Understanding the Nuances of Lending to Contractors
Lending to contractors presents special challenges for banks due to the nuances involved in contractor accounting. This is important to remember now as activity in the construction industry has picked up again after spending years in the doldrums in the aftermath of the recession.
Methods for Contractor Accounting
Contractors can use one of two accounting methods: the completed contract method or the percentage of completion method. Many contractors use the former method for tax purposes and the latter method for book purposes.
With the percentage of completion method, revenue and costs are recognized as the job progresses, based on engineering estimates or the percentage of costs realized compared to estimated costs. For example, the foundation is 10 percent complete or steel is 25 percent complete. At these points, the contractor recognizes the appropriate percentage of revenue and estimates the approximate percentage of cost.
Unfortunately, recognition of revenue isn’t necessarily a true reflection of the contractor’s cash flow. So while 25 percent of a contract may have been billed because the job is 25 percent complete, the contractor may have only spent 10 percent of the money.
This results in what’s known as billings in excess of cost. Conversely, a contractor may have done work it hasn’t billed yet, which is known as cost in excess of billings. The former is listed as a liability and the latter is listed as an asset on the balance sheet.
Meanwhile, with the completed contract method of accounting, all costs accumulate on the balance sheet as work in process until the job is complete, at which point revenue and expenses are recognized.
The Job Status Report
The best way for a lender to analyze a contractor’s financial statements and thus make an informed lending decision is to receive and monitor a summary of jobs or job status report, preferably on a monthly basis. This job summary should include:
- Contract name, number and amount;
- Percentage complete;
- Amount of revenue and cost recognized to date;
- Profit or loss recognized to date;
- Estimated cost to complete and;
- Estimated or actual profit or loss.
Any good contractor should be able to compile this monthly job status report — easy-to-use templates are readily available online. If a contractor balks, it may be trying to hide problems with some (or all) of its jobs.
As you analyze the job status report, pay especially close attention to the following areas:
Percentage of contract completion — If most or all of the jobs have a high percentage of completion, such as 90 percent or higher, this may indicate that the contractor has little if any backlog and, hence, future revenue.
Conversely, if you see low percentages of completion compared to revenue recognized — such as 20 percent completion but 50 percent revenue recognized — this likely indicates that the contractor is front-ending jobs. While this is good news for cash flow, you need to make sure the contractor isn’t using revenue from the job for other purposes, like to finish another job or buy new equipment.
Percentage of accounts receivable that is retainage — This is the portion of payment customers hold back until a job is completed and a certificate of occupancy is issued. It’s usually between 10 percent and 20 percent of the total, which represents the profit on many jobs.
Retainage should be recorded as billed but reported separately in the accounting records from progress billings currently due. It should only be recorded as a current receivable after the job is finished and a certificate of occupancy is issued. This will be disclosed on audited financial statements.
Purchased but uninstalled materials — Materials that have been purchased and charged to a contract but not installed yet should not be counted toward the percentage of contract completion. Instead, they should be excluded from actual costs before computing the percentage of completion.
Accuracy of contractor projections — How well did the contractor estimate costs and revenue when bidding the job? What was the end result — a profit that met or exceeded projections or one that came up short, perhaps even resulting in a loss?
Based on the answers to these questions, you may need to carefully assess the competency of a contractor’s estimator, as well as the contractor’s ability to manage the job. In addition, assess the contractor’s history of completing jobs on time and on budget while paying all subcontractors in a timely manner.
Lending Against Contractor Receivables
In general, it’s not advisable to lend money secured by contractor receivables. These receivables, or billings for work in progress, are often contingent on the work being completed — so if the job isn’t finished, the receivables won’t be collected.
And on bonded jobs, the bonding company has the right of subrogation, or first claim on the receivables. This gives the bonding company payment priority over a bank’s right of assignment. So in most instances, lenders should only loan money secured by a contractor’s equipment.
You should also be wary if a general contractor ever needs to draw down its line of credit. GCs live off of their subcontractors, who incur most of the job costs. So if GCs have cash flow problems, they’ve usually done something else with the money — for example, they’ve funded losses, bought new equipment or used cash to support their lifestyle.
This doesn’t mean, though, that you shouldn’t give GCs lines of credit. These can be very profitable relationships: They provide steady fee income and the lines are rarely used, while GCs tend to maintain large deposits. But keep a close eye out for GCs who might be getting into financial trouble.
Start Preparing Now
From a historical perspective, some of the problems discussed here start to crop up in the late stages of an economic recovery or early stages of a recession.
Given where we are in the economic cycle — the current recovery has been going on for 98 months, making it the third-longest recovery on record — it would be wise to prepare now for how your bank will deal with potential problems like these in the months or years to come.
Please contact us if you have more questions about contractor accounting and the nuances involved in lending to contractors.