Understanding the Liabilities on the Construction Industry
Even though the outbreak of COVID-19 started back in December 2019, it started hitting the United States at the beginning of March 2020. Therefore, it would not be right to measure the actual impact COVID-19 has made to the construction industry in the United States. However, considering the circumstances, it will be all odds that we are likely to witness.
Either it is the financial situation of the contractors or maintaining the cash flow with no loss of liquidity, the situation is quite unfavorable for contractors to meet the banking requirements for surety credits. Though keeping up with all accounting data using reliable accounting software for construction firms could help, there are still many other aspects to consider.
To maintain cash flow and credit availability, all contractors generally follow two practices. These include Line of Credit and Signing Long-Term Debt Agreements to Finance Equipment & Vehicles.
Moreover, the contractors have to ensure that they meet all the guidelines necessary for Line of Credit and Finance agreements.Most of the times, these terms and conditions of the agreement are the financial covenant ratios:
1. Tangible Net Worth Vs Liabilities ratio
Liabilities Vs Tangible Net Worth ratio could be defined as a comparison between total liabilities and net worth of a company i.e. Stakeholder’s Equity. This ratio helps the bank to understand how much the company is weighed down.
In other words, the greater will be the weight of liabilities on the company the greater will be a risk for the bank on issuing any credits. Thus, to reduce the chance of risks and loss, the standard ratio for liabilities to equity is defined as 3:1.
2. DSCR (a measure of available cash flow to satisfy existing debt obligations)
DSCR, also known as Debt Service Coverage Ratio is defined as the measure of cash flow which determines the company’s ability to pay existing debts. DSCR is calculated by the formula:
(Net Income + Depreciation + Amortization + Interest) – (Unfinanced Capital Expenditures) – (Distribution Paid to Stockholders) divided by (Total Principal Payments on Long Term Debt + Interests)
Usually, banks prefer contractors who have this ratio to satisfy the standard ratio of 1.25:1. However, keeping up with the satisfactory ratio entirely depends on the financial year statements as it is the only factor that determines the terms of the contractor with the lender.
Apart from this, the Surety Credit depends on several factors along with financial obligations. Most of the times, these obligations are associated with the Stockholder’s equity/working capital, which is accounted as the measure of the difference between existing assets and company liabilities, adjusted on these factors:
- Receivables outstanding (older than 90 days)
- Fifty to Hundred Percent of Inventory
- Expenses that are prepaid
- Payments due by the parties involved (including affiliates)
- Credit Worthiness of any notes’ receivable
- The cash surrender value of life insurance
Most of the financial institutions rely on financial year statements to avoid any loss of money. However, if you are taking the best advantage of your construction accounting software, it can help you align well with good accounting practices. These practices are all about reducing financial scarcity while improving the chances of surety credit. Here are certain necessary guidelines that must be followed to ensure a great position at the end of the financial year.
- Collecting all the receivables that are outstanding for more than 90 days or greater. The contractor may use this money to pay off any debts and improve their tangible net worth to liability ratio.
- It should be made a part of the routine exercise to keep the inventory minimum to entail long lead time.
- The items that are purchased through prepaid expenses should be examined. This may require modification of agreements that involve upfront payments to reduce the payments at the end of the financial year-end.
- Any amounts due from related parties should be paid to increase cash flow and reduce existing liabilities.
- The construction firm may approach lending institutions to finance equipment and vehicle that are already purchased in cash. It can help improve the status of working capital while reducing pressure on DSCR.
- The owner may lend funds to the company. Further, this amount could be subordinated to surety and banks to improve working capital. Moreover, the subordinated amount could also be made to function as equity to the bank.
All in all, it is about preparing prudently to make it to all the requirements and guidelines for the success of your construction business. Aggressive and timely planning could help make way for financial projections with compliance with banking requirements. This could involve every business actions you make from reducing the inventory to picking a complete construction accounting ERP software for your firm. In short, satisfying the terms helps to maximize surety credit which could lead to growth and stability of the business, year after year.
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