Lenders prefer accrual financials, because accrual records revenue when it is earned and costs when they are incurred, so EBITDA reflects the year's actual work and the balance sheet shows receivables, payables and inventory. Cash-basis books record only money in and out, so profit shifts with collection and payment timing and working capital is largely invisible. Many term and SBA loans can be underwritten from cash-basis tax returns. Lines of credit, covenants and acquisitions need accrual figures. You can convert for underwriting with a reconciliation schedule, without changing or refiling your tax returns.
- Cash basis
- Revenue when collected, expenses when paid
- Accrual basis
- Revenue when earned, expenses when incurred
- What lenders prefer
- Accrual, for earnings, working capital and covenant testing
- Where cash basis is often accepted
- SBA and conventional term loans sized on tax returns
- Where accrual is needed
- Lines of credit, borrowing bases, covenants and acquisitions
- Converting for a lender
- A reconciliation schedule; the tax returns stay as filed
The two methods, and the hybrid most owners actually use
Under the cash basis, a sale is recorded when the customer pays and an expense when the business pays it. Under the accrual basis, a sale is recorded when the work is done or the goods are delivered, and an expense when the cost is incurred, whether or not money has moved. Smaller businesses may file taxes on the cash method, and many keep their books the same way because it is simpler and it lets them manage taxable income by timing payments.
In practice, many books are a hybrid. Inventory is often tracked, equipment is depreciated rather than expensed, and loans appear as liabilities, but receivables, bills and customer deposits are not recorded until cash moves. Lenders call this a modified cash basis. It is closer to accrual than pure cash, but it still leaves out the items that matter most for a line of credit.
| Item | Cash basis | Accrual basis |
|---|---|---|
| An invoice sent in December, paid in January | Revenue in January | Revenue in December |
| A customer deposit for work next year | Revenue when received | A liability until the work is done |
| A supplier bill received in December, paid in January | Expense in January | Expense in December |
| Next year's insurance paid in December | Expense in December | A prepaid asset, expensed over next year |
| Wages earned in the last week of the year, paid in January | Expense in January | Expense in December, as an accrued liability |
| Receivables and payables on the balance sheet | Not shown | Shown |
How cash-basis books move EBITDA
Over many years the two methods produce the same total profit. In any single year they can differ a great deal, and lenders size loans on single years: the last full year and the trailing twelve months. Cash-basis EBITDA is distorted by whatever changed in receivables, payables, deposits, prepaid costs and inventory over that year.
The direction depends on the business. The example below uses plain numbers for two businesses that each show cash-basis EBITDA of 900.
| Adjustment to cash-basis EBITDA | Growing distributor | Contractor that takes deposits |
|---|---|---|
| Cash-basis EBITDA | 900 | 900 |
| Add the increase in receivables (earned, not yet collected) | +180 | +40 |
| Subtract the increase in customer deposits (collected, not yet earned) | 0 | −200 |
| Subtract the increase in unpaid bills and accrued wages (incurred, not yet paid) | −70 | −30 |
| Add the increase in prepaid costs (paid for next year) | +10 | 0 |
| Add the increase in inventory (bought, not yet sold) | +60 | 0 |
| Accrual-basis EBITDA | 1,080 | 710 |
For the distributor, cash accounting hides 180 of earnings the lender could have counted; against debt service of 800, coverage looks thinner than it really is. For the contractor, cash accounting inflates earnings by counting deposits for work not yet performed, and a lender will size the loan on the lower number either way; one that has to discover the gap itself also trusts the rest of the file less. Neither owner did anything wrong. The method simply measured cash, and the lender was trying to measure earnings. See debt service coverage ratio for how the earnings figure becomes a loan size.
Year-end tax planning adds a third distortion. Owners on the cash method often prepay expenses or delay invoicing in December to push taxable income into the next year. Those moves are legitimate for tax, but they shift profit between the years a lender is comparing and can make a stable business look erratic.
How cash-basis books hide working capital
A cash-basis balance sheet shows cash, fixed assets and debt, and little in between. Receivables, payables, accrued wages and customer deposits are absent. For a term loan that may not matter much. For anything built on working capital it matters a great deal.
