Entrepreneurs often end up paying the wrong amount of maintenance, because cash flows are disregarded or not given sufficient consideration. So how SHOULD maintenance be calculated?
The entrepreneur’s financial means
On the face of it, you’d think it is easy to ascertain an entrepreneur’s financial means: it’s just a matter of looking at his income and the company’s profits as indicated in the financial statements. But you’d be wrong. An entrepreneur’s financial statements are (merely) a snapshot of his financial situation in a particular period. How much maintenance an entrepreneur is able to pay in the event of a divorce cannot be determined solely on the basis of the financial statements.
Profits during the three years prior to divorce
One of the basic principles established in 1994 for calculating a company’s profits – namely, that business profits should be used as the basis for determining financial means – is still misinterpreted in legal practice. The recommendation was that lawyers and judges need access to financial statements for the last three years in order to determine a company’s profits. In practice, this recommendation (which was originally made by Drs. T.C.E. Boringa RA) has taken on a life of its own, with the result that the average profit for the last three years is now taken as the baseline. This is what judges still ask for when determining an entrepreneur’s maintenance obligations – and, in practical terms, this means there is far too little consideration of whether the entrepreneur can actually afford the maintenance payments. Even if the average profit is pretty good, there may not be any money available to pay maintenance. When determining maintenance in an entrepreneur’s divorce, as well as past profits, the annual cash flow in recent years and the expected cash flow must also be determined.
Determining cash flow
In order to determine how much maintenance an entrepreneur can afford to pay, in addition to the company’s profits, ideally an overview of cash flows from operating activities, investing activities and financing activities should be drawn up. This should quantify current and projected cash flows from the time at which the calculation is performed, clearly showing how much money is available for maintenance payments without relying solely on past accounting profit or taxable profit.
Analysing cash flow
There’s a lot of effort involved in producing cash flow statements, but they alone are not enough. Cash flows will have to be analysed, so that cost items which do not actually produce a cash flow can be corrected. In other words, the cash flows have to be “normalised”. The Chairman of the Working Group on Maintenance Standards, judge A. Roelvink-Verhoeff, uses the term “Free Cash Flows”, i.e. the amount available for distribution to the shareholder.
Capital expenditure and repayments around the time of the divorce
An entrepreneur may have elected to make certain investments and/or repayments which will affect cash flow. Investing too much around the time of the divorce, raising too little finance for those investments and/or repaying too much on loans when there is no need to do so from a business perspective: these are all scenarios which may call for cash flows to be corrected. It’s also important to know how much money the Director and Majority Shareholder has taken out of the business, how much he owes the business and how things will look in future. In addition to investments and director’s drawings from the business, contributions to a self-managed pension fund are another factor to consider when correcting cash flows. The same goes for depreciation. Why? Well, what if profits are good but the Director and Majority Shareholder owes the business a lot of money? In the cash flow system, a debt on current account is an outgoing cash flow. No money will come into the business, yet money will leave the business because the company has to pay the entrepreneur a dividend.
Forecast for the post-divorce period
The final piece in the puzzle is a forecast for the next few years. The importance of forecasts is greatly underestimated, yet they are a major factor in determining what an entrepreneur can afford. Quite apart from this, I believe every entrepreneur is well advised to prepare a proper forecast for the coming years.
Maintenance must not exceed free cash flow
So, in divorce cases which involve determining how much maintenance an entrepreneur can afford, as well as looking at the financial statements for the last few years, it is also essential to prepare the most detailed cash flow statement possible, complete with a forecast. Only then can an accurate picture be formed of the means – or potential means – at the entrepreneur’s disposal. Past book profits are no help at all here. It is the (free) cash flow that has to be determined. And remember that maintenance payments must never be more than the amount the free cash flow allows, as this would jeopardise the company’s very future – which is certainly not in the interests of either party in a divorce. Consult a specialist if you are involved in sorting out maintenance arrangements.