From Nick Reynolds, Vice President/Credit Services Manager

The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied and wider in scope. This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.

A K-1 is an important piece of analyzing a member business loan.

One important, but often overlooked area of risk is owner distributions. Excessive levels of distributions can have a significant and adverse impact on a business. If the owners withdraw all earnings as distributions rather than reinvesting in the business, then no income is left for equipment purchases, growth in working capital, or repayment of debt. Typical debt service coverage analysis appropriately includes a deduction from income for the amount of distributions.

One of the benefits of using business tax returns to analyze your borrowers is that it is often easy to determine salary paid to the principals. Some partnership and corporate returns have that amount listed on the front page. At other times officers’ salaries are itemized further back in the return.

An officer’s salary should reflect the “market rate” for the work she actually does. If she wasn’t there, she would have to hire someone to take her place. If her salary lines up with typical rates in the local marketplace, then no further analysis is necessary. However, if that salary is greater than you would normally consider reasonable, you should dig deeper to find out why.

Distributions are also typically fairly easy to discern. While you would normally obtain distribution information from the tax returns or K-1s, it is also possible to back into that number with a straight-forward calculation: by definition, a balance sheet should balance, with assets equaling liabilities plus owners’ equity. It should also balance from period to period. Ending retained earnings should equal beginning retained earnings, plus income, less distributions. So, if you know beginning retained earnings, ending retained earnings, and total income earned during the period, you can figure out total distributions.

But the relationship between distributions and salary is a little fuzzy. For example, many owners will elect to take distributions rather than salary to avoid payroll withholdings such as Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA). In addition, a certain level of distributions is normal to cover taxes paid by the individual on the income associated with an S-Corp. S-Corp income flows through to the personal tax return based on the income shown and may have no relation to the amount of distributions taken. That is why the K-1 is so important to the analysis, as it details those amounts.

Another important factor is notes due to the borrower from the shareholder. If the business pays money to the owner other than salary, it can be in the form of either a distribution of income or a note receivable. Both have the same impact on cash – it leaves! But on the balance sheet, the note shows as an asset, while the distribution reduces equity.

Similarly, the repayment of a note receivable or the contribution of paid in capital both have the same positive effect on cash but disparate effects on the balance sheet.

Most businesses are structured so that the principals own the operating company and also hold ownership in a separate LLC that owns the building the business occupies. Rents may be set at higher than market rates as a vehicle for transferring cash to the owners.

The result of all of these factors is a complex web of payments that can have a significant impact on the borrower’s ability to service its debt. With a little bit of prudent detective work, you can unearth some additional detail that will enable fuller underwriting and a more complete understanding of the borrower’s creditworthiness and true financial position.