Manipal Dhariwal | Construction Executive
The outbreak of COVID-19 started in early December 2019, gradually expanding to the other countries of the world. The spread of the pandemic did not just affect the world in terms of health, but also made industries suffer across all verticals—leading to a few unique challenges for construction contractors.
From financial imbalance to trouble retaining cash flow, the circumstances have turned to be completely unfavorable for the contractors that rely on banks for essential surety credits to sustain. To prevent loss of liquidity, the contractors are leaning toward construction accounting software and other technology to keep their accounting data in place and avoid risks with project deliveries.
But still, there are many other factors that must be considered to maintain cash flow for potential credit availability such as debt agreements and lines of credit, which involve financing of equipment and vehicles.
Nevertheless, it is completely the responsibility of the contractors to stick with the guidelines related to the line of credit and debt agreements which in most cases are covenant ratios.
TANGIBLE NET WORTH VERSUS LIABILITIES RATIO
The tangible net worth versus liabilities ratio can be defined as an evaluation of stakeholder’s equity (net worth of the company/contractor) and the total amount of liabilities. This is generally considered by the banks to check the financial status of the company to ensure that they are capable enough to return the lending amount.
It can also be considered as the weight of liabilities on the company, which may limit the bank to allow any disbursement of the loan. However, the standard value which is considered to prevent loss of finance and ensure premiums are paid on time, banks usually follow the ratio of 3:1.
Debt service coverage ratio (DSCR) can be defined as an evaluation of available cash that can satisfy existing debt obligations. In other words, DSCR could be defined as the minimum amount of cash flow that the bank uses to determine the company’s potential to pay any debts, existing or forthcoming.
The formula for DSCR:
(Net Income + Depreciation + Amortization + Interest) – (Unfinanced Capital Expenditures) – (Distribution Paid to Stockholders) divided by (Total Principal Payments on Long Term Debt + Interests)
Most of the banks usually have this ratio to be kept under 1.25:1, as the satisfactory DSCR ratio is measured using the financial year statements, which help the lending authorities establish a contract with the contractor.
However, when it comes to surety credits, it depends on various other factors that may cause financial obligations to the approval process. These obligations take consideration of stockholder’s equity or the total working capital that is measured as the difference between company liabilities plus existing assets, with respect:
- Outstanding number of receivables (those older than 90 days);
- The total value of 50% to 100% of inventory;
- Prepaid expenses;
- All the payments due to be paid by the parties involved (should include affiliates); and
- Credit worthiness of any receivable notes.
- The cash surrender value for life insurance.
Though most lending agencies and banks prefer to check financial year statements to confirm the potential of the contractors, some finance companies even prefer to have a check on all the accounting data. For this reason, most construction companies these days prefer to use construction accounting software, as it helps to avoid financial scarcity as well as unnecessary overruns. But still, there are some essential guidelines that contractors and construction companies should follow to have better chances with surety credits when the financial year ends.
- To maintain a collection of all the outstanding receivable older than 90 days, which can help to pay debts and have an advantage with tangible net worth versus liability ration.
- Always try to keep the inventory to the minimum to have a greater lead time.
- Prepaid orders for items should be examined to counter upfront payment agreements and have reduced payments at the end of the financial year.
- All the dues from related parties should be cleared to improve cash flow and minimize liabilities.
- To approach banks or other lenders to finance existing equipment purchased in cash to improve working capital and minimize DSCR.
- Last but not least, the owner may lend funds to the construction firm so the amount could be subordinated to banks and surety to drive working capital. Also, the subordinated amount can serve as equity to the lending authorities.
All in all, aligning with these practices and rules could help meet all the requirements necessary to get financial aid from the banks. Further, this money could be used to drive business goals while making way to financial projections and meet banking requisites.
However, it is equally important for the construction firms and contractors to have planned actions when it comes to finances, even when using the finest construction software. Whether it is inventory stocking or purchasing of equipment, it should be done with careful consideration to attain surety credit driving business towards better growth and sustainability.