Financing trends in the construction industry
Construction financing continues to be a challenge for many contractors in the United States. Even during the pre-recession period, lending to construction firms presented challenges to most banks. This was due to a number of economic factors, including the sensitivity of contractors to economic cycles, revenue fluctuations from year to year, excess competition and the volatility of the construction industry.
In addition to these economic factors, there are other credit underwriting issues that continue to challenge banks in lending to construction firms, including prominent construction company failures, the unpredictable nature of the work, estimates used in the preparation of financial statements, diminished gross profit margins with continued backlog profit erosion, lending against bonded accounts receivable and addressing “quasi liens” on accounts receivable secured with joint check agreements.
While the national, regional and community banks have cash to lend, many construction firms are faced with difficulty securing financing. This is especially true for contractors who need bank lines of credit to fund short-term working capital needs. Unless a construction firm has a financially sound balance sheet, consistent profitable results and a properly capitalized company, banks generally pause prior to providing financing to a construction firm.
Construction firms that profile similar to the characteristics below continue to face issues in securing a bank relationship:
- Limited liquid working capital and equity
- Significant under-billings
- Poor ratio of accounts receivable to accounts payable
- Significant aged progress billings and retention receivables
- Poor credit rating and reputation for company and business owners
- Delinquent payroll taxes, union dues and insurance premiums
- Limited or no bonding capacity
- Significant related party receivables
While the items above present underwriting issues, contractor collateral continues to present credit underwriting challenges. Most contractor collateral includes special purpose construction equipment and accounts receivable on jobs in progress and completed jobs. In the event that a bank needs to liquidate a construction firm, liquidating equipment and the collection of progress receivables that tend to evaporate in a wind-down situation are big issues.
Additionally, banks have been struggling with allowing bonded accounts receivable to act as collateral for a line of credit. When a contractor fails to finish work on a bonded contract, the bonding company usually is entitled to collection and not the bank. Therefore, if a contractor’s business consists predominantly of bonded work, a bank line of credit needs to be underwritten as unsecured, unless additional outside collateral can be provided.
In today’s lending environment, contractors in search of financing must do everything they can to position their companies in the best possible light to bankers and potential lenders and avoid the high risk lending factors mentioned above.
Banks will evaluate a contractor’s credit worthiness by analyzing financial and non-financial information.
Sample financial information includes:
- 3 years CPA prepared financial statements, reviewed or audited
- Jobs in progress schedule, identifying bonded and non-bonded jobs
- Accounts receivable detail, identifying bonded and non-bonded jobs
- Accounts payable detail
- Fixed asset appraisals on equipment and real estate in collateral pool
- Personal financial statements of owners
Sample non-financial information includes:
- Bonding company agreement and program
- References on credit history
- Listing of litigation in progress
- Listing of previously completed work
- References on job performance
It is critical for a construction firm to make a proper loan request as it relates to lines of credit and long-term debt. Generally, banks will evaluate lending maximums to a contractor based on a variety of factors. For lines of credit, the maximum line of credit a bank will consider a factor of 10 percent to 15 percent of annual revenue. For equipment financing, a bank will evaluate a loan request for 80 percent of the purchase price of construction equipment. This is in comparison to an equipment finance company, which will generally be able to lend 100 percent of the purchase price.
Construction companies need to keep in mind that banks are focused on requiring financial covenants to be part of the line of credit and term loan agreements. A construction company needs insure compliance with the negotiated covenants to eliminate exposure to a credit default.
Most common covenants considered by banks include:
- Current ratio
- Net working capital
- Liquidity minimum
- Debt to equity
- Funded debt to equity
- Cash flow coverage
While lending to the construction industry continues to present underwriting challenges for banks, it is an industry in which banks do lend to frequently. It is critical that a construction company position itself in the best light and provide accurate reliable financial information to the bank during the loan request and loan monitoring periods. Banks look very favorably to companies that borrow to support growth in operations and not to finance historical losses. For construction companies, the best opportunity to obtain a loan while mitigating the risks to the bank is to providing the most accurate financial and non-financial information as part of the loan request.
Todd A. Feuerman is CPA, MBA, CCA, and Director at Ellin & Tucker, Chartered