4370.4 REV-1

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CHAPTER 3

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STATEMENT OF FINANCIAL POSITION

(BALANCE SHEET) IN DETAIL

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3-1 The Statement of Financial Position, commonly referred to

INTRODUCTION as the Balance Sheet, provides the Asset Management/Loan

Management staff with the information needed to evaluate

the financial health of a project. Consequently, the

Asset Management staff must have an understanding of the

contents of the Balance Sheet to evaluate project

Performance.

This chapter discusses each of the three sections of the

Balance Sheet:

o assets,

o liabilities, and

o owner\'s Equity

Objectives After reading this chapter, you should be able to:

o define assets, liabilities, and owner\'s equity;

o discuss the interrelationships of the various types

of accounts; and

o analyze the financial condition of a project using

information shown on the Balance Sheet.

3-2

ASSETS

Definition Current assets are defined as cash and other assets that

are expected to be converted to cash or consumed within

one year.

Examples Current assets include:

o cash,

o collectible tenant receivables,

o collectible short-term notes receivable,

o marketable securities intended to be used as cash

resources

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3-1 6/92

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4370.4 REV-1

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for operations (short term investments),

o mortgagee escrow deposits, impound accounts and

amounts due within one year,

o prepaid expenses, and

o inventories of merchandise or supplies.

Cash

What it is Cash is the most liquid asset a project owns. In

accounting terms, it consists of:

o currency,

o checks, and

o checking account balances.

Definition An asset is liquid to the extent that it can be spent

immediately or easily converted to cash which is the most

liquid asset. A check is the next most liquid asset and

is often considered cash. A building is the least liquid

asset a project owns.

What it does Cash is used by the project to pay off its liabilities.

Why it is Cash balances and transactions are of great importance to

important the Asset/Loan Management staff because at some point,

the activity in almost every account involves the

transfer of cash.

How it The Asset Management staff uses cash as one of the main

is used components in the determination of the short-term

financial solvency of a project.

Definition Short-term financial solvency is the project\'s ability to

pay off its current liabilities as they become due.

What it Cash relates to current obligations. It shows how many

relates to current obligations can be met with the available cash on

hand.

Why it is The most liquid asset is listed first on the balance

presented sheet. If the cash balance is reported on the balance

first on sheet as zero or negative, this would indicate a troubled

the balance project or a project in the process of being sold.

sheet

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6/92 3-2

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4370.4 REV-1

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What should and should not be counted as cash:

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What Should What Might What Should

Be Included Be Included\* Not Be Included

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Currency \*if \"on hand\" IOU\'s

as of the Balance

Coins Sheet date Paid bills

Certified Traveler\'s checks Post-dated

cashier\'s checks

check

Checks not yet Postage stamps

Checking deposited

accounts Travel advances

balance

Savings

account

balances

Money orders

Bank drafts

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Comment The items listed as \"What Should Not Be Included\" should

not technically be considered as part of cash. However,

they are often included if their total is small when

compared to the total cash balance.

The total amount of undeposited checks should be minimal

since it is a weak internal control to keep checks in the

office rather than depositing them in the bank. Some of

the internal control requirements regarding cash receipts

include:

o all cash receipts (including those collected by

management agents) must be deposited in the name

of the project in a bank whose deposits are

federally insured;

o all collections, if possible, shall be promptly

deposited on the day received;

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3-3 6/92

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4370.4 REV-1

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o bank statements shall be reconciled promptly to

the formal accounting records by persons other

than those recording or handling cash, or

preparing and signing checks.

Note For more information on internal controls regarding cash

receipts and balances please see HUD Handbook 4370.2,

Financial Operations and Accounting Procedures for

Insured Multifamily Projects.

Accounts Receivable

Definition Accounts receivable are amounts owed to the project that

are due within the current operating cycle, usually one

year.

Examples The three major types of receivables found in HUD

projects are included in the following table.

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Type of Receivable What It Includes

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Tenant accounts The balance of rent due from

receivable from current tenants, but unpaid

current tenants. as of the statement date.

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Amounts for other Future receipts from garage,

services. furniture, meals, and damage

repairs.

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Tenant subsidy The balance of subsidy

payments receivable payments due to project

from HUD. owner, but unpaid as of the

statement date.

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What it does Accounts receivable measures the potential or future

revenue of the project. When revenue is earned prior to

its cash receipt, it is recognized as an account

receivable because the project has a right to collect

that revenue in cash.

Why it is The project\'s accounts receivable records amounts due the

important project for goods or services rendered and is a source of

potential cash.

