With the country in a recessionary mode and consumer confidence dropping, banks and lenders are being extremely cautious. Those companies in the construction industry, however, have continued to be a bright spot, experiencing continuing strong demand and profitability. Therefore, most mason company owners and suppliers are going to be well received at banks and non-bank lending companies. Interest rates on borrowing generally are based on the "prime rate," the best rates offered by major banks to their most credit-worthy customers, which (at press time) is currently 4.25 percent at most banks. Therefore, prime plus one percent floating would be 5.25 percent and prime plus two percent equals 6.25. Commercial mortgage rates have been higher, generally from 5.5 percent for the best clients to 6.5 percent and even seven percent for riskier projects as determined by the banks. This, then, is the current environment: favorable rates, but cautious lenders.
Strategies for Approaching Lenders
How should you go about getting yourself ready to approach your local bank or regional office of a national lender? First, you want to have your tax returns and operating results structured to show the history of your business over the past three years, on its best footing. Very often, the way your accountant did your tax return is not going to make your business attractive to a lender. Typically, separate company financial statements should be structured on an accrual basis, with Gross Revenue identifying product sales by revenue category and labor sales separately. The list of revenues by product can then be compared to direct costs of purchases, labor and possibly sales commission directly attributable to the subject category. Adding up the columns you will get Total Revenues to begin with and Total Direct Costs, resulting in Gross Profit. An interesting point for consideration on most masonry jobs is to include work-in-process as an asset somewhere, as often costs will include actual supplies and labor paid out already but the completed work has not been billed by the end of the accounting year.
From Gross Profit you want to deduct General and Administrative Expenses. There are policy decisions to be made here dealing with depreciation, amortization, prepaid costs and other expenses having to do with the owner's salary and expenses, which you may want to consider carefully. For example, automobile expenses can be handled in two ways. One is to pay the entire cost of key employee vehicles and charge a taxable amount to personal use; the other is to have the employee contribute cash as a payroll deduction for some prescribed amount of the total cost, like 40 percent.
In addition, most people know the smart strategy for paying owner salaries is to maximize them at the FICA level, approximately $84,000 times 6.8 percent, and take any other monies as dividends or advances bonused into the next tax year at the end of the current year. Thus the withholding taxes on additional key salaries will let you leave a profit in the company for debt structuring purposes, taking the same compensation, but reducing expenses by that amount. The tax rate operating as a "C" corporation is 15 percent on the first $50,000, so if you are a small business you can probably save money on the company paying tax at a low rate, which assists you with cash to amortize corporate debt.
Buying Real Estate
Another interesting method of making your company look better for financing, especially if you are buying real estate for company use, is to buy the building using the company lease as collateral. In this uncertain market there often will be a good buy on a commercial property where someone has foreclosed and a user-buyer is needed. The bank will be selling the property at a relatively low price and you want to use personal credit with the company lease being there as additional collateral to make the rate lower.
Typically a $1 million building with 20,000 square feet or a $50 per square foot price is a good buy today in most smaller- to medium-sized communities. But rent for such buildings may be $5 per square foot, delivering $100,000 in income.
Yet you can probably borrow $1 million at six percent interest, based on a lease with a good credit risk. The payments may be $75,000 per year and the tenant (company) picks up the taxes and maintenance as well. The depreciation on a $1 million building will typically be five percent of $800,000, or $40,000 per year, using straight line 20-years as a depreciation life. This will shelter the amortization plus $25,000 in cash flow, tax-free, in the short run.
Of course, a depreciated building may be subject to depreciation recovery on future sale, which may be some years off. Typically a deal structured in such a manner can result in the entire $1 million being available for borrowing, if not entirely, from a bank, then from a combination of bank and seller financing. Since the lease on the building is not a direct long-term liability only the current portion of leasehold payable needs to be a liability on the balance sheet this strategy leaves more room for additional corporate financing.
Consider my earlier comment about increasing profit by including work-in-process inventory on the balance sheet, where you cannot bill it to customers at the end of the accounting period. Many masonry jobs have materials and partially-completed work on-site on the last day of the accounting period and the costs of producing this inventory are typically included in expenses. Thus, failure to actually bill out the work with profit can be captured in an asset account called work-in-process inventory that will turn into a receivable as soon as you bill it. The accrued profit receivable can be a small additional profit to help your "financability."
Cash vs. Accrual Accounting
Cash versus accrual accounting is another issue. Many smaller business people do business on a cash basis, therefore, when you look at their assets they have no accounts receivable or payables and costs are recorded only as they are paid in cash. Switching to the accrual basis will create assets which are "financable" as part of an overall growth company plan. Since most masonry companies work on a draw and partial completion basis, including both the amounts receivable and the unbilled work-in-process on a balance sheet will create more accrued profit, especially if sales are increasing. Payables will also be included so this is an incentive to keep bills paid if you can.
