Owner Salaries – Bank Considerations
By Alan Miklofsky
September 28, 2024
Why Banks Want to See Owner's Salaries Separated from Total Payroll in Financial Statements
When banks evaluate a business for lending or credit purposes, they rely heavily on financial statements to gauge its financial health and stability. One particular item they scrutinize is payroll expenses. However, for privately owned businesses, banks prefer to see Owner’s Salaries separated from total payroll expenses. This distinction provides crucial insights that influence lending decisions, creditworthiness, and the overall risk profile of a company.
The Importance of Transparency
For any lender, understanding a business’s operating costs is paramount. Payroll expenses are typically one of the most significant line items on a company’s income statement. Separating the salaries of the owners from total payroll offers a clearer picture of how much it actually costs to operate the business without the influence of personal compensation decisions made by the owners.
When owner's salaries are lumped into total payroll expenses, it can skew the perception of operating costs and profitability. This lack of transparency may complicate the bank’s ability to differentiate between genuine operating expenses and discretionary spending. By isolating owner’s compensation, banks can better assess the business's financial performance and profitability.
Understanding True Profitability
Owner's salaries can be considered discretionary to a certain extent. For instance, in lean years, an owner might reduce or defer their salary to ease cash flow. Conversely, in profitable years, they might increase their compensation. This variability can mask the true profitability of a business if it's not separated from other fixed payroll expenses.
By excluding owner’s compensation from general payroll, banks can get a more accurate measure of the company's Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), which is a key indicator of operational performance. EBITDA is commonly used by lenders to assess the business’s ability to generate cash flow and service debt, and it becomes more meaningful when not distorted by discretionary owner withdrawals.
Segmenting Compensation: Salary vs. Distribution
Another important aspect of owner compensation is the ability to segment it into salary and distributions, particularly for businesses structured as Subchapter S corporations. In this context, part of the owner's compensation can be treated as a distribution rather than a salary.
Distributions refer to the allocation of profits to shareholders, which can provide tax advantages. Under IRS regulations, Subchapter S corporations allow business owners to avoid double taxation by passing corporate income, losses, deductions, and credits directly to their shareholders. This means that owners can take distributions from profits without subjecting those amounts to payroll taxes, unlike salaries, which incur additional taxation.
By strategically segmenting compensation in this manner, owners can optimize their tax liability, receiving reasonable salaries to meet IRS guidelines while also taking distributions that reduce the overall tax burden on the business. This method can enhance cash flow, allowing for reinvestment into the business or personal use of the funds.
For banks, understanding how a business structures owner compensation can provide insight into financial health and planning. If a significant portion of the owner's compensation is categorized as distributions, it can indicate a strong profit margin and effective tax management strategies. However, banks also want to ensure that the salary portion meets IRS standards for “reasonable compensation,” as underpaying oneself to increase distributions can raise red flags during audits.
Assessing Cash Flow Stability
Another reason banks prefer separate reporting of owner’s salaries is to evaluate the stability and sustainability of cash flows. When analyzing the company’s cash flow, banks want to ensure that the business can comfortably cover its operating expenses and service its debt. Because owner compensation can fluctuate based on personal and business considerations, including it in operating expenses could suggest a higher baseline for expenses than what is realistically required.
By stripping out owner’s salaries and differentiating between salaries and distributions, banks can better assess the true operating cash flows of the business. This allows them to analyze scenarios where the business might reduce discretionary spending (like owner compensation) to maintain cash flow during challenging times.
Creditworthiness and Debt Capacity
For businesses seeking loans, a bank’s primary concern is whether the company can meet its debt obligations without undue strain on its finances. Separating owner’s salaries and categorizing part as distributions helps banks assess the business's capacity to absorb new debt. It’s a way to gauge if the business could maintain or even increase its debt capacity by adjusting owner compensation in the short term, should the need arise.
Additionally, if an owner is drawing a substantial salary that is not justified by the company’s current cash flow and profitability, it raises red flags for banks. They may question whether the business is generating enough profit to support the owner’s lifestyle or if the business is being propped up by external funding or reserves. This can affect the owner’s perceived commitment to the business and overall financial discipline.
Benchmarking Against Industry Norms
Many industries have established norms for operating expenses, including payroll costs. If a company’s total payroll appears unusually high relative to its industry peers, banks need to determine whether this is due to legitimate business reasons, such as hiring more skilled labor, or simply because the owners are drawing excessive salaries. Breaking out owner’s salaries and identifying distributions allows the bank to benchmark operating costs against industry standards more accurately.
Planning for Succession or Sale
Lastly, separating owner’s salaries is critical for succession planning or business sale scenarios. If an owner plans to step away from the business or sell it, the buyer or successor needs to understand what the true operating costs of the business will be without the current owner’s salary. This separation helps establish a realistic picture of future profitability and provides clarity on what changes might be necessary in compensation structures post-transition.
Conclusion
Separating owner’s salaries from total payroll expenses—and understanding the distinction between salary and distributions—is not just a matter of transparency; it’s about providing a true representation of a business’s financial health. For banks, this distinction allows for a more accurate assessment of profitability, cash flow stability, debt capacity, and overall risk. By analyzing financial statements with these separate categories, banks can make more informed lending decisions that benefit both the financial institution and the business owner.
Alan Miklofsky is a semi-retired Professional Shoe Dog with a distinguished career in the footwear industry. Over the decades, he successfully ran an award-winning shoe business while dedicating 29 years to the National Shoe Retailers Association (NSRA) Board of Directors, including serving as Chairperson from 2009 to 2011. Today, Alan channels his expertise into creating content on issues vital to independent shoe retailers and offering consulting services with a focus on financial oversight. Learn more about Alan Miklofsky online at:
https://sites.google.com/view/alanmiklofskypersonalwebsite/alan-miklofsky
https://www.linkedin.com/in/alanmiklofsky/