White Paper: Smart Debt Structure Is Critical to a Contractor’s Success

Almost every contractor with a significant equipment fleet knows the company must balance working capital and cash flow requirements with the need to invest in a new and more efficient construction fleet. Contractors are often caught in a tug-of-war between their surety and their bank on one side and the equipment needs of the field operations on the other side.

Getting the right balance in this struggle can mean the difference between success and failure for the contractor. Contractors with the right balance can obtain the equipment they need in the field and the surety bonding and capital requirements necessary for success.

The Contractor’s Financial Needs
As always, contractors need cash to fund their work on a daily, weekly, and monthly basis. Tangible working capital is the best indicator for this. Working capital comprises current assets (primarily cash and current receivables) less current liabilities (accounts payable, accrued expenses, billings in excess of costs, and current debt maturities). As everyone knows, equipment and other fixed assets are not included in working capital, and long-term debt does not count against working capital. Stock investments, inventory, and costs in excess of billings (under-billings) are discounted or excluded by most users of contractors’ financial statements and are not fully valued when computing tangible working capital. When analyzing the components of working capital, a contractor should simply ask this question: “Will the asset make payroll?” Old receivables, non-turning ­inventories, under-billings, and similar current assets do not convert to cash quickly and consequently are not available for payroll when needed.

When working capital increases, the amount of work a contractor can successfully perform also increases. More painfully, if working capital decreases, the amount of work must also decrease. Lack of tangible working capital is the number one reason for contractor failures—they simply run out of cash.

A good rule of thumb for the amount of working capital a contractor needs is 10% of expected annual revenue. A contractor expecting to perform $50 million in volume next year should target having $5 million of working capital. The amount of work subcontracted to others, owner payment terms, retainage amount, and other factors can affect how much working capital a contractor requires. However, 10% is the best and safest benchmark for a contractor, particularly a contractor in the heavy highway and civil construction sectors. Most sureties and state DOT prequalification departments start with the 10% benchmark in computing the amount of work a contractor should perform.

The amount of “interest-bearing” debt a contractor has on hand is another very important financial consideration. As a rule of thumb, most sureties limit a contractor’s debt levels to less than 80% of equity. Debt above 100% of equity is a concern. The structure of the debt terms and the related collateral base is equally important as it affects both working capital and the amount of cash available in future years.

Debt Structure
Many contractors and some financial advisors underestimate the importance of structuring debt correctly. Most informed users of a contractor’s financial statements will see through poorly structured debt, especially surety analysts. It is common for a surety underwriter to impute certain adjustments to a contractor’s financial statements that will significantly change the amount of working capital.

Most sureties automatically impute an entry for off-balance sheet leases as if they were debt on the balance sheet. An adjustment to discount ­certain assets will correspondingly reduce the equity amount. Sureties also routinely reclassify so-called “13-month” debt maturities as current maturities, reducing working capital significantly. (As explained below,”13-month debt” is technically long term due only to the maturity date, but in reality should be treated as short-term debt.) Many contractors find out about these adjustments when it’s too late to do anything about it. This makes it critically important to choose the right lender and the proper debt structure on the front-end.

Know that the cheapest interest rate is not always the best deal or the smartest option. If debt is poorly structured and reduces the surety capacity for the contractor, the opportunity cost of losing additional construction projects will far outweigh the cost of an interest point or two.

Lines of Credit
Most contractors choose to have a line of credit as part of their debt structure. A line of credit is often utilized to provide extra cash flow during peak volume times in the month or during the year. Many sureties will give “extra credit” to a contractor who has a line of credit on standby to meet additional cash flow needs. Some state transportation departments also give extra prequalification capacity based on unused lines of credit.

Lines of credit normally provided by banks and other traditional lenders are often …

To continue reading the full article, which includes additional case studies and in-depth reporting, check out the May edition of Erosion Control. Please click here. You may need to log-in or subscribe to our magazine.