In last weeks blog  What you need to know about distributions vs K1 income I reviewed what both FNMA and FHLMC require a seller to confirm too qualify your borrowers income for borrowers with K-1 1065 and K-1 1120S income.  I had reviewed “option 3” when your borrower does not show distributions that support the income being used to qualify.  As part of using “option 3” to confirm you could use K-1 income, I stated that you must review the business’ schedule L to confirm the business was solvent to use the income.  As promised let’s review the acid test or business liquidity test outlined in FNMA B3-3.2.1.08.  Please note FHLMC does not lay out the detail of the math like FNMA but does state the following.  FHLMC 5304.1  (03/06/17)  “In addition, the Seller may calculate and consider the liquidity ratios of the business using generally accepted accounting practices when analyzing the liquidity of the business”.  With this statement, it shows that the formulas below can be used for both agencies reasonably.

How To Perform a Solvency Test

First keep in mind, the reason you are completing this solvency test is to document an accurate answer to this question.

“Why does the borrowers K-1 show no distributions”

The solvency test will reveal one of these two answers

A. The business does have the funds to pay, but held onto distributions for a business purpose

B. The business did not have the funds to pay, therefore no distributions were paid.

Of course the outcome we want is option A, options B confirms that the borrower may have had taxable income according to the IRS, but did not have actual income to qualify for a mortgage according to FNMA and FHLMC.

Test 1 – Quick Ratio or Acid Test Ratio

Appropriate for businesses that rely heavily on inventory to generate income. This test excludes inventory from current assets in calculating the proportion of current assets available to meet current liabilities.

First add up the current assets from the schedule L

Cash on Hand 1D + Accounts Receivable 2B(D) +Other current assets 6D

Second add up the current liabilities from the schedule L

Accounts payable 15D (for 1065) OR 16D (for 1120S) +
Mortgage, notes, bonds, payable less than 1 year Line 16D (for 1065) OR 17D (for 1120s) +
Other current liabilities 17D (for 1065) OR 18D (for 1120s) +
(Please note the mortgages notes and bonds payable in less than 1 year can be ignored if you have documented these debts can be “rolled over” year over year.)

Third complete the math by dividing the assets by the liabilities.  This is your quick ratio, otherwise known as acid test ratio.

acid test ratio calculation

 

Test 2 – The Current Ratio or Working Capital Ratio

This may be more appropriate for businesses not relying on inventory to generate income.

First add up the current assets from the schedule L

Cash on Hand 1D + Accounts Receivable 2B(D) + Inventory 3D + Other current assets 6D

Second add up the current liabilities from the schedule L

Accounts payable 15D (for 1065) OR 16D (for 1120S) +
Mortgage, notes, bonds, payable less than 1 year Line 16D (for 1065) OR 17D (for 1120s) +
Other current liabilities 17D (for 1065) OR 18D (for 1120s) +
(Please note the mortgages notes and bonds payable in less than 1 year can be ignored if you have documented these debts can be “rolled over” year over year.)

Third complete the math by dividing the assets by the liabilities.

current ratio calculation
This is a lot to take in!  I have often felt as an underwriter I had to have a good understanding of not just mortgage underwriting but accounting and taxes.  This information can be overwhelming at first but after you follow the steps above it will become easier.
Good news to help you out!  We will be creating a video explanation for this income topic and many more, with over 30 videos that are just 15 min or less.  These are created to show practical examples, supporting guidelines, and our best explanation of the “why behind the what” in our new video teaching library.  Keep up with the information at our website at www.uber-writer.com for more information.