Surety Corner: What contractors should be thinking about in a changing lending environment

Surety companies prefer contractors who have established partnerships with strong banking institutions and have access to operating lines of credit.

From the surety’s perspective, operating lending should be used as a contingency fund for challenging times, such as cash flow shortages, disputes over receivables or to support business growth until the balance sheet stabilizes.

However, surety companies are cautious about contractors who rely on chronic bank usage.

In the event of contractor insolvency, a bank’s security takes precedence over the surety, negatively impacting the surety’s position. Chronic bank usage may also indicate cash flow difficulties, profitability challenges or struggles in converting receivables into cash.

Eric Ludwig, a manager of surety at Tokio Marine Canada, said when we spoke to him about banking and contractors: “From a surety’s perspective, we are paying close attention to those contractors heavily using bank financing to fund their operation. Not only due to rising interest costs affecting their P&L, but more importantly to ensure they maintain a healthy buffer in case of any kind of cash flow pinch. It is imperative that contractors complete medium term cash flow forecasting and incorporate provisions for uncollectable receivables. In addition to maintaining strong relationships with their lenders, we recommend contractors to keep an open line of communication open with their broker and surety, including covenant compliance and line of credit renewals to ensure there is no disruption in bond support due to lack of information flow.”

In the past, the construction industry benefited from easily accessible credit due to low interest rates and a high demand for credit following the 2008 financial crisis.

However, the landscape is changing. Banks are now scrutinizing their portfolios and being more selective about lending to specific industries. Additionally, the cost of carrying regular operating debt is increasing for contractors as interest rates rise.

Furthermore, banks are paying closer attention to the revenue sources of contractors.

Those heavily reliant on the private sector, especially residential construction, have faced challenges in recent years. While housing demand remains high due to immigration, rising debt costs and inflation in material inputs have caused delays and cancellations of private developments.

This puts pressure on contractors heavily reliant on this sector for revenue. This further underscores the importance of debt-serviceability. Contractors with high debt levels will experience increased servicing costs and, therefore, require stable revenue streams and profitable projects.

So, what should contractors do if they don’t fit into the category of having strong cash flows and equity bases or have experienced a difficult year?

Contractors who rely on bank financing should focus on strengthening their relationships with their banks. This includes transparent reporting, detailed financial projections and continued improvement in financial reporting sophistication, especially regarding project profitability tracking.

Effectively communicating the company’s business plan and direction is also worth considering. If banking support for the construction industry tightens further, these steps will be vital in maintaining a strong relationship and ongoing support from banking partners.

Furthermore, contractors with multiple sources of debt that are feeling the strain of servicing should look at consolidating debt and terming it out.

This can improve short term liquidity and ease the cash flow for the business. For those who find this difficult, they should be looking at rationalizing their fixed assets. Do you see the appropriate rate of return on each piece of equipment, is renting better than buying, do you need to purchase that property versus just renting? Reducing fixed assets to pay down debt is a viable option contractors can look to when looking to improve cash flow.

Lastly, plan ahead.

If your business is in growth mode or you have just secured your largest contract, make sure you consider the cash flow implications.

How will you finance holdback and can you negotiate payment terms with the owner? Ensure your payment terms with the owner match those with your subtrades and suppliers, if possible. Negotiate strong mobilization payments or have the owner pay for large high value items directly.

There are many tools available to contractors in handling cash flow and a changing lending environment, the most important thing is that businesses understand cash flow and the impacts that large debt loads can have on their success.

Andrew Cartwright is the vice-president of surety for FCA Insurance. Send comments and column ideas to editor@dailycommercialnews.com.