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6/92 3-4

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4370.4 REV-1

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How it Accounts receivable is one indication of how well the

is used project is being managed. The accounts receivable

balance can be studied to determine how much of the

project\'s revenue is being deferred and whether or not it

can realistically continue to extend accounts receivable.

It also measures management\'s effectiveness in collecting

rent and other amounts owed to the project.

Note Accounts receivable are often set up when the project

lends money to owners or related projects. These types

of loans are improper and accounts receivable can be used

to identify such diversions or misuses of funds. For a

more detailed discussion of diversion or misuse of funds,

please consult Program Integrity Bulletin P-88-5, Misuse

and Diversion of Funds, HUD Insured and HUD-Held

Multifamily Projects.

Allowance for

Doubtful Accounts

Introduction In Chapter 2 it was mentioned that there is no guarantee

a project will collect all of its accounts receivable.

In fact, there is often a considerable portion of

accounts receivable whose collectability is doubtful.

Due to the uncollectible nature of a portion of the

accounts receivable, an allowance for doubtful accounts

is included in the Balance Sheet,

What it is The allowance for doubtful accounts is an estimate of how

much of the accounts receivable the project will be

unable to collect. It is subtracted from accounts

receivable on the Balance Sheet.

What it does It can take several years for an account to be identified

as uncollectible, only then can it be written off

(charged to expense). For this reason the contra account,

allowance for doubtful accounts, must be set up. The

allowance for doubtful accounts is recorded as an expense

on the Statement of Income and is deducted from the

receivables balance on the balance sheet. Consequently,

it has the effect of reducing accounts receivable to a

more realistic figure. (See Handbook 4370.2 for a

discussion on allowance for doubtful accounts.)

How it is The Asset Management/Loan Management staff can use

used allowance for doubtful accounts as a measure of the

project\'s ability to collect tenant account receivables.

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3-5 6/92

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4370.4 REV-1

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What it Allowance for doubtful accounts relates mainly to tenant

relates to accounts receivable. It reflects the estimated amount of

rent that will not be collected from tenants.

Notes Receivable

What they Notes receivable are amounts due the project that have

are the form of a signed written agreement describing the

terms of the amount due.

What they They provide a way of recording money owed to the project

do other than tenant accounts receivable. They usually

represent the sale of a single item or are the result of

negotiations regarding the payment of amounts previously

due.

Why they Notes receivable are a source of future cash, and a

are reflection of goods or services already provided,

important

How they Notes receivable are considered when evaluating the

are used solvency of a project. It is also an indication of

possible diversions or misuse of funds such as an

unauthorized loan of project cash to the owners (although

these are most often found in accounts receivable),

Short Term

Investments

What they Short term investments represent cash a project has

are invested and that is not needed to meet current operating

expenses.

Examples Short term investments include the following:

o certificates of deposit,

o savings account balances, and

o purchase of U.S. Treasury Notes.

What they Short term investments provide an additional source of

do revenue (interest) for the project.

Why they Short term investments are important for two reasons:

are

important

o they provide an additional source of financial

strength for the project, and

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6/92 3-6

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4370.4 REV-1

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o they are assets of the project that are not used to

meet current obligations.

How it The Asset Management staff will check to see if the

is used investments are properly protected and have been

guaranteed by the U.S. Government. They will also check

to see that interest earned on investments is properly

handled.

What they Short term investments are related to cash and current

relate to liabilities. These investments represent the second most

liquid asset that could be converted to cash and used to

pay off liabilities.

Deposits Held

In Trust

What they Deposits held in trust consist of cash that is being held

are by the project that will be returned if certain

conditions are met.

What they It is a way of separating out money, like tenant security

do deposits, from other current assets. They provide added

assurance that certain actions or conditions will be met

and are a added guarantee against losses.

Tenant

Security

Deposits

What they Tenant security deposits consist of cash collected from

are renters which is being held by the project. When a

tenant vacates, security deposits may be used to:

o pay delinquent rent, and

o repair damages over and above normal wear and tear.

Why they These deposits cover part of repair costs which would

are otherwise be offset against rental revenue. The need for

important a rent increase may be reduced if security deposits are

used for appropriate repairs. The potential loss of the

deposit gives tenants an additional incentive to take

better care of their respective units.

How they The Asset Management staff monitors this account to make

are used sure that the owner is not improperly using the tenant\'s

money to pay off the project\'s obligations.