- Lines of credit and asset-based loans lend against receivables and inventory. A borrowing base cannot be calculated from books that do not record receivables, and the aging a lender asks for has to agree with the balance sheet.
- Acquisitions set a working capital peg that the seller must deliver at closing. The peg is an accrual concept; on cash books there is nothing to measure it against.
- Covenants such as a current ratio or tangible net worth test are defined in accrual terms, and a lender will not test them on cash figures.
- Liabilities the lender needs to see, such as customer deposits that represent work still owed, or unpaid bills stretched past terms, are exactly what cash books omit.
Which lenders will underwrite cash-basis figures
| Loan | Cash-basis figures | What the lender does |
|---|---|---|
| SBA 7(a) term loan | Often accepted | Underwrites from tax returns, adds a year-to-date P&L, and asks about large swings in receivables or deposits |
| Conventional bank term loan | Often accepted for smaller loans | Reconciles to tax returns; may ask for an accrual conversion if results are uneven |
| Line of credit or asset-based loan | Rarely | Needs accrual receivables, payables and inventory that tie to the agings |
| Private credit with covenants | Rarely | Needs accrual statements, often prepared under GAAP, for covenant testing |
| Acquisition financing | Starting point only | Converts to accrual in diligence, often in a quality of earnings report, to measure earnings and the peg |
Converting for underwriting without restating the tax returns
The tax method and the reporting method do not have to match. A business can keep filing on the cash method and give its lender accrual figures, provided the two reconcile. Changing the tax method itself requires IRS consent and produces a catch-up adjustment to taxable income, which is a decision for the business's tax adviser and is rarely necessary for a loan.
A conversion for underwriting is a schedule, not a new set of books:
- Take the receivables outstanding at each year-end: invoices dated on or before the year-end and paid after it. If no aging was saved, rebuild it from invoice and deposit dates.
- Do the same for unpaid bills, accrued wages and other costs incurred but not yet paid at each year-end.
- List customer deposits and prepayments received for work not yet performed, and costs prepaid for the following year.
- Confirm inventory at each year-end from the count used for the tax return.
- Build the bridge: cash-basis profit, plus or minus the change in each item, to accrual profit, for each year and the trailing twelve months.
- Reconcile the result back to the tax return, so the lender can see the conversion adds no revenue that was never reported.
Many accounting systems can report on either basis if invoices and bills are entered in them, so for some businesses the conversion is largely a report setting plus a review of what was not entered. Where the books were kept purely on deposits and checks, the reconstruction takes more work, but it uses records the business already has.
A lender trusts a conversion that ties back to the filed return. It discounts one that simply presents a better number.
Transparent's lender package builds this bridge where the books are on the cash basis, and the underwriting memo explains each adjustment, so the lender underwrites the accrual earnings with the tax return beside them. If a CPA is involved, the same point applies to reviewed or compiled statements prepared on the tax basis; see reviewed vs audited financials and cash vs accrual financials compared.
Common questions
- Can I get a business loan with cash-basis financials?
- Often, for a term loan. SBA and many bank term lenders underwrite from cash-basis tax returns. A line of credit, an asset-based loan or a loan with financial covenants usually needs accrual figures.
- Do I have to change my tax accounting method to give a lender accrual statements?
- No. A conversion prepared for the lender can sit alongside cash-basis tax returns, as long as it reconciles to them. Changing the tax method requires IRS consent and is a separate decision.
- Why would accrual EBITDA be lower than my cash-basis profit?
- Usually because the business collected cash for work it had not yet done, such as customer deposits or prepaid contracts, or because bills and wages incurred at year-end had not yet been paid.
- Why would accrual EBITDA be higher?
- Usually because the business is growing: sales were earned near year-end and not yet collected, or inventory was bought ahead of sales. Cash-basis books leave both out of profit.
- What does a lender need to see the conversion?
- Receivables, payables, customer deposits, prepaid costs and inventory at each year-end, a bridge from cash-basis to accrual profit, and a reconciliation back to the filed tax returns.