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To Lend or Not to Lend? That is the Construction Sector Question

August 15, 2018, 07:00 AM
Related: Conway MacKenzie

When seeking to invest in a company, most lenders, banks and investors look at EBITDA and growth plans to decide if they’ll fund companies in a particular industry. The construction industry is different as EBITDA provides only a small part of the overall view into a construction company’s financial health. For a more accurate and comprehensive picture, more in-depth questions should be asked. Among them:

  • Can the company fund its working capital needs?
  • Is additional funding necessary to stimulate growth and widen capabilities? 
  • What is the company’s historical performance? 
  • How stable and profitable is the company’s backlog?

Determining the answers to these questions is a much stronger indicator of future performance and the likelihood of loan repayment.

Reliable indicators for lenders can be found on the balance sheet, including the overall health of the company, work-in-process schedule (WIP), what transactions are taking place, and why additional capital is being pursued. The company's WIP schedule, which isn't a traditional part of a financial statement, provides a look behind the veil and can be an important part of the financial package provided by a contractor.

It is not unusual to hear contractors say, “Business is great. We’ve sold more work and want to add significantly to our workforce.” What they often seem to overlook is the limited amount of working capital available from lenders or investors to support more work. Such capital can be hard to find. In fact, most working capital providers do not lend to the construction industry because of the nature of accounts receivable activity (i.e. progress billings).

Fool’s Gold

A disconnect for many lenders is appreciating the balance sheet. What is unique for a contractor’s balance sheet compared to other industries is cost in excess of billings ("Under Billings," an asset on the balance sheet) and billings in excess of cost ("Over Billings," a liability on the balance sheet). These two items are a result of Percentage of Completion accounting (POC). POC accounting recognizes revenue based on cost versus cost estimates. The difference between revenue and what a contractor actually billed (cash inflow) is parked on the balance sheet as either an asset or a liability. Construction projects have a long cash cycle with labor typically paid on a weekly basis. Billing is done monthly, typically at the end of the month and collected 60 to 90 days later. Additionally, lenders should not take accounts receivable (AR) for granted as it can be "Fool’s Gold." A project may drag on for a long period of time, if ever completed. Customers could hold AR if they have concerns about a contractor’s ability to complete the project or the project accounts payable (AP) is large. Subcontractors and trade vendors can also place a lien on the project if they are not paid. This allows customers to offset a contractor’s AR with open AP. 

But not all AR is risky. Contractors providing regularly scheduled service have a better chance at finding funding than project-based businesses. An example is an electrical contractor who keeps 50 employees busy maintaining electrical systems and servicing facilities and overhead power lines. This is a reliable income stream because of its reoccurring client work. The receivable is collectable because the work is completed on a regular basis and there is a reliable agreement to fall back on, if necessary.

Contractors that have project-based businesses find a harder time locating funding. This modus operandi can be fundable, though, as long as projects get finished within a reasonable length of time. The customer will pay—if the contractor is around to finish the project. Revenue backlogs need to be thoroughly understood in order to determine future cash flow. This can be a very good indicator from a revenue perspective. Let's say you have a $25 million revenue company with a revenue backlog of $20 million. The contractor is thinking, "Wow, I have almost my entire next year's revenue on the books." However, this can be “smoke and mirrors” if, for example, the backlog includes projects that have been overbilled. As such, the revenue backlog may be $20 million, but the billing backlog (i.e. future billings), which indicates true future cash flows, is only $17 million.

This is the point where the balance sheet and the work schedule by project can shed light on where the company truly sits financially as it shows the strengths and weaknesses of a given entity’s projects. If not thoroughly knowledgeable about construction sector financial practices, a lender can be caught off guard with their investment not being used for its intended purpose. A common scenario for construction companies is possessing, say, $20 million of revenue backlog with a need for $30 million in cash to finish the project as the revenue backlog was overbilled. Another surprising construction sector practice is to bill for work that hasn't been performed yet. And, it’s not unusual for money paid on one project to be used for another project. A lender must closely follow the WIP.

When it comes to physical assets, asset-based lenders are extremely reticent to attaching value to equipment unless it is easily locatable and not used for specialty applications. The only remedy for a lender in a project-based scenario when the contractor defaults is relying on equipment owned. However, there are important nuances lenders need to be aware of when using equipment as a collectible asset. One has to consider: Is it industry-specific construction equipment, or, is it general construction equipment? By way of an example, energy company contractors use specialty equipment to build pipelines. When the energy market tanked, the associated equipment/collateral lost value.

Another example: Lending to a contractor where their equipment is used for general construction, such as an excavator. Every type of construction uses excavators and, as such, their equipment makes for desirable construction collateral as it maintains its value and is available for a wide range of potential construction projects. That type of equipment held its value when the energy sector collapsed and a lot of this equipment flooded the markets. The reason it still held its collateral value is that residential contractors were seeing a boom and bought up excavators at auctions.

Another consideration in using equipment as collateral is finding the assets. Simply stated: Will you be able to locate a company's assets should a doomsday scenario occur? For example, a lender’s collateral is the company’s fleet of pickup trucks. The construction company owner tells the bank, "I can leave those trucks anywhere, anytime and if you pull the plug on me, have fun trying to find out where the assets are, because none of the trucks have GPS." In this potential scenario, the collateral is potentially un-locatable and, thus, unreliable.

In another situation where equipment collateral was hard to leverage, a rental company that was renting equipment to a contractor wanted to repossess the equipment. Again, their problem was locating it. In this case it was sitting out on a pipeline project in a remote mountain range, making it impossible to retrieve without a lot of time, expense and effort. That reality provided the contractor with leverage to the disadvantage of the lender.

Providing capital for the construction sector can be a lucrative play if the wide range of considerations and potential pitfalls are understood and navigated properly. Risk versus reward? Certainly. But with the right approach, profits can be built from the ground floor up.

Michael Beaver
Managing Director | Conway MacKenzie
Michael Beaver is a Managing Director at Conway MacKenzie. Beaver is a Certified Construction Industry Financial Professional (CCIFP) Certified Public Accountant (CPA), Certified Insolvency & Restructuring Advisor (CIRA), Green Belt Six Sigma (GBSS) and Lean Sensei.
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