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Boost Your Credibility With Bankers

Bankers routinely ask borrowers for financial information because lenders need to know if borrowers can repay the loans requested. Some key financial ratios help banks to identify bankable contractors; if contractors want to raise their visibility , it may be worth it to see how they stack up.

Specifically, banks are likely to analyze five interrelated financial indicators:

  • cash/total assets;
  •  net fixed assets/total assets;
  • receivables/payables;
  • underbillings/total assets; and
  • overbillings/total assets.

These measures share the advantage of all being balance sheet measures, and none of them require information from the income statement. Their second advantage to the banker is that only one balance sheet is necessary to perform the screening test, which evaluates whether the contractor has invested in the right combination of cash and fixed assets to meet customers’ project expectations for satisfactory work delivered on schedule. Third, Risk Management Association (RMA) industry statistics are available for all five of them, including the most recent five years. RMA statistics are derived from financial statements of existing borrowers provided by RMA member banks, so these are contractors who are current clients of the banks. Thus, the statistics outline a profile of bankable contractors.

Cash. One irony of contractor financial life is the constant need for cash despite seemingly high levels of the stuff on the balance sheet. In fact, RMA industry statistics routinely report that on average, contractors carry 10 percent to 12 percent of its total assets in cash, nearly double that of other non-contractor businesses. So why do contractors tend to run on empty in the race for cash month in and month out? There are two basic reasons, the bunching of receivables toward the end of the month and the need to cover weekly payrolls.

Project billings are usually submitted toward the end of the month for processing and payment at the end of the month. The month-end payment practice means very little cash flowing into the firm during the rest of the month. Meanwhile, contractors typically pay workers weekly because of trade practices, high employee turnover and various regulatory requirements. Consequently, the prudent contractor will bankroll four weeks of payroll at the beginning of the month. A non-construction firm with two payrolls a month and a steady flow of customer payments over the month is likely to be able to begin the month with just enough cash to cover a two-week payroll, half what the contractor needs. These facts of financial life reconcile the higher cash levels of contractors with their higher liquidity stress levels. A positive sign is a contractor with cash balances averaging 10 percent or more.

Fixed Assets. Another fact of contractor life is the need for fixed assets—construction equipment, tools, rolling stock, etc. Nevertheless, net fixed assets as a percentage of total assets generally runs 20 percent to 25 percent, and it only rises above 30 percent for heavy construction contractors such as those engaged in the road and bridge, pipeline, cable, and related fields where large amounts of material and earth must be moved. Many contractors keep their fixed asset investment low by renting equipment for specific projects. Tools are generally expensed, and many trades carry their own tools anyway. A positive sign is a contractor with net fixed assets under 25 percent of total assets.

Receivables and Payables. RMA’s Annual Statement Studies has been tracking the receivables/payables ratio for many years, and this ratio has generally averaged better than 2-to-1 over that period. The ratio compares receivables to accounts payable, and in a typical project, materials comprise a relatively small percentage of the total bill. Further, gross profit margins have averaged around 20 percent for the construction industry, so that leaves 80 percent to cover total costs. In turn, the two large components are labor and materials, and materials are the smaller of the two. The result is that materials are often only a third to 40 percent of the total billing. If receivables reflect billings and payables include primarily accounts payable, the receivables/payables ratio is usually going to run 2.0 times and higher.

There is no good reason that payables should ever exceed receivables, and, in such instances, the contractor is usually seriously past due or relegated to C.O.D. status by its suppliers. Likewise, because of the close interrelationship between the company and its owners, the firm’s principals often are generating low credit scores. Therefore, a positive sign is a contractor with a receivables/payables ratio of 2.0x or better.

Underbillings and Overbillings. Underbillings and overbillings are two unique items in contractor accounting, and they are shorthand terms for the current asset “costs and estimated earnings in excess of billings” and for the current liability “billings in excess of costs and estimated earnings,” respectively. Because no contractor likes to be underbilled and none of the contractor’s clients wants to be overbilled, these two accounts tend to be very small, usually only no more than 5 percent of total assets. A positive sign is a contractor with both underbillings and overbillings under 5 percent of total assets.

Contractor Credibility Checklist

To see how a bank might size up a prospective contractor, look at Figure 1 Contractor Credibility Checklist review of a site preparation and landscaping contractor:

Figure 1. Contractor Credibility Checklist
Financial Measures

Credible if:

Actual

Yes

No

Comments

1-Cash/Total Assets

> 10%

11.5%

X

$500 cash on hand, remainder in bank account
2-Net Fixed Assets/Total Assets

< 25%

21.8%

X

Equipment, no real estate, probably leased premises
3-Receivables/Payables

>2.0x

2.3x

X

D&B shows prospect current in trade
4-Underbillings/Total Assets

<5%

3.2%

X

Next step—review CSR to identify UB’d jobs
5-Overbillings/Total Assets

<5%

3.4%

X

Next step—review CSR to identify OB’d jobs
Summary and Final Comment/Decision

5

0

Good to go to next level

The Figure 1 summary reflects that all five measures meet or exceed the five measures’ standards, so the banker will be moving on to the next level– evaluating the income statement, analyzing the contract status report (CSR) and calculating a downside cash flow. The next step lies beyond the horizon of this article, but the comments column offers some additional quick observations at this stage.

First, most contractors have cash on hand to deal with day-to-day petty cash requirements, e.g., travel and expense reimbursements, office supplies, postage, etc. Company purchase credit cards obviate most of the need for cash on hand. Because having petty cash raises the risk of internal theft, necessitates daily accounting of transactions, and requires physical security of the cash itself, petty cash balances should be minimal, under $1,000.

Second, the contractor’s net fixed assets consist entirely of equipment, so the absence of real property infers that the company operates out of leased premises. A banker’s next step would be to inspect the premises for any other equipment that might serve as possible collateral.

Third, a parallel step to calculating the receivables/payables ratio is ordering a credit agency report on the contractor, and in this instance, the Dun & Bradstreet report’s trade debt summary reports it as current, no accounts on COD or delinquent.

Finally, the last step in evaluating underbillings and overbillings is to identify which jobs are underbilled and overbilled and to find out what the contractor is doing to manage the underbillings and overbillings within the standards.

Remember, the purpose of the checklist is to help a banker to quickly identify bankable prospects and avoid less creditworthy borrowers. A cash flow projection would be the banker’s next step, and for that step, the lender will need the income statement, but that is beyond the scope of this checklist and a topic for further discussion and reading.