Financing: credit lines, loans and leasing

Even a well-run contractor needs outside money at times: to carry receivables during a busy season, to buy equipment, to fund growth or to bridge a slow-paying owner. The choice of financing matters beyond its interest cost, because each form of borrowing affects working capital, equity and the ratios that sureties use to set bonding capacity. This lesson describes the main sources of financing for contractors, how banks size and police an operating line of credit, how term loans and equipment finance work, how leases are accounted for and how they look to a surety, and what owners' money in the form of equity and shareholder loans does for the firm.

Interest rates in this lesson are illustrative. Actual rates depend on the central bank's policy rate, the lender's prime rate and the contractor's risk.

Sources of financing

A recurring theme is the difference between short-term and long-term financing. Money borrowed on the operating line appears as a current liability, so using it to buy equipment or cover a loss reduces working capital just as paying cash would. Financing a long-lived asset with long-term debt keeps the current portion small and protects working capital. Matching the term of the financing to the life of what it pays for is a basic rule that many failed contractors broke.

The operating line of credit

An operating line, or revolving credit facility, lets the contractor borrow and repay as needed up to a limit, paying interest only on what is drawn. It is meant to smooth the timing differences in the operating cycle: drawing when payroll and suppliers are due before owner payments arrive, and repaying when they do. A line that is fully drawn for months at a time is no longer bridging timing; it is funding a permanent shortfall, and lenders and sureties will notice.

Banks usually limit the amount available under the line to a borrowing base calculated from the contractor's receivables. Only eligible receivables count, and each type is margined at a percentage.

# Borrowing base for Kestrel at month-end (illustrative)
receivables_by_age = {"current": 3_560_000, "31-60": 1_970_000, "61-90": 900_000, "over 90": 470_000}
disputed = 380_000            # included in the 61-90 bucket
holdback = 2_700_000
priority_payables = 210_000   # government remittances due
eligible = sum(v for k, v in receivables_by_age.items() if k != "over 90") - disputed
base = 0.75 * eligible + 0.0 * holdback - priority_payables
limit = 4_000_000
print(f"Eligible receivables: {eligible:,}")
print(f"Borrowing base: {base:,.0f}; line limit {limit:,}; "
      f"available {min(base, limit):,.0f}")

Eligible receivables: 6,050,000
Borrowing base: 4,327,500; line limit 4,000,000; available 4,000,000

Kestrel's line has a $4 million limit, but on this month's receivables the margin formula gives a borrowing base of about $4.3 million, so the full limit can be used. If receivables aged or a large owner disputed a claim, the borrowing base could shrink below the limit at exactly the moment the firm most needs cash.

Covenants and reporting

Loan agreements include covenants: promises the borrower makes about its financial condition and conduct. Breaching a covenant gives the lender the right to demand repayment, raise the rate or impose conditions, even if every payment has been made on time. Contractors should know their covenants, test them each month, and talk to the bank before a breach rather than after.

liab, equity, intangibles = 12_750_000, 4_400_000, 0
cash_flow = 1_230_000 + 620_000 + 140_000 + 330_000   # net income + depreciation + interest + tax
debt_service = 380_000 + 140_000                      # principal repaid + interest
print(f"Debt to tangible net worth: {liab / (equity - intangibles):.2f}")
print(f"Debt service coverage: {cash_flow / debt_service:.2f}")

Debt to tangible net worth: 2.90
Debt service coverage: 4.46

The debt service coverage here uses a simple measure of cash flow, earnings before interest, tax, depreciation and amortization (EBITDA); banks define it precisely in each agreement, and some deduct taxes, dividends or maintenance capital spending. Total liabilities to equity is high for Kestrel at 2.9 times, but typical for a general contractor whose liabilities are mostly payables to subcontractors.

Term loans and equipment financing

A term loan is repaid over a fixed period, usually in equal monthly payments of principal and interest. Contractors use term loans for equipment, yards and buildings, and sometimes to convert a chronically drawn operating line into permanent financing. Equipment loans are usually secured on the equipment, with terms matched to its life and a down payment of 10 to 25 %. The payment on an amortizing loan is found with the annuity formula.

def payment(principal, annual_rate, years, per_year=12):
    r, n = annual_rate / per_year, years * per_year
    return principal * r / (1 - (1 + r) ** -n)
principal, rate, years = 350_000, 0.068, 5
pmt = payment(principal, rate, years)
bal, first_year_principal = principal, 0
for m in range(12):
    interest = bal * rate / 12
    first_year_principal += pmt - interest
    bal -= pmt - interest
print(f"Monthly payment: {pmt:,.2f}")
print(f"Principal repaid in year 1 (current portion): {first_year_principal:,.0f}")
print(f"Balance after one year: {bal:,.0f}")
print(f"Total interest over the loan: {pmt * years * 12 - principal:,.0f}")

Monthly payment: 6,897.44
Principal repaid in year 1 (current portion): 60,842
Balance after one year: 289,158
Total interest over the loan: 63,846

On the balance sheet, the principal due in the next twelve months is a current liability and the rest is long-term. That split is why a five-year equipment loan affects working capital far less than paying cash or drawing on the line: only about $61,000 of the $350,000 loan reduces working capital in the first year.

Leasing

A lease gives the contractor the right to use an asset for a period in return for payments. Contractors lease equipment, vehicles, office space and yards. Leases can be short-term rentals, long-term operating leases that return the asset at the end, or finance leases that transfer most of the risks and rewards of ownership and often end with a purchase option. The accounting depends on the framework, and it affects how the lease looks to a surety.

Sureties look through the accounting label. Whether or not a lease appears on the balance sheet, a contractor that has committed to five years of equipment payments has a fixed obligation. Many surety analysts add the next year's lease payments to current liabilities, or capitalize long-term leases, when they assess working capital and leverage, so that firms that lease and firms that borrow are compared on the same basis.

def pv_annuity(pmt, annual_rate, months):
    r = annual_rate / 12
    return pmt * (1 - (1 + r) ** -months) / r
buy = 240_000 - 80_000 / 1.07 ** 5
lease = pv_annuity(4_250, 0.07, 60)
print(f"Buy with loan, net present cost: {buy:,.0f}")
print(f"Lease, present cost:             {lease:,.0f}")
print(f"Advantage of buying:             {lease - buy:,.0f}")

Buy with loan, net present cost: 182,961
Lease, present cost:             214,633
Advantage of buying:             31,672

Owners' money: equity, shareholder loans and dividends

For a private contractor, the owners are often the most important source of financing. Every dollar of profit left in the business adds to equity and working capital. Many owners take money out of the business through salaries, bonuses and dividends in a way that minimizes their personal tax, and sometimes lend it back as shareholder loans. Sureties and banks pay close attention to these flows.

Choosing the right mix

There is no single right capital structure for a contractor, but a few principles hold. Fund permanent needs, such as equipment and the base level of working capital, with equity and long-term debt. Use the operating line for genuine timing swings. Keep enough unused borrowing capacity to absorb a bad month. Match equipment financing to equipment life. Watch how each decision affects working capital and equity, because those decide bonding capacity. And talk to the surety and bank early about plans for growth, large equipment purchases or owner distributions, so that the financing is in place before it is needed.