One of the hardest parts of making a loan decision is determining the true cash flow situation for a self-employed borrower. If you lend money to borrowers, chances are that those borrowers are commercial in nature as consumer lending laws and considerably more stringent. That means that in most situations, you’ll be working with self-employed borrowers. Our members-only area has classes on cash flowing self-employed borrowers, but we wanted to focus on one area that can really throw a lender a curve ball…extraordinary events.
What is an extraordinary event (we’ll call them EEs for this article)? An EE is any influx of cash into a business that is not part of their normal course of business. In other words, it’s not ordinary..It’s “extraordinary.” Perhaps a business owner sold a piece of machinery and recognized a significant gain on it. For a bulldozer dealer, selling bulldozers is an ordinary, every day event. For a contractor, however, their sale of a fully depreciated bulldozer might not happen every day. That event is deemed to be “extraordinary” and would not be a recurring source of revenue.
Prudent lenders remove these EEs from the borrower’s income when determining their average cash flow. For instance, a borrower might come to you and show that they made $300,000 last year on their tax returns. When you dig down deeper you see that they had an unusual windfall that will not continue to regularly occur. You don’t want to base your loan decision on the larger figure as they borrower will not have that coming in regularly to service your debt. It’s very important to peel the onion back a bit to uncover these extraordinary events so you don’t overestimate your borrower’s ability to continually make payments.
Uncovering and removing Extraordinary Events from cash flow is critical to properly underwriting a loan. Please see our members-only area for more information on properly underwriting a loan.