Creating a formal debt management plan for your construction company will save you thousands or even tens of thousands of dollars in interest, over haphazard borrowing.
Following certain best practices and using a structured approach to your company’s debt plan is part of an effective construction finance, accounting and tax strategy.
Your accounting and tax advisers can help you structure a formal debt management plan for your company. This may save you a great deal in interest.
Look at Current Debt, You May Be Surprised
First, create a table like the one below listing all your current debt, including working capital lines of credit, loans of any kind, any interest bearing notes or other financial obligations. Do not include Accounts Payable.
If you look squarely at the rates of interest you are paying on your different notes, credit cards, and loans — and then rate them according to market interest benchmarks, you will always see room for improvement.
Consult with your accounting and tax adviser to verify the market rates of interest on your different debt instruments. Knowing what you should be paying as a standard rate of interest will help you start your debt management plan.
The High Cost of Working Cap Utilization
One of the most common debt instruments construction firms use is the working capital revolving line of credit. The biggest mistake small construction firms make is to utilize most of the line of credit right away– and then keep the utilization high.
Think of it this way. A term loan usually starts with a high balance, and then as your firm makes its payments of principal and interest the loan balance goes down, so interest is steadily being charged on less and less of a loan balance as time passes.
With working capital lines of credit, however, when high balances are maintained continually (in the false belief that this provides better access to cash), this is the same as paying interest on a high balance loan that never goes down– never gets paid off — and never goes away.
Structured Debt: A Better Way
All borrowing is more efficient (with less cost of interest) when the use of funds and payment terms are predetermined. For example, planning your use of debt is important if your firm has wide access to many forms of loans and borrowing. This is true because debt may be too freely used by those who are not responsible enough to make solid debt issuance decisions.
On the other hand, if your firm is hard pressed to get loans and is awarded one, staying true to its purpose ensures that the borrowed funds will actually be used for that purpose, and the loan money is not squandered.
How to Structure Your Firm’s Debt
Debt should be structured in both use and payback. When you take out a mortgage, you borrow a certain sum of money and all of the money gets used to buy a specific piece of real estate property. All debt should be used in this purpose-driven manner. Working capital lines of credit are not the only debt instruments which are too sloppily used. Credit cards are also used here, there, and everywhere and credit card balances are rarely managed as tightly as they should be in smaller firms.
A better alternative is to plan usage of debt instruments more carefully. Give credit cards to project managers for use only on particular projects, or with particular vendors who don’t offer credit terms, or only for gas charges. Defy the perception that credit is a “bottomless pit,” by telling cardholders they have to justify why they would use credit over other more conventional terms of payment.
The reason you want to limit the careless use of credit is because vendors that extend you credit don’t charge interest. Gas stations that take cash for fuel don’t charge you interest. Cash-on-delivery (COD) material drops don’t accumulate interest charges.
Is a credit card or working capital draw so attractive that it’s worth cutting a chunk of your capital for the convenience? A project manager who is rushed may make the split-second decision to use his merchant credit card to charge $2,000 in materials, even though he knows you have a house account. It’s quicker, the card was right there in his wallet, and besides, he wasn’t sure how much house credit was available. Easier, yes. More convenient, yes. But whose convenience are you feeding?
Encourage smart use of credit cards by your project managers. Once you’ve set the precedent, they will find their interest-saving “groove” very easy to maintain. And your interest expense will drop down so low that you’ll feel it in your bank account balances.
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