A good concept to understand in business is good versus toxic debt. Good debt promotes growth, while toxic debt makes a bad situation worse.
The most successful construction companies rely heavily on debt to generate growth and manage risk. A classic example of leveraging debt to create growth is Vinci, the largest privately owned construction company in the world. In 2017, Vinci reported €2.5 billion in net cash. Surely, Vinci would use that cash to pay off debt, right? On the contrary, its net financial debt in 2017 grew from €15.5 billion (approximately $19.1 billion): nearly €13.9 billion ($17.1 billion) more than 2016. The increase in debt was used as working capital to finance new construction contracts and purchase medium-sized companies in new markets.
The same principle applies to smaller construction firms. Business loans need to be viewed as an investment opportunity. If a business loan doesn’t make you money in the long run, it is a bad idea. In other words, contractors should only consider getting a business loan to generate long-term growth, not to compensate for a dry spell or prolong a business model that is not viable.
For example, investing in heavy machinery and equipment can help a contractor accept larger jobs and reduce the need to hire or lease equipment for construction jobs. Recruiting new talent, modernizing your facilities, or opening a new office in an up-and-coming location are also good reasons to apply for a loan.
What Types of Loans Should a Contractor Consider?
According to a recent survey by the Federal Reserve, the lenders with the highest approval rates for firms with annual revenues of less than $1 million are community development financial institutions, also known as CDFIs (77 percent); small banks (60 percent); and alternative online lenders (59 percent). Companies with annual revenues of more than $1 million are more likely to get approved with an online lender (84 percent) than with a CDFI (77 percent), small bank (78 percent), or large bank (84 percent).
When it comes to loan types, secured loans, such as auto and equipment loans (79 percent), have the highest approval rates. Small Business Administration loans (SBA loans) have the lowest interest rates, but they also have the lower approval rates (55 percent) and typically have a slower funding timeline.
Tips for Getting a Business Loan
Business loan planning: Take a moment to write a basic plan before you apply for a business loan. Explain what you will use the money for and the return on investment you expect to generate. Be realistic. Some lenders require businesses to provide a detailed business plan, which makes this exercise particularly useful. But even if you choose a lender that doesn’t require a formal business plan, having one is a business best practice that will help you run a smarter and leaner company.
Calculate your debt service coverage ratio. Don’t overextend yourself. Good debt can turn into toxic debt if you can’t afford to make payments. A good rule of thumb to calculate whether you can afford a loan is divide how much cash on hand your company typically has at the end of the month by the monthly payment of the business loan. The result is your debt service coverage ratio. Although lenders will consider lower ratios (the SBA has a minimum of 1.15), aim for a ratio of 1.5 or higher. The higher the ratio the less likely you are to miss monthly payments.
Don’t waste your time applying for lenders you can’t qualify for. Research the eligibility criteria of potential lenders before you invest your time in applying for a loan and collecting financial documentation. SuperMoney makes it easy to filter lenders by the key factors, such as loan type, the intended use of funds, annual revenue, years in business and credit score.
Compare rates and terms with several lenders. Don’t limit your options by relying on just one or even a few lenders. Use loan comparison tools, such as SuperMoney’s business loan comparison engine, to see which lender offers the lowest rates and the best terms. The eligibility criteria, fees, funding timeline and rates of business loans vary widely from one lender to another.