There are two types of financing available to the construction industry to satisfy short-term capital needs, standard and substandard. Banks and large institutional lenders provide standard financing, sometimes referred to as first tier financing. Lenders willing to assume greater risk provide substandard financing, often referred to as second tier financing.
The difference between the two is that standard financing is usually provided at a very competitive rate to qualifying companies while second tier financing is typically much more expensive due to the higher level of risk that is assumed. A financial relationship with a first tier lender is more desirable because the money is less expensive.
Short Term Debt
Short-term refers to the time for which a loan is required and the period over which its repayment is expected to take place. Short Term Loans usually take the form of revolving lines of credit. These finance the day-to-day operations of the business including wages of employees and purchases of inventory and supplies. The amount of the operating line of credit will be determined from projected cash flow information. Lenders favor businesses that exhibit strong management, steady growth potential and reliable projected cash flow (demonstrating the ability for the business to pay the monthly interest payments on the line of credit from its projected revenues.)
Revolving Lines of Credit
A typical agreement with a first tier lender is a revolving line of credit. This is a long-term commitment by a commercial lender to provide a source of funds to support the day-to-day expenses of a business up to a maximum dollar amount. The business normally draws upon the line to meet daily obligations and applies sales revenues to “pay down” the outstanding balance whenever the funds are available to do so.
This up and down, fluctuating nature of the loan amount (account balance) is why it has come to be called a “revolving line of credit.” There is no scheduled repayment of principal because there is no set principal amount of the loan. The interest rate normally floats at 1%-3% above the prime rate and is applied to the daily amount of loan outstanding in that account during the course of any month. There are usually no other account service fees.
Traditionally, revolving lines of credit are the preferred borrowing formats of most construction companies because of the large fluctuations in cash flow. The normal sources of these loans are commercial lenders, the chartered banks, and more recently, some credit unions. Most commercial businesses require differing amounts of cash each month to meet their actual operating commitments; they want to pay only interest justified by the actual usage of borrowed cash (without penalties) and pay nothing at all when revenues are entirely sufficient to pay the month’s expenses. This requires a special kind of loan that can provide long-range flexibility (allowing the principal of the loan to vary from month to month); that can temporarily cancel the loan without penalty in a month where borrowing is not required; and that can provide an almost automatic approval from the lender for each new loan amount (to a maximum overdraft.) While a Bank Overdraft format might achieve some of this, the more commonly accepted way is to use a revolving line of credit.
Security for Working Capital Loans – Assignment of Book Debts (Receivables)
The lender uses accounts receivable (the money owed by customers) and inventory as the security (collateral) for the loan. For accounts receivable, lenders may lend between 50% and 75% of the total receivables outstanding, first deducting any invoices that have gone over 90 days. On inventory, lenders may lend up to 50% against cost, based on supplier invoices. Any additional cash required must come from your own resources or by careful management and re-circulation of the business’ profits and cash.
The receivables are assigned to the lender to secure the operating line of credit. These are still collected by the business but in the event of business default the lender can assume collection of these directly. The assignment is supported by the monthly submission of the list of receivables.
Personal guarantees are nearly always required in small to middle market companies. The personal guarantee states that the principal makes an agreement that if the limited company is unable to repay the loan, they will do so personally. If this guarantee is on top of other security, attempt to negotiate a limited guarantee to cover only the shortfall in the security. Recover the personal guarantee as soon as the business has paid off its obligation or can carry the debt on its own security.
More Short Term Instruments
Modern Overdraft Scenario
More recently the banks have fine-tuned this program to what could be called a planned overdraft scheme. The bank will approve a business for a certain overdraft amount. They no longer work with a series of pre-signed drafts. The actual interest rate has been dropped to one to two points above the prime rate and a system of service charges for the overdrafts has been substituted to make up the difference.
Interim loans are a type of bridge financing intended to “bridge the gap” between the time a specific receivable is received in cash and the time the company’s payables become due. The assignment of the receivables is the primary security for the loan. This is quite common where a government agency purchase has been made. The lender knows the customer will pay, but also that the cash may take some time to collect. When a government financial assistance program makes an award, reimbursable only after the monies have been spent or the project is in place, bridge financing is an appropriate format.
Approaching Short Term Debt Lenders
Commercial Banks/Credit Unions
The Commercial Banks and Credit Unions are normally prepared to offer financing based on accounts receivable bridging and/or inventory purchases. Revolving or operating lines of credit (and overdraft schemes) are offered by the major commercial banks and some credit unions.
Loan evaluation tends to be more rigorous and sophisticated than mortgage loan evaluation. In summary, the lender is evaluating the immediate abilities of the management team, the collateral available to support the loan and the short-term commercial viability of the situation as portrayed in the projected cash flow financial submissions. This cash flow projection will normally be included in a detailed business plan providing extensive information on the management of the company or project; a detailed history of the business, its current products, its production methods, its operations, its position in the marketplace; the purpose for which the loan is intended (in intimate detail); any security available to be pledged; and extensive financial information and projections.
One might think that getting money from a first tier lender would be easier than from a second tier lender, this is not the case. As a matter of fact, obtaining working capital from a bank or institutional lender is much more arduous of a task than obtaining money from a second tier lender. It is not unusual for it to take six months to secure a loan from a bank, while securing one from a second tier lender or private lender can take as little as thirty days.
In order to obtain a loan from an institutional lender you’ve come to the right place. Druml Group has been securing loans for contractors for over 20 years. We have the resources and the knowledge to bring you the best deal, well suited to your company.
Call us today and we can begin the process of getting you the money you need.