How to determine Income: 3 Filters

 Determining a borrower’s “qualified” income is an extremely important step when reviewing a loan (because your ultimate goal is for them to be able to pay the money back ;).  Not all income is created equal, and your role as a Community Bank is to be able to determine what portion of an applicant’s income you can count on to repay your loan.  There are three quick “filters” through which to view a borrower’s income.  If the borrower’s income meets all three filters, then include it.  If it does not, then exclude it.  Only use qualified income to make your decision (believe me, that is a mistake you will only make once :).  The three filters to use are: Stable, Recurring & Likely to Continue.

Stable

This one is pretty obvious, but it will be much easier for someone to make their loan payments when their income is stable.  Much of the time, bankers look at annual income.  One of the pitfalls of this is that you are oblivious to the ups and downs that maybe have happened during the year because you are only seeing the “net” figure for the full year.  Does the borrower’s business have seasonality?  Do they make their money during the summer, but little in the winter?  Is their income based on commission?  Stable sources of income are preferable to volatile because at the end of the day you want to have income you can reliably expect to be received in order to pay your loan.

Recurring

The second one focuses on the track record of that income.  Is it an income the borrower has a history of receiving or is it something new?  Income sources that the borrower has had for a long time are preferable to something brand new.  Again, your overall goal is to get the loan repaid, and a proven income source that has consistently been present is a good start.

Likely to Continue

The past is a good indicator, but it is the future borrower that will be repaying the loan; so you need to ask yourself will this income continue into the future?  Did they lose that job?  Did their big customer shift to someone new?  Just because their historical income looks good, doesn’t mean we should be oblivious to how that income looks going forward.  We actually had this happen on a recent loan application.  The business was a startup, and one of the things that made us feel good about the loan was that their co-borrower (and spouse) had a strong outside income source that could help supplement during the startup phase.  All the numbers looked fine, but while talking with the customer, they mentioned that their spouse had recently quit his job and started his own business as well.  Had we not had the conversation, we would have jumped into the relationship expecting one thing and finding another.  Just because it is on a tax return or happened in the past, doesn’t mean it will happen in the future.

What does this look like:

Alright, now that we have covered the theory, let’s talk about practically, how do you apply it:

Scenario 1: Business with Capital Gains

You have a business applicant who gives you their tax return, and you notice they had a large Capital Gain last year.  What do you do with this income?  Run it through the filters:

Before we apply the filters, let’s cover what a capital gain is.  A capital gain happens when a business sells a long term asset, and the gain (or loss) is the difference between the sale price and whatever the depreciated book value of the item was at the time of the sale.  For example, if you bought a piece of equipment originally for $1,000,000, and since origination, you have depreciated $600,000, now the book value of the item is $400,000.  If you sell the item for $700,000, the $300,000 difference between the sale price and the book value will be listed as a capital gain on the business’s income statement.

Let’s run it through our filters:

1. Is it stable? No, capital gains happen sporadically when a business sells a asset that is not in their normal course of business
2. Is it recurring? No, capital gains tend to be one-off income (or expenses)
3. Is it likely to continue? No, again capital gains are infrequent

Result: Exclude that income

Scenario 2: Atypical expense

You have a business applicant who gives you a few of their tax returns, and your eyes quickly navigate to the net income for the most recent year, and you see a large negative number, crap.  You begin to wonder what caused the negative income.  Flipping between the prior tax returns, it appears revenue and gross profit are about the same as prior years.  Then you notice the most recent year’s expenses had a large jump, and after running through the list, you identify repairs and maintenance as the biggest contributor.  What do you do?  Well, first things first, you need to talk with the customer, and figure out what happened.  Here is what the customer says: last year they had older piece of machinery that had some major troubles (and expense).  After spending a boatload on fixing the equipment, they ultimately decided to replace the piece of equipment with a new version since the repairs didn’t work.  Now what do you do?  Let’s run the filter (because yes, you should do this on their expenses as well):

Stable: No - sounds like this was an abnormally high expense in that year

Recurring: No - It sounds like prior years were much more manageable

Likely to Continue: No - They ultimately replaced the machine; so there shouldn’t be the same worry for the coming year.

Result: Exclude the Expense

Why does this matter

In my past we had a customer who continually struggled.  This customer could never consistency produce a profit, and the bank had a decently large loan relationship which causes a bunch of heartburn.  Given the bank’s strong filter for loan quality, it surprised me they had a customer who has had such consistent problems; so I got curious and looked back at the customer at the time the loan was originated.  On that presentation, the customer for the current (but not prior) years had an adequate DSCR; so the loan got approved.  I took a look at the income statement, and for that year, they had a large positive income, but it was due to a large capital gain from the sale of some excess land they didn’t use next to their facility.  Had land sales been a stable source of profits in the past? No. Was a land sale something they had done before? No.  Did they have more land to sell in the future? No.  Should the bank of excluded that income? Yep.  Did the bank wish they didn’t have this relationship?  You better believe it.