda Says:

Interesting question, Kirsten. It sounds like the type of lending you do is CRE but could be personal mortgage to complex borrowers?

My take on this is based on 40+ years of training financial institutions on tax return analysis to determine debt repayment capacity. In that time I have seen the guidelines of hundreds of banks and helped shape many.

You have two issues, not one.

One is whether to use actual cashflow, as evidenced by k-1s versus what the company could afford based on the underlying tax returns of the entity. The other is how to project continuing cashflow based on history.

Actual vs available cashflow

As the sole shareholder of my s corporation, I take out whatever I want to. And I leave in whatever I want to. Or contribute whatever I want to. For whatever reason.

Seeing what I am doing (or have done) does not tell you why I did it and is not helpful in projecting what I will do next.

True story...

Here is an oddball but completely true example. There was a time when I wanted to accelerate the payoff of our personal mortgage. My husband was not in favor of doubling our payments, even though we could afford to do so.

I decided if I had an extra $50,000 to throw at it all at once, he might go for that. So when my 100%-owned company recovered from the Great Recession and I could increase my distributions back up to my previous amounts, I held off on the distributions until I had an extra $50k.?

Here is the hypothetical:

Wages were steady. On top of that, distributions (per k-1) were:

Year 1 $50k (Had not saved up an extra $50k by end of year.)

Year 2 $100k (Saved up $50k twice this year.)

Year 3 $150k (Wow! Saved up $50k three times by year end.)

Year 4 $100K (Paid off the home mortgage. YAY!!!)

It turns out that the average of $100k was the norm over 4 years, but you can see that which 2 or 3 years you had would influence what you think would continue. It might even make you nervous because it was all over the place.

Add to that, if you knew why I was choosing those distribution levels and that the mortgage was paid off, what will happen next is an interesting question.

A more relevant question

And I would argue that the question as to what the company did pay is not relevant with a high-percentage owner. Certainly with a 100% owner.

What could the company afford to pay me is much more relevant. In our training, we encourage you to compare what the company can afford in distributions to what they are taking and understand any big differences.

Your CRE example

Your example is another great one. Rolling the next deal can come in when a refinance on one project creates cash available for a higher-than-usual distribution in that entity and the needed contribution into the next. In a global cashflow analysis that would wash.

How are projections impacted?

As to historical vs projected, that is where you can dig into the why of both contributions and distributions. I completely agree that in CRE an entity analysis is helpful, and a global analysis may be essential.

Risk mitigation

You mentioned risk mitigation. The risk of making a loan that does not perform requires we get this right. But as you point out, you run the risk of declining perfectly good, performing loans when solely paying attention to historical ?k-1 cashflow.

I remember a Chief Credit Officer of a community bank making the case in 2006 that the k-1 historical cashflow was the best indicator of debt payment capacity. His bank failed in the Great Recession. Just saying...

You asked for resources

That was a lot and I hope it helps. If you want to explore whether our manuals or a seat in our online training is the best option for you or your team to get the depth to make this decision, or go further into this question, ?book a quick complimentary call with our Senior Credit Trainer, Robert. He may have another insight for you on your question. https://www.lendersonlinetraining.com/talk/?

Got a Question? Send it to us at [email protected] and have your question answered by one of our Credit Analyst Experts.

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