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3-7 6/92

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4370.4 REV-1

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What they The tenant security deposit asset account must always be

relate to equal to or exceed the balance of the tenant security

deposit liability account. These funds must be

maintained in a separate bank account. (Some state laws

also may require deposits to be held in a separate bank

account.)

Other Deposits

Example Other deposits might include deposits held at the utility

company. These are sometimes required by a utility

company before service is offered.

How they Other deposits are not used very often. If a large

are used amount of other deposits exist, the Loan Management staff

should investigate, or review the Notes to the Financial

Statements to see if an explanation was provided.

Prepaid Expenses

Definition Prepaid expenses represent payments made for products or

services that have not been delivered or received. Their

value is likely to be used up within one year.

What Prepaid expenses:

they do

o provide some benefit during the current year, and

o reduce cash outlay during the current year.

Examples Prepaid expenses include the following items:

o unexpired insurance,

o prepaid taxes, and

o supplies.

Comment Prepaid expenses are generally not important to the Loan

Management staff except as they reduce cash outlay during

the current year. Accounting procedures require the

proper recordation of expenses that have already been

paid for before the product or services have been used.

If only a portion of prepaid expenses has been used they

should be prorated to the proper accounting period.

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6/92 3-8

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4370.4 REV-1

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Restricted Deposits

and Funded Reserves

Components Restricted deposits include:

o mortgagee escrow deposits,

o reserve for replacement account, and

o residual receipts account.

Why they Restricted deposits represents money set aside to pay

are large future obligations like taxes, insurance and major

important repairs. Except for escrow deposits, these funds are

generally released only upon HUD\'s approval.

Mortgagee Escrow

Deposits

(Synonym:

Impound

Accounts)

Definition Mortgagee escrow deposits consist of cash and investments

belonging to a mortgagor but held by a mortgagee. They

ensure that the mortgagor will have enough cash on hand

to pay such items as taxes and insurance when they become

due.

Why they Mortgagee escrow accounts are important to the Loan

are Management staff because enough money must be set aside

important for future payment of the following items:

o taxes,

o insurance, and

o Mortgage Insurance Premiums (MIP).

How they Taxes, insurance, and MIP are generally paid once a year.

work They are usually large amounts which could not be paid

out of one month\'s rental income. The mortgage requires

the mortgagee to collect a portion of the taxes,

insurance and MIP expense as part of the total monthly

mortgage payment.

How they The Asset Management staff can compare the balance of the

are used deposits to prior actual expenses to determine if the

reserve will be adequate to cover the upcoming expense.

Comments The mortgagee usually performs an escrow analysis at

least

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3-9 6/92

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4370.4 REV-1

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annually to ensure that amounts collected are sufficient

to cover any increased costs due to inflationary

pressures and tax rate increases. Consequently, the

monthly escrow deposit amounts to be collected often

increase from year to year.

Reserve Fund for

Replacements

Definition The Reserve Fund for Replacements is money set aside to

help pay for some of the replacements to the major

structural and mechanical components of the building and

to replace major appliances.

Why it is If the deposits are made as required, there will be some

Important cash set aside for major repairs when rental revenue may

not be adequate to cover them. Withdrawals from the

replacement account must be authorized in writing by HUD.

Adequate funding of the Reserve Fund for Replacements

account helps ensure the long term financial health and

physical well being of the project.

Examples Examples of major structural and mechanical components

often covered by the Reserve Fund for Replacements

account include:

o roof,

o major appliances (refrigerators, ranges, etc.), and

o heating plant (furnace, boiler).

How they The Reserve Fund for Replacements account can be used to

are used review one aspect of the project\'s long term financial

strength. This is done by comparing the amounts set

aside with the estimate of future replacement needs.

What it Reserve for replacements should be examined along with

relates to any long term budgets that have been prepared.

Note Residual Receipts. For all projects required to make

deposits to a residual receipts fund, a computation shall

be included showing the amount of any such receipts at

the end of the fiscal year and the date of their deposit

to the fund. An analysis of this fund and the

computation are required regardless of whether or not

residual receipts have actually been generated. For more

discussion on residual receipts see Handbook 4370.2.

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6/92 3-10

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4370.4 REV-1

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Miscellaneous

Current Assets

What they Miscellaneous current assets are any current asset that

are does not fit into one of the previous categories of

current assets.

Examples Examples of miscellaneous assets include inventories of

merchandise or supplies.

How the This account is rarely used. If a relatively large

servicer number appears on this line, the Asset/Loan Management

uses them staff should ask for details. A good IPA (Independent

Public Accountant) will include an explanation of large

items that appear here in the Notes to the Financial

Statement.

