Should You Rely Solely on K-1s for Global Cash Flow Analysis?

Sean Asks

I have a personal guarantor for my main borrowing entity. This guarantor also holds ownership stakes in six other partnerships/S-Corps. To assess the global cash flow of my borrowing entity and the guarantor, should I only review the K-1s from those six other entities, or do I need to examine their full financials? I believe focusing on the K-1s is sufficient since they reflect the cash inflow and outflow specific to my guarantor.

Linda Says

Your question revolves around guidelines, Sean. Many lenders conducting a global analysis would only include the business returns of an entity obligated on the loan under consideration. They typically use the K-1s of entities the guarantor owns to gauge the guarantor's available cash flow.

However, other lenders might consider the percentage ownership of the additional entities. For instance, if I own 100% of another company, what I take from that company is less indicative of my personal cash flow than what the company can afford to pay me. Furthermore, if one or more of my closely held companies are struggling, I might approach you with a well-performing company to secure a loan, only to divert funds to support the troubled company.

Some lenders might also evaluate the relative impact of the K-1 cash flow from the non-obligated entity. If it is significant and the largest source of the guarantor's cash flow, and you are heavily relying on the guarantor's cash flow, you need to ensure that the K-1 cash flow is backed by a sustainable source.

Therefore, I cannot provide a definitive answer. You need to understand your company's guidelines. It may be that if the guarantor owns 25% or more, you will need to obtain the entity's tax return to verify that the K-1 cash flow is supported by operations.

The Trouble with Relying Solely on K-1s:

The risk of relying solely on K-1s is that you might depend on what someone has been taking home rather than what is sustainable. There are six sources of cash flow available to pay the owners, but only one is sustainable:

• Operations
• Built-up liquidity
• Borrowed money
• Capital injected from other owners
• Sale of assets
• Windfall

Without reviewing the underlying tax returns, you have no idea which source it is. The risk is likely lower with a low percentage owner because they have less control over what they take home.

I am not saying you are wrong to follow your guidelines and use the K-1s when the entity is not obligated on the loan. However, if you adhere strictly to a cut-and-dried rule, you will likely be wrong some of the time.

More on Pass-Through Entities:

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