A Contractor’s Line of Credit Can Affect the Firm’s Bonding and Banking Relationships

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By Richard P. Higgins of McCarthy & Company

Building a solid foundation for good relationships with sureties and bankers is important for every contractor, impacting growth and profitability. Sureties and bankers rely on your credit history, payment record, credit score, and performance when making a credit decision. Sureties also factor the three C’s into their decision to issue a bond: a contractor’s capital, capacity, and character. In addition to these indicators, bankers and sureties also consider the following factors when determining a company’s creditworthiness:

Profitability – A contractor’s gross profit percentage and net income as a percent of revenue compared to industry averages.

Working Capital – To realize the expected profit margin on a job, a contractor needs to have enough working capital to meet short-term expenses; otherwise, the project might have to be financed, which increases costs and reduces profits.

Liquidity Ratios – Liquidity ratios (current ratio, quick ratio, and operating cash flow ratio) measure a company’s ability to pay debt obligations. Bankers and sureties will look at a contractor’s liquidity ratios to determine if the company is highly leveraged and using a high percentage of its revenue to pay off debt.

Although sureties like to see that a contractor has a line of credit (LOC) in place, using it can impact your ability to maintain your bonding capacity. Sureties will scrutinize how and why you are using the LOC to finance your business and specific jobs. Ideally, they are looking for minimal or no borrowings on the line.

What is a Line of Credit?

A line of credit is a predetermined amount of funding that can be borrowed over time from a financial institution such as a bank. The client can take out money until they reach the maximum loan amount and, in the case of an open line of credit, they can borrow the money again as they repay the debt. This arrangement is contingent on the borrower not exceeding the credit limit or missing minimum payments.

Like a credit card, you are required to make the minimum payment each month on your line of credit. Your account balance can fluctuate significantly depending on the amount you draw out of your account and the variable interest rate. By contrast, if you took out a loan, you would receive the funds in a lump sum with interest rates and payments fixed over the life of your loan.

What Do Sureties Look for in a Line of Credit?

Bank borrowings are fine for contractors and subcontractors, but sureties want to see:

Demand Clause – The bank can call in the LOC whenever they like, and the contractor will have to pay it back on demand. Therefore, surety companies consider lines of credits a current liability even if it is not due in more than one year. Banks that call in a line can have a devastating impact on a business.

Working Capital – Sureties (and bankers) are focused on working capital. The definition of working capital is current assets minus current liabilities. Sureties consider lines of credit a current liability. Therefore, they reduce working capital unless they are converted to term loans and reclassified as a long-term liability.

Cash vs. Borrowing – Most sureties want to see that cash and receivables are greater than your bank borrowings, so it is important to have the ability to pay off the LOC if the bank demands immediate repayment.

Extend the Maturity Date – Since most sureties will consider a LOC as a current liability, it is advantageous to have the maturity date extend beyond two years. Some sureties will reclassify some of the debt as a long-term liability if you can do so.

How Do Lines of Credit Affect Your Credit Score?

FICO and other credit-scoring models take many factors into consideration when calculating your credit score. The length of credit history accounts for 15% of your FICO score. Your payment history is particularly important in the calculation. Always try to make payments on time to improve your credit score.

Nearly a third of your credit score is based on your credit utilization. Many people think that a high balance-to-limit ratio on your LOC can hurt your credit score; although scoring models do not consider a LOC when they calculate your revolving utilization, sureties might. Therefore, paying your LOC on time could improve your score, as well as lowering your utilization ratio by paying down credit card debt.

When you apply for a line of credit, the lender will typically review your credit reports, which could negatively impact your credit score. Inquiries influence 10% of your FICO score. As long as you are not frequently applying for new credit, seeking a LOC should not have a major impact on your FICO score.

Why Not Get a Credit Card?

There are advantages to using a LOC instead of a credit card. The main advantage is that a LOC is not considered in your credit utilization ratio, so if you borrow money that you do not intend to pay back by the next statement date, a LOC might be a better alternative. Not making payments on a credit card would have a negative impact on your credit score.

On the other hand, the draw period on a LOC typically lasts only for a few years, and a credit card does not have a time limit. If you do not hit your borrowing limit, you can make payments with your credit card indefinitely.

What About a Term Loan?

LOCs are better for short-term capital needs, and term loans are better for long-term investments. Interest rates are usually higher on a LOC than a term loan. A LOC might not ever be used, so banks cannot charge the same rates as they do for a term loan unless the line is used. However, application fees and monthly maintenance fees associated with LOCs are often small compared to the hefty origination fees and pre-determined interest payments with a term loan.

LOCs and other forms of bank financing need to be used correctly and managed responsibly to maximize your surety bond capacity. Contractors need to keep their leverage ratios low to maintain their bonding capacity.

This article was originally published in the April 2021 issue of the Utility and Transportation Contractor.

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Richard P. Higgins, CPA, is the Managing Principal—New Jersey office for McCarthy & Company, PC. Contractors trust Higgins to assist them with a strategy to achieve their goals by looking at key indicators such as productivity, job costing, profit margins, and cash flow. Higgins helps contractors to establish realistic benchmarks to assess how well they are doing or to alert them to issues that need to be addressed. He can be contacted at 732.341.3893 or Richard.Higgins@McCarthy.CPA.