Fixed Assets

Definition Fixed assets are those assets with an expected life

greater than one accounting period, usually one year.

Fixed assets are:

o used for operations and are not held for resale,

o subject to depreciation, amortization or

depletion, and

o made up of physical (tangible) substance.

Components Fixed assets include:

o buildings,

o land,

o improvements (landscaping),

o equipment,

o vehicles,

o tools,

o furniture, and

o other owned tangible property.

Comments Buildings, furniture, equipment and fixtures are recorded

at historical cost. Their current market value or

replacement cost has no bearing on the books of an

ongoing concern. An allowance for depreciation is then

deducted from that amount to arrive at the book value.

Some of the monies required to replace and repair fixed

assets are generated by monthly deposits to the reserve

for replacements account, as required by the regulatory

agreement.

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3-11 6/92

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4370.4 REV-1

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What they Fixed assets measure the value of property belonging to

do the project. These assets are generally used in the

production of services (and goods), rather than being

held for resale.

Example For example, a HUD project purchases a quantity of major

appliances for its apartments. The appliances are not

purchased with the idea of reselling them. They are used

to maintain proper living conditions in the individual

units.

Why they are The Asset Management staff should be concerned with major

important changes in fixed asset accounts rather than their

amounts, as compared to current or other assets. The

fixed assets are indispensable to the project. They

provide the physical base from which the project can earn

revenue by selling its services.

How they If the value of a fixed asset changes drastically. The

are used HUD servicer should investigate to determine whether or

not the disposal or improvements to the asset were

approved by HUD.

What they When new fixed assets are acquired, their cost is added

relate to to the appropriate account. Similarly, when a fixed

asset is disposed of, its cost and the related

depreciation should be removed from the account. A more

detailed discussion of depreciation can be found in

Chapter 4 of this Handbook.

3-3

LIABILITIES

Current Liabilities

What they Current liabilities are obligations that must be

are generally met within one year. These obligations must be

met using existing resources properly classified as

current assets or by the creation of another liability.

Why they are Proper statement of current liabilities is extremely

important important in the analysis of a project\'s financial

position, particularly when computing surplus cash and

residual receipts.

How they The Loan Management staff compares the total current

are used liabilities to the total current assets to see if there

are enough current assets to cover all of the current

liabilities. This is a way of analyzing the short term

liquidity of the project.

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4370.4 REV-1

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What they Current liabilities interact with cash. Cash is the most

relate to liquid asset in the project and is most often used for

satisfaction of current liabilities.

Components Current liabilities include the following six items:

o accounts payable,

o accrued liabilities,

o Notes payable (short term),

o deferred income,

o distributions or dividends payable, and

o security deposit liability.

Accounts Payable

What they Accounts payable are obligations of the project that have

are been incurred and billed but not yet paid for. Accounts

payable usually represents the actual invoices from

vendors.

Example An example of an accounts payable is a utility bill that

a project received at the end of one month but will not

pay until the middle of the following month.

What they Accounts payable interact directly with cash. The

relate to accounts payable balance can be compared with the cash

account balance to see if it is sufficient to cover

accounts payable.

Accrued Liabilities

Definition Accrued liabilities are a record of expenses that have

been incurred but not yet billed or paid,

Examples Accrued liabilities included the following:

o payroll,

o taxes,

o part-period utilities, and

o interest due.

How they The amount of the accrued liability has an impact on the

are used financial solvency of the project.

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4370.4 REV-1

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What they Accrued liabilities are an indication of the projects

relate to short-term obligations that will show up on the statement

of income as an expense when paid.

Notes Payable

(Short Term)

Definition Notes payable (short term) is the account where the

dollar value of the project\'s short term borrowing is

recorded.

What they do The existence of notes payable may imply that rental

revenue has not been sufficient to meet obligations, and

often times is an indication of financial difficulty.

Example For example, a short term bank loan needed to meet the

payroll.

What they Short term notes payable interacts with current assets

relate to like cash, which will be used to pay them.

How they The Loan Management staff may compare notes payable to

are used either current assets or cash remaining after normal

operations to determine whether or not the project will

be able to repay the loan when it is due.

Comment If the notes are payable to related parties, such as the

project\'s owners, this fact should be disclosed in the

Notes to the Financial Statements and the details

investigated to ensure this is not a violation of HUD

requirements.

