Strategies for Managing Your Debt

For many contractors, liquidity is becoming increasingly stretched due to growing backlogs, ever-slowing collections, and retainage requirements.

In addition, many contractors are buying construction materials in bulk given continued price escalations and the need to finance additional equipment to support the aforementioned increase in backlogs.
All of these factors have resulted in many contractors relying heavily on debt to provide the necessary liquidity to run their business. Throw in a rising interest rate environment and it becomes apparent that effectively managing your debt is as important as ever.

Consider terming out a portion of your line borrowings. Line borrowings are designed to be used for working capital needs.  However, I have worked with many contractors that have used their line of credit for capital expenditures, distributions, ownership buyouts and even to fund losses. While these uses are not what the line of credit was intended for, borrowings for these purposes happen from time to time. The concern with non-working capital borrowings is that they can add up over time and choke a contractor’s liquidity as line availability may be used up and/or insufficient to fund increased accounts receivables (A/R).

You can create additional availability on your line of credit by taking a portion of the line of credit that represents amounts used for non-working capital needs and creating a new term loan.  Keep in mind, you and your bank should consider your ability to generate enough cash flow to service the new required principal payments. You should only term out the amount outstanding on the line you expect to be outstanding for several years. If there is insufficient pledged collateral for the new term loan and line of credit, the bank may require additional collateral and/or a guarantee for the new term loan.

Terming out a portion of your line outstandings is also positively viewed by your bonding company. By terming out a portion of your debt, you will improve your working capital ratio (current assets divided by current liabilities) as you are now classifying a portion of your outstanding debt as long-term. It also institutes a discipline of reducing debt over time. While we bankers like to see our clients have outstanding debt, we do like to get paid back from time to time!

Balance the amount of fixed rate and floating rate debt. Once you determine the amount of debt you have that will be outstanding for several years, you may want to consider locking in the rate of this debt. While this rate will be higher than the floating rate, you will at least know exactly the amount of cash you will need to cover the principal and interest payments on this debt.

After seven prime rate increases during 2005 and three thus far during 2006 (2.75 percent total), many contractors say to me they wish they had locked in a long-term rate for some of their debt.  Clearly, this could have saved them a significant amount of money. However, many contractors were not interested in fixing a rate two years ago given the much lower floating rate they were paying relative to the fixed rate offered at the time.

The lesson is: You should diversify your interest rate risk. When you invest in stocks, many will tell you to diversify into different industries to mitigate investment risk. Shouldn’t the same be true for your interest rates? You should have a good balance of fixed and floating rate debt. That way, you have some protection in both a rising and lowering interest rate environment.

Ask for incentive pricing. Most of the lines of credit I see for contractors have set pricing until the maturity of the note. If a covenant is violated during the term of the note, many times the bank will increase pricing or charge a fee for the covenant waiver. If the bank is able to increase your pricing with poor financial performance, shouldn’t it also agree to lower pricing if financial performance is strong? Many banks will offer different pricing levels based on a leverage ratio and/or equity level. If you are able to achieve the agreed upon financial results, the bank is required to lower the rate on your line. You can also apply this strategy to reducing guarantees.

Understand your financial covenants. In almost every deal, the bank will have financial covenants. The bank can call your loan in default if you violate one of these covenants.  Therefore, it is imperative that you understand how the bank is calculating these covenants.  Request from you banker a sample calculation of all of the proposed covenants with your most recent year-end and interim financial statement. Then have your financial professional model the proposed covenant levels using the bank’s calculations and different financial assumptions for the coming year. By going through this exercise you can make sure the bank’s covenant levels provide sufficient cushion to avoid a covenant violation and having to potentially pay a waiver fee.

Have an attorney review your loan documents. The banker you are working with does not prepare the loan documents, the bank’s attorney does. Why then would you review the documents instead of your attorney? While there can be additional costs associated with having an attorney review the documents, you might be able to avoid having unreasonable clauses in the loan documents like the “general insecurity clause,” which enables a bank to call the loan in default if at any time it deems itself insecure. That means, if you decide to part your hair on the opposite side one day and the bank does not like the way it looks, it can deem itself insecure and attempt to call your loan in default. Leaves things pretty open doesn’t it? Bankers are willing to negotiate various items within the loan documents like the general insecurity clause. That is why it’s a good idea to have an attorney identify these items to discuss with your bank before you sign the deal.

Request a two-year line of credit. Historically, banks did not offer greater than one-year tenors on its lines of credit as it did not need to reserve capital against lines of credit that had a one year or less maturity. New banking regulations now require banks to reserve capital based on a company’s risk rating rather than the tenor of the commitment, therefore, virtually all lines of credit have to be reserved against. Since it does not cost the bank any less to have a one-year line, why not see about having a two-year commitment? This will once again help with your bonding company as they prefer to see long-term commitments from banks.  It also avoids having to go through the renewal process every year.

Maximize your pledged assets. While the primary assets securing your line of credit are accounts receivable and inventory, the bank will also take additional collateral including equipment and real estate.  While it may be necessary to do so if significant advances on the line were used for purposes other than working capital and/or the company experienced recent financial difficulty, it is worth a discussion with your bank to make sure you are getting full credit for your pledged assets.

Ask the bank what its particular advance rates and eligibility requirements are for equipment, real estate, accounts receivable and inventory. Have your financial professional apply these advance rates and eligibility criteria to your pledged assets then subtract the amount of debt the bank has committed to the company. If the bank is significantly over-collateralized, you may want to ask the bank to release some of the collateral, or increase the commitment to a level that is more in line with the value of the assets pledged.

Most importantly, have a good open line of communication with your banker, and make sure your banker has a good understanding of your business. It is equally important that you take time to meet and develop relationships with the decision makers at the bank. Going through a full review of your credit with your bank provides a good opportunity to accomplish these goals and will hopefully provide you with a much-improved credit structure.

Construction Business Owners, July 2006