For construction companies, strong revenue does not always tell the full story. Cash flow can shift quickly between payroll, materials, subcontractor costs, equipment needs, retainage, and project delays. In this blog, Steve Watts explains how banks evaluate construction businesses, what makes the industry unique from a lending perspective, and why the right banking relationship starts with true industry understanding.
Having been a commercial banker for a good number of years, I’ve had a wide variety of clients including manufacturers, distributors, transportation companies, professional firms, non-profits, and contractors. Each sector has its own characteristics that sets it apart from other types of businesses. The purpose of this narrative is to articulate some of the unique ways banks work with companies in the construction industry.
To start off, construction companies have different banking needs and underwriting criteria than most other businesses. Revenue can be strong, but cash flow is often uneven. Payroll, materials, subcontractor costs, and equipment expenses are usually paid before a project is fully billed and paid. Retainage, delays, and change orders can add even more pressure as management works to keep crews busy and backfill for work delays. If a job is delayed and management is unable to shift crews to other jobs, the profitability of that job will begin to “fade”. Understanding the work in progress or “WIP” report and the unique nature of progress payment receivables are critical skills for the banker.
That is why banking a construction company requires more than a standard loan conversation. A banker needs to understand the industry, how to read and analyze the reports, how the business operates, how jobs are managed, and where cash flow gets tight. It should go without saying that timely reporting and accurate financial reporting are critical for both the bank as well as the company’s leadership – jobs can slip into loss territory if problems are not recognized early.
The WIP report is generally one of the first places we look. Reviewing the jobs, the margins, concentrations, and the overall status of work can tell us quite a bit. Is there job fade, is the contractor billing in excess of its earnings (or allowing costs to exceed billings), what does future cash inflow vs. outflow looks like, and how will repayment on our line of credit be covered? If the scope of a job is growing, is the contractor diligent getting change orders signed before doing additional work? Does the net future cash flow from the WIP cover projected overhead and leave sufficient cash to cover debt obligations? In addition, a couple important and unique factors to note regarding contractors are that receivables for progress payments aren’t always viable sources of collateral. If the job isn’t finished and the contractor defaults, the project owner isn’t likely to honor payment and, if the job is bonded, the bank takes a second position behind the surety issuing the bond. Given this, it is imperative that the banker review the WIP carefully because the bank’s primary source of repayment is found there, not in the value of the receivables as collateral.
On that note, another area of focus is on receivables because they impact cash. Is the contractor in a sector that is early on projects (e.g. groundwork, concrete work) where they don’t get paid retention for months? Or are they among the last on site, meaning they receive payment on the retention relatively soon after completing their work? These factors can determine the size of the line needed. Recent legal changes now allow contractors to bond around retention (for a price), allowing early payment in exchange for a bond assuring the project’s owner that any punch list items will be covered after the job is substantially complete. Another thing the banker will want to know is if the contractor is consistently filing mechanics liens to ensure past due receivables get paid? Over the course of my career, I’ve seen millions of dollars lost because this simple practice was not consistently applied.
Lastly, many contractors have need for equipment financing. The banker will monitor this part of the financials too, even if the loans are not issued by the bank. Contractors can benefit from manufacturers eager to move equipment by offering heavy discounts on financing. As tempting as this may be, too much debt creates a concern for the bank as it drains working capital and can put a significant strain on the contractor should the backlog tail off. The misconception that equipment can always be sold to pay off its debt can lead to a false sense of security. When the economy goes into a downturn, there is usually a glut of equipment on the market, which puts downward pressure on resale values. It’s always a good idea to keep equipment financing in check.
Lastly, treasury management should also be part of the conversation. Construction companies move money frequently and often work with a wide range of vendors and subcontractors. This creates complexity and increases fraud risk. Tools like dual approvals, ACH and wire controls, and positive pay can help protect the business and tighten internal processes. Furthermore, if a contractor holds retainage for its subs and carries deposits exceeding FDIC insurance limits, the contractor might want to discuss ICS accounts with their banker to provide FDIC coverage for those funds.
In conclusion, the best banking relationships are always built on industry understanding, responsiveness, and trust. Construction companies need a banker who looks beyond the basic financial statements to offer practical advice and who understands the pace of the business, the inherent industry risks, and who can help the contractor prepare for challenges well before they show up.