Mortgage Payable

(Current Portion)

Definition Mortgage payable (current portion) is that portion of

the long-term liability that becomes payable within one

year after the balance sheet date.

What The existence of mortgage payable indicates a creditor

they do has a secured prior claim against one or more of the

project\'s assets which can be sold if the debt is not

paid within the operating year.

Why is it The loss of significant assets due to nonpayment on a

important mortgage can result in the failure of the project.

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4370.4 REV-1

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What they Mortgage payable (current portion) interacts with current

relate to assets like cash, which are used to make the mortgage

payments.

How they The Loan Management staff may use it to determine if the

are used project is financially sound to satisfy the current

portion of the mortgage without risking the loss of

collateral.

Deferred Income

Definition Deferred income is created when cash has been received

but not yet earned. A liability exists to provide the

service or to otherwise earn the income.

Example Prepaid rents are an example of deferred income, although

their amount is rarely large.

What it The function of deferred income is to measure the dollar

does amount of services that the project will have to perform

for money that has already been received.

Why it is Deferred income is important because it represents the

important possibility of using future income to pay current

expenses.

How it is If the deferred income represents a large figure when

used compared to project income, the Loan Management staff

should investigate the cause.

What it Deferred income interacts with future budgets.

relates to

Distributions or

Dividends Payable

What they Distributions or dividends payable are an accumulation of

are unpaid dividends owed to the owner. If distributions are

made they must be in accordance with the Regulatory

Agreement.

Why they They represent money the owner expected to get but

are didn\'t. Therefore, the owner may be reluctant to make

important additional cash contributions to the project.

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How they Existence of these items usually means that project

are used rental revenue has not been sufficient to cover both

operating costs and return the permitted profit to the

owners. This means the rent collection efforts must

increase, expenses must be reduced, or rents must be

raised.

What they When the distributions or dividends payable is increased,

relate to the owner\'s

equity line on the Balance Sheet is decreased, and vice

versa.

Security Deposit

Liability

What it Security deposit liability measures the financial

does obligation of the project to the tenants.

What it is It is the project\'s obligation to repay funds held on

deposit if certain conditions are met by the tenants.

Interactions Security deposit liability interacts directly with the

asset of tenant security deposits. If an owner is

complying with HUD requirements regarding security

deposits, the balance in the tenant security deposit

account should equal or exceed the total security deposit

liability, including any interest owed or potentially

owed to tenants.

LONG TERM

LIABILITIES

Notes Payable

What it is Notes payable (long term) is the Balance Sheet account

that records money lent to the project that is due in

more than one year.

Why it is Notes payable represent potential noncompliance with HUD

important regulations because HUD has to approve any long term

notes payable.

Interactions Notes payable interacts with future income of the project

(in the budget). It also affects the long term liquidity

of the project.

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Example A bank loan to the project to purchase equipment such as

lawnmowers, motor vehicles, etc. is an example of a notes

payable.

Mortgage Payable

What it is Mortgage payable is the Unpaid Principal Balance (UPB) of

the mortgage principal less the current portion.

What it Mortgage payable is a record of the unpaid principal

does balance.

How they The Loan Management staff may use it to see if a

are used project\'s monthly mortgage payments are being made on

schedule.

Other Liabilities

Why they are Other liabilities provides an all encompassing account

important for any other long term liabilities not fitting any other

categories.

Example A bond is an example of a long term liability that comes

under this category.

How the If the amount of other liabilities is large compared to

servicer the total liabilities, the Loan Management staff should

uses them investigate for possible project financial troubles.

Amounts Due To

Owners

What it is Amounts due to owners is the amount of money advanced by

the owners that is not currently due.

What it Such amounts appear as a liability to emphasize the

does owner\'s right to collect them, even though this right is

dependent on the future financial performance of the

project.

Why it is Amounts due to owners is important to the Loan Management

important staff because this obligation usually cannot be paid to

the owners without prior HUD approval.

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3-4

OWNER\'S EQUITY

What it is Owner\'s equity is the claims of the owner against the

assets of the project. The balance in owner\'s equity

plus all liabilities should always equal the total value

of the project\'s assets.

The owner\'s equity consists of the following accounts:

o capital account,

o withdrawals account, and

o retained earnings.

What it does Owner\'s equity summarizes the financial loss or gain of

the project.

Interaction Owner\'s equity interacts with total liabilities and total

assets.

Why it is The dollar amount of owner\'s equity has very little

important economic meaning beyond its effect on the owner\'s tax

return. The most important factor is the transactions

that affect owners equity. The Loan Management staff

should pay close attention to the contributions and

distributions reported in calculating owner\'s equity.

