It is common for surety companies to want their contractors to obtain a bank line of credit for their business. To surety companies, a bank line can be the equivalent of financial insurance, giving contractors access to cash when receivables are slow to collect, change orders take time to get approved, or in the worst case, there is a job losing a lot of money with major disputes. There is an old saying that banks won’t lend you money when you need it, so lines of credit are best obtained when times are good.
While some contractors obtain bank lines of credit simply to appease their surety, many don’t understand the covenants that the lines of credit contain and the impact that can have on their ability to borrow on their line when it’s needed most.
We are occasionally asked by our contractors to review their bank covenants to give them guidance and share our experience on what we normally see. Here we will walk you through some common covenants, challenges they can present, and factors you should consider when negotiating which are right for you with your bank.
Examples of Common Bank Covenants
Each bank is different in their approach to covenants and which ones they include in lines of credit. It may depend on your financial strength, what you intend to use the line for, the type of work you perform, and their own philosophy on managing the credit they extend. Below are some of the most common covenants we see in our contractors’ lines of credit and some important considerations with each.
Version A
- Maximum Total Liabilities to Tangible Net Worth (also called Debt to Worth) Ratio
This ratio measures a contractor’s leverage and whether the company has enough equity in the business to safely operate. A 3 to 1 ratio may be common for general contractors who don’t require as much capital while a 1.5 to 1 ratio may be viewed as more acceptable for sub-trades.
- Minimum Tangible Net Worth
The most important thing with this ratio is to understand what the bank considers “tangible”. Often banks, like sureties, will exclude certain assets from a contractor’s financials like disputed receivables. If you have a net worth of $1 million but you have a disputed receivable of $100,000, your bank may view your net worth as $900,000.
- Current Ratio
This covenant is calculated by dividing your current assets by your current liabilities. It is similar to the one above for net worth as it calculates the balance sheet strength, and I’ve seen the ratios range from 1.00 for a general contractor to 1.5 for certain sub trades that may require more liquidity.
- Net Income
Many banks have a requirement that you show at least $1 of profit. This is very important to understand, because this means if you breakeven or have a very small loss, you may be in violation of your line of credit even if your company has a strong balance sheet.
- Maximum Funded Debt to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization)
This ratio essentially ties the amount of debt a contractor can have to their income. So, if you earn less in a given year, you’ll be able to draw less on the line of credit. Not an ideal situation, especially since you’re more likely to need the line in a down year. We typically recommend avoiding this covenant.
- Minimum Liquidity
Requires the contractor to have a certain amount of cash to borrow on the line of credit, and when do contractors typically borrow on their lines, when they’re low on cash. This is a very restrictive covenant that most contractors should avoid.
- Out of Debt Requirement
This very common covenant is often referred to as a “30 day clean up period”, and it requires contractors to pay off the line of credit for 30 days. This can be challenging to do if you are borrowing on the line because you ran into a problem job or have an old receivable or change order that will take a while to collect.
Version B
- Maximum Total Liabilities to Tangible Net Worth (also called Debt to Worth) Ratio
This ratio measures a contractor’s leverage and whether the company has enough equity in the business to safely operate. A 3 to 1 ratio may be common for general contractors who don’t require as much capital while a 1.5 to 1 ratio may be viewed as more acceptable for sub-trades.
- Minimum Tangible Net Worth
The most important thing with this ratio is to understand what the bank considers “tangible”. Often banks, like sureties, will exclude certain assets from a contractor’s financials like disputed receivables. If you have a net worth of $1 million but you have a disputed receivable of $100,000, your bank may view your net worth as $900,000.
- Current Ratio
This covenant is calculated by dividing your current assets by your current liabilities. It is similar to the one above for net worth as it calculates the balance sheet strength, and I’ve seen the ratios range from 1.00 for a general contractor to 1.5 for certain sub trades that may require more liquidity.
- Net Income
Many banks have a requirement that you show at least $1 of profit. This is very important to understand, because this means if you breakeven or have a very small loss, you may be in violation of your line of credit even if your company has a strong balance sheet.
- Maximum Funded Debt to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization)
This ratio essentially ties the amount of debt a contractor can have to their income. So, if you earn less in a given year, you’ll be able to draw less on the line of credit. Not an ideal situation, especially since you’re more likely to need the line in a down year. We typically recommend avoiding this covenant.
- Minimum Liquidity
Requires the contractor to have a certain amount of cash to borrow on the line of credit, and when do contractors typically borrow on their lines, when they’re low on cash. This is a very restrictive covenant that most contractors should avoid.
- Out of Debt Requirement
This very common covenant is often referred to as a “30 day clean up period”, and it requires contractors to pay off the line of credit for 30 days. This can be challenging to do if you are borrowing on the line because you ran into a problem job or have an old receivable or change order that will take a while to collect.
Version C
Maximum Total Liabilities to Tangible Net Worth (also called Debt to Worth) Ratio
This ratio measures a contractor’s leverage and whether the company has enough equity in the business to safely operate. A 3 to 1 ratio may be common for general contractors who don’t require as much capital while a 1.5 to 1 ratio may be viewed as more acceptable for sub-trades.
Minimum Tangible Net Worth
The most important thing with this ratio is to understand what the bank considers “tangible”. Often banks, like sureties, will exclude certain assets from a contractor’s financials like disputed receivables. If you have a net worth of $1 million but you have a disputed receivable of $100,000, your bank may view your net worth as $900,000.
Current Ratio
This covenant is calculated by dividing your current assets by your current liabilities. It is similar to the one above for net worth as it calculates the balance sheet strength, and I’ve seen the ratios range from 1.00 for a general contractor to 1.5 for certain sub trades that may require more liquidity.
Net Income
Many banks have a requirement that you show at least $1 of profit. This is very important to understand, because this means if you breakeven or have a very small loss, you may be in violation of your line of credit even if your company has a strong balance sheet.
Maximum Funded Debt to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization)
This ratio essentially ties the amount of debt a contractor can have to their income. So, if you earn less in a given year, you’ll be able to draw less on the line of credit. Not an ideal situation, especially since you’re more likely to need the line in a down year. We typically recommend avoiding this covenant.
Minimum Liquidity
Requires the contractor to have a certain amount of cash to borrow on the line of credit, and when do contractors typically borrow on their lines, when they’re low on cash. This is a very restrictive covenant that most contractors should avoid.
Out of Debt Requirement
This very common covenant is often referred to as a “30 day clean up period”, and it requires contractors to pay off the line of credit for 30 days. This can be challenging to do if you are borrowing on the line because you ran into a problem job or have an old receivable or change order that will take a while to collect.
Negotiating the Right Covenants for Your Business
Contractors would obviously prefer bank lines with no covenants, which is possible in some cases, but most banks will impose some. So, which ones are right for you? To decide that, it can be helpful to think about the situations in which you may need to use the line of credit. What would happen if you lost 30% of your company net worth next year? What if your biggest job had a receivable or disputed change orders equaling 20% of your net worth? Figure out what your balance sheet would look like from the bank’s perspective in those scenarios and whether you would be out of compliance with your line of credit covenants.
Conclusion
Violating a covenant isn’t the end of the world, because your bank has the ability to waive it, and if you have a good relationship and are in close contact, they are more likely to work with you. That said, it’s wise to understand what the covenants mean to avoid the position of not being able to access your line when you need it most, and follow Warren Buffett’s wise words about Berkshire Hathaway when he said, “We will never become dependent on the kindness of strangers.”
Get a payment bond quote now
We want to know more about how we can help your construction company get the right contractor bond for your next project.
