Using Tax Returns For Better Loan Underwriting

Given all the energy around tax reform, we need to point out that tax returns are one of the most underutilized instruments in banking. Most banks require current tax returns from prospects as a condition to making a commercial loan. There are many reasons why banks would want to have the information contained in a tax return as a prerequisite for prudent underwriting and ongoing loan monitoring. Tax returns are also an important way of calculating and validating a borrower’s cash flow generating ability, debt leverage, and liquidity position. In this article, we highlight some new ways to look at tax returns to make for more effective underwriting and in future articles, we data mine tax returns to uncover how tax returns can help bankers better market and better detect fraud.

Benefits of Tax Returns

Tax returns provide valuable information to the lender about financial and non-financial matters and offer the following insights and benefits:

Authenticity: Because information contained in a tax return has been accepted by, or filed with, the IRS, the information has another layer of validity that may not be present in financial statements prepared by an auditor or self-prepared by the borrower.

Detail: Financial information contained in a tax return is typically broader and contains greater detail than many GAAP prepared income, balance sheet and cash flow statements.

Profitability and Marketing Data: Detailed schedules can give you insight into other banking relationships, financing opportunities, cash balances, risk tolerance, organizational structure, other investments, charitable giving and much more.

Validity: Tax returns allow a lender to cross-reference information contained in GAAP statements increasing the possibility of identifying error or fraud.

Non-Financial Information: Tax returns offer non-financial information that GAAP statements do not. Tax returns can help a lender identify the following information about a borrower:

a.    Marital status.

b.    The number of dependents.

c.    Other personal information that allows the lender to identify product needs and wants.

d.    Financial information about ventures not directly related to the subject credit request.

e.    The life cycle of the borrower.

Global Cash Flow Data: Most importantly, tax returns contain information that allows lenders to calculate the borrower’s global cash flow, which is a critical element in every loan making decision.

Structure of Tax Returns

The personal federal tax return is the form 1040. Although form 1040EZ is available to fillers, because of the restrictions (income earners under $100k, and typically not homeowners) we do not see many 1040EZ forms for commercial loan applications. The 1040 form has the following common schedules:

1)    A – Itemized deductions.

2)    B - Interest and dividend income.

3)    C – Sole proprietorship or single member LLC.

4)    D - Capital gains and losses.

5)    E – Three categories that include rental income, royalty income and pass through income from partnerships, S Corp or LLCs.

6)    F – Farm income.

All of the forms follow a similar flow and contain the following components: personal information, total income, adjustments to gross income, deductions, exemptions, and calculation of taxes. Community banks deal mostly with personal fillers, partnerships, and LLCs. We do occasionally see S corporations as primary obligors or guarantors. We see few C Corporations as obligors in community bank lending (for the obvious reason that C Corps have a tax disadvantage over the other entities that allow income to be passed through to individuals and are typically used for very large or public entities).

Cash Flow Analysis

By far the most important use of borrower tax return is to more accurately calculate cash flow to arrive at the probability of repayment. This is the inverse of the probability of default (1- the probability of default) and tells bankers the probability of the loan paying as agreed. The largest predictor of creditworthiness is the ability of the borrower to generate cash flow to repay its debts, and the most common measure of cash flow is EBITDA (earnings before, interest, taxes, depreciation, and amortization). We add back interest because that is the final measure that we want to include in the denominator. We also add back taxes because taxes are paid after interest payments are deducted from income. Finally, we also add back depreciation and amortization because those are not cash items.

There are a few common issues to using EBITDA as a proxy for cash flow for personal and corporate tax returns that underwriters need to consider. 

First, NOL or net operating losses can skew income and cash flow. NOL can generally be carried back two years and forward up to 20 years. While reporting entities will utilize NOL to minimize taxes, underwriters will want to remove the NOL for the reporting period if they aim to calculate debt payment capacity (the primary purpose of calculating EBITDA). However, some prudent underwriters will want to assess the likelihood that the NOL will be a recurring item and make adjustments to EBITDA accordingly.

Second, line items used to calculate EBITDA must be recurring and verifiable. For example, section 179 of the tax code allows entities to treat certain capital investments as direct and immediate expenses. Should the entire cost of a new roof be removed or included from the calculation of EBITDA? Different banks have different policies, but in our opinion, if the expenditure would not have been captured under any of the other acceptable amortization treatments under form 4562, then section 179 costs should not be part of the EBITDA calculation (i.e. excluded from EBITDA) and should instead be part of a free cash flow from operations formula.

Third, tax returns are primarily focused on income and expenses and give little valuable information on working capital management. Underwriters need to consider the specific business and assess the risk to cash flow depletion from working capital. In growing businesses or mismanaged enterprises, reduction in account payables, or increases in receivables or inventory can drain cash quickly. While EBITDA may show cash flow generation, working capital can drain cash and wipe out a business that does not have appropriate liquidity lines.

Fourth, calculating EBITDA from tax returns does not take into account capex. In growing businesses or many capital-intensive businesses, equipment, machinery or stock must be replaced because of normal wear and tear. Because EBITDA excludes depreciation, and amortization, capex is not factored in this cash flow proxy. Therefore, underwriters include another proxy for cash flow called free cash flow from operations. For this proxy of cash flow, underwriters will include annual economic attrition of capital (which will often not match amortization schedules like those found in form 4562).  But underwriters will not subtract capex from cash flow where that capex is used to expand the capital of the business (versus that capex that is used to replace attrition of capital).

Conclusion

Most banks are using the information found in tax returns as part of their underwriting process. Tax returns at the initial underwriting process, and ongoing, as a loan monitoring tool, provide insights that other financial statements cannot provide. As a validation of cash flow, whether underwriters use EBITDA or free cash flow from operations, tax returns offer indispensable information into the creditworthiness of commercial borrowers.

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