Capital Account

What it is The Capital account is the account used to record the

owners initial investment of the business plus any

permanent additional increases or decreases in owner\'s

equity. The capital account is often referred to as

contributed capital. For corporations and cooperatives

this account is represented by paid in capital which may

include surplus or deficient amounts from operations.

What it does The Capital account measures the individual owners

initial investment plus any increase or decrease in the

individual owners equity.

Interaction The capital account interacts with the other equity

accounts.

Why it is The capital account is one indication of the owners

important willingness to invest capital into the project.

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Withdrawals Account

What it is

The withdrawals account is the account used to record

transfers of assets from a project to its owners.

What it does The withdrawals account measures the individual owners

collection of assets from the business. These draws

reduce the owners equity.

Interaction The withdrawals account interacts with the other equity

accounts.

Why it is The withdrawals account is important because it is an

important indication of the owners ability to receive a return on

monies invested.

How it is The withdrawals account can be used to determine if

used amounts are being distributed to owners in accordance

with HUD guidelines.

Retained Earnings

Account

What it is Retained earnings details the types of transactions that

result in the increase and decrease in equity resulting

from earnings.

What it Retained earnings measure the results of operating

does activities.

Interaction Retained earnings accounts interact with the other owner

equity accounts.

Why they are These accounts are important in determining how net

important income relates to how much money an owner is able to

realize on amounts invested.

3.5

FINANCIAL

RATIOS

What they Financial ratios are mathematical computations that

are assist in the analysis of financial statements.

Financial ratios include:

o Liquidity Ratios,

o Acid Test Ratios,

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o Profitability Ratios, and

o Activity Ratios.

What they Financial ratios help the Loan Management staff asses the

do financial health and stability of the project.

How they The Loan Management staff can use financial ratios to

are used predict the amount and timing of future net cash flows

and project viability.

How they Financial ratios interrelate with the various financial

interrelate statements. The relationship of financial ratios to the

other statements will be discussed later.

Note For a more detailed discussion of ratios, please see

Handbook 4370.1.

Liquidity Ratios

Current Ratio

What it is The Current Ratio is one of the liquidity ratios that is

the relationship of a project\'s current assets to current

liabilities.

What it It provides an analysis of the working capital (current

does assets less current liabilities) structure of a project.

What it A high Current Ratio indicates a large proportion of

means current assets to current liabilities. The higher the

ratio, the better is a company\'s current position, and

the better able to it is meet current obligations. As a

general rule a 2:1 ratio is considered to be an adequate

index for most industries.

How it is The Current Ratio is arrived at by dividing a projects

used current assets by its current liabilities. The resulting

ratio can be used to evaluate a projects working capital

position. Appropriate actions should be taken if ratios

fall well outside of the HUD or industry standards.

The formula for calculating the Current Ratio is as

follows:

Current Assets

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Current Liabilities

Acid Test

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(Quick Ratio)

What it is The Acid Test Ratio or Quick Ratio is the relationship

between a project\'s quick assets to current liabilities.

Quick assets are those assets which can easily be

converted to cash such as (cash, short-term investments

and accounts receivable).

What it It provides an analysis of whether the project can meet

does current obligations without the use of non-cash current

assets.

What it An Acid Test Ratio of less than one would indicate that

means if all the quick assets were converted to cash, this

would not satisfy the current liabilities owed.

Therefore, an Acid Test Ratio of at least 1 would be

considered satisfactory to meet current obligations. As

a general rule, a 1:1 ratio is considered to be an

adequate index.

How it is The Acid Test Ratio is arrived at by adding up the quick

used asset balances and dividing the sum by the current

liabilities balance. The Acid Test Ratio measures the

immediate solvency or debt-paying ability of a project.

(Traditionally, short-term notes receivable are

considered quick assets and are included in the numerator

of the Acid Test Ratio. However, for purposes of this

discussion, short-term notes receivable have been

excluded from the ratio because generally, projects do

not have notes receivable.) The formula for calculating

the acid test ratio is as follows:

Quick Assets

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Current Liabilities

Mortgage Coverage

Ratio

What it is The Mortgage Coverage Ratio is defined as net available

funds divided by the current mortgage payment, including

escrows.

What it It provides an analysis of whether the net available

does funds are sufficient to meet the current cash

obligations.

What it A Mortgage Coverage Ratio of less than one indicates that

means net available funds are not sufficient to meet current

cash obligations. Therefore a ratio of at least one would

be satisfactory.