Create a Track Record
Another good idea for getting financing is to create a track record. I find that taking cash and putting it into some municipal bonds, such as the Nuveen Dividend Advantage funds, which have a monthly income based on six percent per annum or better, tax free, can provide collateral for a bank loan you might not need, but would be a good positioning strategy. What you want to do is take $100,000 and buy some of these bonds and offer them to the bank as collateral for a $100,000 90-day note. The note may be at prime plus one percent to allow the bank to make money, but if you are a profitable company, the 5.25 percent interest rate on the note will be one percent or so less than the bond yield and the interest will be tax deductible. So if you are in the 15 percent tax bracket, you pay 4.8 percent after taxes and get back 6.2 percent tax-free while building your credit history.
If you do this a couple of times, building up your credit rating, when you go to a non-bank lender, the fact that you have $100,000 plus of short term investments, even tied up in collateral, is going to assist in making your balance sheet more attractive to an equipment lender. This strategy is especially useful, even on lower amounts for newer businesses without a solid credit history. Taking $20,000, $50,000 or whatever you can afford will help.
Summarizing, we dealt with improving your profitability, enhancing the balance sheet by getting accrual statements done in addition to your tax return, and putting spare cash into higher return bond funds in tax exempt bonds, generating a small profit in addition to the cost of money and enhancing your credit rating with an improved current ratio and a history of on time payments on bank loans.
In addition, we brought the real estate purchase into focus using a lease with the business to finance a personal mortgage allowing you to take more money out of the business tax-free during the 20-year depreciation period.
Now we are ready to buy equipment. Many banks have leasing companies, so if you aren't dealing with them find one in your area that does have leasing. The reason for this is that if you let the bank have the depreciation on the equipment during the first few years they may have a sweetheart interest rate on their lease and do 100 percent financing on the equipment you want. SBA guaranteed bank loans may only do 75 percent of equipment cost so that's the difference.
That means, generally, your down payment on the lease is two months lease payments up front, as compared to 25 percent of cost for a loan. Right now a good lease such as this would be at prime or even under prime where the bank gets the depreciation. Thus all of the bank leasing income from various sources might be impacted by a significant first year depreciation on the equipment you financed, allowing them to shelter other income and increasing their after tax return.
However, they will likely use another trick to finance you by adding all the interest on the entire term of the lease to the front end and making the payments divide into the total of all the interest plus the purchase costs. This may not be attractive because the payoff will often have an early pre-payment penalty. So if you financed something for seven years and you wanted to pay off in five, you might have paid interest based on six years. Therefore, whenever you are negotiating equipment loans make sure you get an early cancellation clause in you favor.
In addition, you can figure out the actual interest rate by taking the annual buy out of the lease amount and comparing it to the amount outstanding based on 100 percent of the payments going to equity and none to interest. Typically the payoff is going to be considerably higher than the amount indicated by the payments made and the difference between the two numbers equals the interest. Divide the amount of the outstanding lease at the beginning of the year into the interest to get an actual rate. When you are shopping leases between institutions, this number is going to be the one to compare.
OK, we have provided for three years of tax returns and separate statements to pick up accruals, but you are also likely going to need your financial forecast for the next three years of sales and profits to get any real money. This forecast should include growing retained earnings, receivables and inventory. If you get your CPA to do these projections with your input it will be on his or her letterhead and much better as a presentation with credibility, plus it will probably all add up.
Today, projecting a 10 percent per annum growth rate on sales and a three percent growth in expenses should provide a nice foundation of increasing profits for your lender. If you can do better based on actual experience don't hold back but be prepared to defend your assumptions with an attachment. Each assumption needs to be numbered and lined up with the forecast amounts, by number.
In masonry and masonry supply businesses, this overall approach is likely to attract support from financing. However, losses are not a palatable thing for banks or non-bank lenders, such as CIT Group, and if you have losses in the past three years, you might need to be prepared to put up additional collateral in the form of real estate, often the owner's residence, to secure working capital (working capital pays payroll and supplier bills while you await collections on jobs completed).
Personal guarantees are a high likelihood on almost anything you borrow today, and thus having a 401(k) plan building up in your business is probably a good idea. This increases your personal net worth each year even if your company is not increasing, using tax-deductible contributions. Borrowing clauses in 401(k) plans would allow you to get access to savings without exposing the assets themselves to creditors in the event of a judgment or bankruptcy.
In closing, making requests for loan or lease funding requires that you prepare well in advance. Use your accountant to help dress up your operating history and your projections and keep retained earnings in the company to show net worth which will make your lenders feel you are a borrower of substance. Plans resulting in the distribution of all earnings, such as those that apply to Sub (S) corporations and LLC organizations, make it more difficult to borrow, in this writer's opinion.
Wayne F. Currie is Chairman and CEO of Incentive Capital Management, Inc. He has been a financial planner and investment advisor since 1970. Call 404-259-3992 with any questions or send them via e-mail to firstname.lastname@example.org, attention Wayne Currie, CEO.
Return to Table of Contents