What do Banks Look at When Evaluating Creditworthiness of Contractors?
Reading Time: 3 minutes
As credit begins to loosen, cash begins to flow and the building community starts to recover, we are in a unique position to advise both contractors and banks as to legal issues pertaining to loan origination due to our practice focuses in banking and construction. Contractors often ask us to reveal the secrets of how to be viewed as the best candidate for a loan or credit to further expand their business. Thanks to Dev Strischek’s (Senior Vice President and Senior Credit Policy Officer at SunTrust Bank) recent article in the RMA Journal, we have an insider’s perspective on how banks can judge if a contractor is creditworthy or not. As Dev Strischek points out, there are a few key financial ratios derived from the balance sheet that can allow credit officers to quickly and easily screen the contractor’s credit risk. This blog post summarizes those key ratios.
1. Cash- Oddly, most contractors are cash poor despite having comparatively high levels of cash assets on hand. So why does this contractor liquidity crisis always occur? Strischek points out that this crisis is caused by “bunching of receivables toward the end of the month and the need to cover weekly payrolls.” The construction field requires some flexibility (i.e. only monthly billings and receivables, yet weekly payroll) and cash provides just that. Thus, banks are eager to see contractors with a high cash asset position because it has the flexibility to cover weeks of payroll in the event of a payment cycle disruption. Banks do not consider contractors unworthy based on higher cash levels, for it is how their financial life is mandated to be.
2. Fixed Assets- Contractor’s assets are mainly concentrated on their equipment and tools. On average, Strischek states that their percentage of total assets range from 20% to 30+%, which is a large number considering the majority of contractors rent equipment. Contractors who carry net fixed assets of less than 25% of total assets are healthy credit risks.
3. Receivables and Payables- When it comes to contracting evaluating the receivables-to-payables ratio is very difficult. Historically receivables should be greater than 2:1 over payables. Strischek points out, “there is no good reason why payables should ever exceed receivables.” If that happens, the contractor is usually seriously past due with trade creditors and relegated to a C.O.D. status. Any ratio above 2:1 receivables to payables indicates financial health.
4. Under and Overbillings- Strischek states the obvious saying that “no contractor likes to underbill and none of the contractor’s clients wants to be overbilled.” If a contractor is able to keep a good balance and maintain both under 5% of total assets then it is a very good sign.
Lastly, Mr. Strischek’s article provides a quick and easy checklist for deciding the “high grade and low grade prospects” of a potential contractor borrower and using a real life credit as a case study.
If you are a contractor and you find yourself in a position where you are in need of representation with negotiating loan terms, you should contact an attorney who understands both banking and construction law in order to assist you in receiving the most provident bargain the market will yield.