How it The Mortgage Coverage Ratio is arrived at by determining

is used the net

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available funds and dividing the sum by the monthly

mortgage payment. The net available funds consists of

available funds (unrestricted cash, HUD receivables,

investments of unrestricted cash and other current

assets) less cash obligations. Cash obligations consists

of all current liabilities, except accrued liabilities

related to (but not including) mortgage escrows. The

mortgage coverage ratio is an indication of how easily a

project can meet it\'s current mortgage payment without

converting net available funds to cash or acquiring

financing. The formula for calculating the mortgage

coverage ratio is as follows:

Net Available Funds

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Coverage Ratio

Monthly Mortgage Payment\*

\*Per note and including escrows

Other Other types of financial ratios include, Profitability

Financial Ratios which provide insight about how effectively a

Ratios project is being managed, and Activity Ratios which

measure how effectively an entity is using its resources.

Profitability Ratios include:

o Profit Margin on Rental Revenue, and

o Return on Partners\'/Owner\'s Capital.

Profit Margin on Rental Revenue Ratio is a ratio

which evaluates how effectively a project is being

managed. Profit Margin on Rental Revenue is

calculated as follows:

Net Profit Before Depreciation

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Profit Margin

on Rental Revenue Rental

Revenue

If profit margin is comparatively low, either the

project\'s rental income is relatively low, or cost

is relatively high, or both.

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Return on Partners\'/Owner\'s Capital Ratio is a ratio

which evaluates the project\'s ability to provide

owners with a return on their investments. Return

on Partners\' Capital Ratio is calculated as follows:

Net Profit Before Depreciation

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on

Partners\' Capital Partners\' Capital

If return on partners\' capital is comparatively

high, they are either enjoying relatively high

profits, or relatively low personal investment in

the project.

One useful Activity Ratio is the Average Collection

Period which measures accounts receivable turnover.

This ratio is a valuable tool in evaluating a

project\'s rent collection procedures. The Average

Collection Period Ratio is calculated as follows:

Total Rental Revenue Per Year

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Revenue

360 Days Per Day

Accounts Receivables Average

\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ = Collection

Rental Revenue Per Day Period

If the average collection period is relatively high, it

indicates a possible problem in the collection area, as

there simply is too much cash not being collected, and

there are a high number of accounts overdue.

The Percentage of Uncollected Rent is a second activity

ratio which indicates the percentage of potential

uncollected rent revenue for a given period. The

percentage is calculated as follows:

Compute percentage of rent potential that was not

collected. This ratio should not exceed 7%.

Vacancy Loss + Bad Debt Expense

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Percentage of

Rent Potential Uncollected Rent

A related indicator of the adequacy of the rent

collection effort is

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the level of accounts receivable. Generally, receivables

should not exceed 10% of the monthly rent potential.

Carefully examine if the amount exceeds 10%.

3.6 A detailed understanding of the Balance Sheet can help

CHAPTER the Loan Management staff determine both the long and

SUMMARY short term solvency of the project. This conclusion is

arrived at by studying the relationships between the

various assets and liabilities of the project. In order

to understand the relationships between a project\'s

assets and liabilities, the Loan Management staff has to

understand the following:

o how the project records its earnings,

o how it records and spends its monies to pay its

debts, and

o how it handles uncollectible accounts.

It is also helpful for the Loan Management staff to

understand what the Balance Sheet reveals about the

owner\'s relationship to the project, since it has a

bearing on the willingness of the owner to contribute

additional capital to the project. Financial ratios help

evaluate the financial health and stability of a project.

Many of the financial ratios discussed here and in later

chapters can be generated via MIPS. For more detailed

information regarding MIPS and financial ratios please

review HUD User Manual Application 5.3b, Data Entry and

Performance Risk Analysis.

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CHAPTER 3

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ACCOUNTING KNOWLEDGE QUIZ

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Questions

1\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ is the most
liquid asset a project owns.

2\. Short term financial solvency is the project\'s ability to pay off

its \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ as they become due.

3\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ are amounts
owed to the project.

4\. Allowance for doubtful accounts can be used as a measure of a

project\'s ability to collect
\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

5\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ are cash a
project has invested that is

not needed to meet current operating expenses.

