Contractor lines of credit

Underwriting Lines of Credit for Contractors.

In the last couple of years my employer has expanded its lending to contractors substantially. It used to be that we would stay away from this type of lending due to concerns about receivable payment tied to additional performance, the priority of bonding companies on bonded receivables, and our history with contractors in the past.  However, a new set of lenders have been successful in bringing in several large contractor relationships, and this has prompted me to write about how to underwrite them.

Hopefully, this post will help you understand the particular issues that need to be understood when analyzing a contractor borrower. If you are a contractor reading this, it will give you insight as to what your bank will be looking at. All commercial lending underwriting has to include a capable analysis of the five Cs. Capacity, Capital,  Collateral, Conditions & Character. In the case of contractors, a good analysis has to make sure that the following concerns are discussed, understood, and if needed mitigated.

Issue I: The bonding issue. This is definitely a problem when it comes to bank financing. Most of the largest jobs that your contractor will be involved with require the contractor to get a bond. The problem is that once the job is bonded, the bonding company has priority over the receivables associated with the particular job. The bonding company does not even have to file a Uniform Commercial Code (UCC) financing statement to be in first position. As an unsophisticated lender, it would be easy to do a search of the public records and mistakenly think that you have a first position on all of the receivables. However, the bonding company most likely already got an assignment of the payments from the job prior to issuing the performance bond.

How can you remove this concern? It really depends on the risk appetite of each lender. It is a completely acceptable position to say that you are comfortable with a line of credit to a contractor whose A/R is 100% from bonded work. However, you have to understand that you will be in a junior position when it comes to those receivables. As such, your loss in event of default will increase substantially so at the very least you better price that accordingly. On the other hand, you could set up an Asset Base Lending facility, and only allow non-bonded receivables in the advance formula. We favor the later approach, and it works well with our borrowers.

Issue II: Understanding backlog and Work In Process. There are benefits to having the present backlog / WIP report and historical ones when analyzing contractors. Because there is a lag between the bidding process, the signing of the contract, and the actual completion, it is easy to recognize trends, and gives the analyst an opportunity to ask questions to truly understand the business of the contractor. Be on the lookout for the following:

a)      A negative drift in the amount of backlog or the gross profit margin exhibited in the backlogs. Is the contractor losing jobs to the competition? Is the gross profit being squeezed by market conditions?

b)      A higher than normal cost in excess of billings. Are there a lot of change orders that have been performed without correct approval?

c)      A higher than normal billings in excess of cost. How will this affect the performance in the future if you have already billed for work that is yet to be performed?

Issue III:  Performing additional downside scenarios. As part of the underwriting for all commercial & industrial borrowers, a lender usually looks at breakeven scenarios to compute debt service coverage. These scenarios usually cover 3 situations. A) How much can revenue drop? B) How much can the cost structure deteriorate?, and C) How much can interest rates rise?. In addition, for contractors, we like to run an additional scenario D) What would happen if the contractor did not get a single additional job?

This is similar to a liquidation scenario, and is something that a lot of bonding companies do to analyze contractor’s cash flow. In this spreadsheet, the particulars of the WIP for your contractor will come into play. It could very well be that the contractor’s margins have decreased or that he has overbilled to the point of eliminating all future excess cash flow from its backlog. Anyway, it is a simple way to see where the business stands.

Here are the calculations that we do, feel free to use it or modify it as you please.


Analysis of Cash Flow from Backlog 06/30/2012




Total Contract Value



(Billings to date)



Remaining Cash Flow



(Remaining Costs)



Excess Cash



Billed A/R



Cost in Excess of Billings



(Deferred Taxes)






Billings in Excess of Costs



(Accounts Payable)



Excess Cash to Complete



(less: 1 year of Oper. Exp)



Net Excess Cash Flow to cover Debt Service


I could not find any books that cover the underwriting of contractor lines of credits that I could recommend for further reading. However, I did find a good book if you are trying to improve your knowledge of the financing skills required to run a small contracting business. Smart Business for Contractors

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