In our K-1 and Pass Through Entity Series, one of the most common questions sounds simple, but it sits right in the middle of good underwriting judgment.

Ask the Experts: Should I use cash flow the latest K-1 if it appears to be recurring, or should I average the past three years?

Many lenders were taught to average in their forward-looking analysis. Three years is the standard. It smooths the bumps.

But the problem is also obvious once you have been doing this for a while:

Sometimes the three year average is not what you truly believe is going to recur.

So the real question is not average versus most recent.

The real question is:

What is the best estimate of recurring cash flow available to pay debt?

Why this question shows up on K-1s

A K-1 can wobble.

A borrower can have one year up, one year down, one year back up.

So someone asks, should I average or just use the latest because it seems recurring?

However, Linda caught something important in the wording:

If it “appears to be recurring,” what makes you think that?

You might know something about the borrower or the business that tells you the most recent year is the most representative.

Or you might be guessing.

And that difference matters.

Start with the simplest underwriting move: ask why the numbers changed

If the three year average does not line up with the most recent year, that is not a math problem.

That is a borrower conversation.

A few common explanations came up in the discussion:

• Tariffs, supply chain disruptions, labor challenges, weather issues, or just general economic conditions

• Expansion, preparing to expand, or pulling back

• A major nonrecurring expense and the owner took less home to cover it

• A windfall year and the owner took more home than usual

All of those can be true. All of those lead to different underwriting conclusions.

Watch out for confirmation bias

Linda added a warning that is easy to miss and very important:

If you only know the business category, do not assume you know this borrower’s story.

Example: “They are a restaurant, I know restaurants are struggling.”

That can be a useful starting point for questions.

But it can also become confirmation bias if you apply general industry assumptions to a specific borrower without evidence.

A better approach is:

Some businesses in your industry have been dealing with X. How has that affected you?

Look for anomalies, not just averages

David shared a practical technique from business valuation work:

• Use a longer view when possible

• Look for the year that is clearly an anomaly

• Consider weighting toward more recent years when it is supported

COVID is the example most lenders recognize.

For many businesses, 2020 and 2021 were not normal years.

So you may document it as history, but place less emphasis on it when you are estimating recurring cash flow.

The key is consistency:

If you treat one year as an anomaly, you need to be able to explain why.

Underwriting goal: recurring cash flow, especially projected recurring

David put it plainly.

Lenders are focused on recurring cash flow that can service debt next year and the year after.

History matters.

But underwriting is forward-looking, too.

Linda added a nuance that shows up in real files:

Sometimes what looked recurring based on three years changes once you have a conversation and learn the business is shifting again.

That is where judgment and documentation come in.

If the K-1 is wobbling, you can shore up risk mitigation

If you decide not to average all three years, you may still support the loan decision by strengthening structure.

Linda mentioned examples like:

• Require a higher debt service coverage ratio

• Tighten liquidity expectations

• Seek additional collateral when appropriate

• Use documentation to support why the structure fits the risk

This is not about giving someone a worse deal for no reason.

It is about aligning structure with risk and being able to explain it later.

Documentation is not optional when you deviate from the standard

This might be the most important operational point from the whole conversation:

If you do not document why you used the most recent year, or why you excluded a year, you may not remember later.

And neither will anyone else.

Two years from now, it might look like you guessed or missed something.

Regulators and senior credit people often review these decisions long after the moment has passed.

If the loan performs, nobody asks.

If it does not, everyone asks.

The notes are how you show that the decision was reasonable based on the information available at the time.

So should you use the latest K-1 or average three years?

Here is the LOT answer:

 A. It depends B. Check your guidelines C. Your job is to estimate recurring cash flow as accurately as possible

Use this decision checklist:

1. Start with three year average as the baseline

2. Identify what changed and why

3. Confirm whether a year is an anomaly and document it

4. Decide whether the most recent year is more representative and document that too

5. If cash flow is volatile, consider risk mitigation through structure

6. Write clear notes so future you knows exactly what you were thinking

That is how you move from plugging numbers into a worksheet to leading credit decisions with confidence.