6\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ consists of
cash collected from the

renters by the project that are an assurance or guarantee that rental

units will be properly maintained by tenants. If a tenant vacates

the apartment these funds can be used to:

a\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ and

b\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

7\. Prepaid expense are likely to be used up within
\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

8\. Mortgagee escrow accounts must have enough money for future payment

of:

a\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_,

b\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ and

c\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

9\. The \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ is
money set aside for replacements

to the major structural and mechanical components of the building.

10\. Assets with an expected life of more than one accounting period are

known as \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_

6/92 3-26

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4370.4 REV-1

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11\. Obligations that must be met within one year are
\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

12\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ are
obligations of the project that

have been incurred and billed, but not yet paid.

13\. Prepaid rent is an example of
\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_.

14\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ is the
account that records money lent

to the project that is due in more than twelve months.

15\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ records
the Unpaid Principal Balance

(UPB) of the mortgage.

16\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ represents
money advanced by the owners

that is not currently due.

17\. Place a check mark next to the items listed below that are defined

by accountants as assets of a HUD project.

\(a\) \_\_\_\_\_\_ Prepaid expenses

\(b\) \_\_\_\_\_\_ Depreciation

\(c\) \_\_\_\_\_\_ Escrow deposits

\(d\) \_\_\_\_\_\_ Rent supplement contracts

\(e\) \_\_\_\_\_\_ Mortgage on the property

\(f\) \_\_\_\_\_\_ Checking account balance

\(g\) \_\_\_\_\_\_ Accounts receivable

18\. When a tenant \"skips\" owing \$300 in rent and \$1,250 for
legitimate

damages, does a \$1,550 receivable exist?

\_\_\_\_ Yes \_\_\_\_ No

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3-27 6/92

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4370.4 REV-1

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19\. What are the arguments for including prepaid expenses and mortgagee

escrow deposits as current assets?

a\.
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b\.
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20\. If a mortgage balance is \$10 million, but three payments (totaling

\$200,000 of interest and \$ 100,000 of principal) are delinquent, what

is the total mortgage payable amount to be shown on the Balance

Sheet?

\$ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_

21\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ is the claims of the
owner against the assets

of the project.

22\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ represents the initial
investment of the

owners plus any permanent increases or decreases in owner\'s equity.

23\. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ are mathematical
computations that assist in

the analysis of financial statements.

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6/92 3-28

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4370.4 REV-1

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Answers

1\. Cash (p. 3-2)

2\. Current liabilities (p. 3-2)

3\. Receivables (p. 3-4)

4\. Tenant receivables (p. 3-5)

5\. Short term investments (p. 3-6)

6\. Tenant security deposits (p. 3-7)

a\. Pay delinquent rent (p. 3-7)

b\. Repair damaged apartments (p. 3-7)

7\. One year (p. 3-8)

8\. a. Taxes (p. 3-9)

b\. Insurance (p. 3-9)

c\. Mortgage insurance premiums (MIP) (p. 3-9)

9\. Reserve for replacement (p. 3-10)

10\. Fixed Assets (p. 3-11)

11\. Current liabilities (p. 3-12)

12\. Accounts payable (p. 3-13)

13\. Deferred income (p. 3-15)

14\. Notes payable (3-16)

15\. Mortgage payable (p. 3-17)

16\. Amounts due to owners (p. 3-17)

17\. a. Yes: despite the word expenses, they are assets, because

they will result in future benefit to the entity.

(p. 3-1)

b\. No: depreciation is an expense, and the allowance for

depreciation on the balance sheet is an offset to an

asset. (p. 3-11)

c\. Yes: they are the project\'s property and have future value.

(p. 3-9)

d\. No: only the cash received by the project from the contract

is an asset. (p. 3-16)

e\. No: the property is an asset and the mortgage is a

liability; the mortgage is an asset of the mortgagee,

however. (p. 3-17)

f\. Yes: part of cash. (p. 3-2)

g\. Yes: but the estimated uncollectible portion reduces the

value of the asset. (P. 3-4)

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3-29 6/92

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4370.4 REV-1

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18\. Yes, but, unless it is likely to be collected an allowance for

doubtful accounts should be set-up or eventually it should be

written off. (p. 3-4)

19\. a. They will be of benefit during the coming year.

b\. If they had not been there, cash would have been required in

the coming year. (p. 3-8, 3-9)

20\. \$10 million. The delinquency does not change the Unpaid Principal

Balance, it only describes its status. The \$200,000 would be shown

on the Balance Sheet as delinquent interest payable. (p. 3-17)

21\. Owner Equity (p. 3-18)

22\. Capital Account (pgs. 3-18)

23\. Financial Ratios (p. 3-19)

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6/92 3-30