Credit may be harder for rental companies to come by, but a strong balance sheet and well-managed business are the best defense against the increased scrutiny of today's lenders.
With the most recent threat to the economic recovery barely in the rearview thanks to the United States' debt ceiling crisis early this month, the state of the U.S. economy seems uncertain. The subsequent chain reaction included the U.S. losing its Standard & Poor's AAA credit rating, followed by an investor panic that triggered the worst day Wall Street has seen since the crash in 2008.
While the widespread economic recovery clearly remains fragile, the rental industry is showing positive signs of recovery with rental revenues growing quarter by quarter, equipment buying on the upswing and the credit availability needed to make those purchases opening slowly. So how do the latest events in Washington affect the optimism and recovery showing from the rental industry? How will it affect rental owners' ability to obtain the credit needed to move forward and grow their businesses? The lenders and industry consultants interviewed for this article all share the opinion that well-managed rental businesses will continue to see a slow, steady improvement and that good management is the most effective way to ensure credit availability when it's needed.
“Rental company owners and operators cannot run their businesses based on the stock indexes, nor can they stick their head in the sand with declines like what we have seen the last few days,” says Gary Stansberry, managing member, The Stansberry Firm, Granbury, Texas. “What we have just seen may best be interpreted like a yellow flag in a car race; a signal to be careful the next few turns around the track. The best thing that a rental company can have in place is a good management reporting system where they can closely monitor their trends on a daily, weekly and monthly basis. Watch closely revenue trends, track dollar and time utilization of the fleet, track payroll expense to revenue and take action if you see trends going downward.”
Credit is tight and lenders are cautious. The past several years have been a merciless challenge for most rental companies. With the economy in recession and fewer construction projects in progress or in sight, many companies have struggled to endure the worst of the storm. With equipment demand down, so too were utilization, rates and thus revenue and profits. In many cases, businesses reported losses in quarter after quarter, doing their best to bail water as quickly as they could, hoping to make headway fast enough to keep the ship from sinking. Still, despite best efforts, those losses resulted in negative cash flow — a silver bullet to a healthy company's balance sheet.
“If the balance sheet shows negative cash flow, it is not likely that any lender will approve putting on new debt when there is no evidence that shows the customer can make the payments on the current debt,” explains Harry Schneider, president, Allied Financial Solutions, Florence, Ky.
When the widespread financial fallout began in 2007, it forced rental businesses to put purchases of new equipment on hold indefinitely, pushing many owners to the point of taking the maximum depreciation allowed on their current fleet. As a result, this heavy depreciation caused the equipment to be greatly undervalued on their balance sheets, which caused a reduction in many companies' equity or net worth.
“When net worth is reduced there are many ratios on the balance sheet that are detrimentally affected,” says Schneider. “Debt to net worth or leverage goes up. Current assets compared to current liabilities may become lopsided. And some lenders require that the amount being requested represents no more than 25 percent of the equity or net worth. If equity or net worth has declined, then the amount you can borrow has been decreased as well. These hurdles are extremely hard to leap in the short run. The best way to increase net profit is to increase revenue.”
What Schneider suggests, however, is neither easy nor painless. While there are ways to increase net profit without an increase in revenue, these methods are generally associated with negative actions such as laying off employees, or dramatically cutting other operating expenses and overhead.
So what does all this mean in terms of the availability of credit to rental businesses now?
The good news is that the biggest national rental companies — a barometer for the independents — reported healthy rental revenue gains in the first and second quarters of 2011. In addition, cash flows are on an upward trend, and used equipment pricing and equipment values are also showing improvement. And while credit is available, Stansberry advises business owners to expect increased scrutiny from lenders and cautions them not to be surprised if lenders now require a down payment or higher equity ratio to get approved for new credit.
Mike Arness, president of Ephrata, Wash.-based ClearView Financial, also sees some loosening in the credit environment, noting that banks and underwriters are starting to deploy money again. The large number of defaults on loans by rental businesses in the past three years has scared off a lot of banks, according to Arness, who says that compared to 2007, money is “definitely harder to borrow today. The credit windows are smaller now, meaning that the credit requirements are tougher, and the size of the loans has been reduced in some instances. For strong companies with positive financials, there is still plenty of money. Loans for start-up operations, along with tougher credits are harder to come by today.”
Tim Cetto, managing member, Wenatchee, Wash-based Full Circle Finance, has also witnessed the slow return of the credit markets' injection of capital back into the rental industry. There are far fewer lending institutions that will now loan to the rental market, both because fewer exist and because others have changed their underwriting or have restricted the industry. “Every deal is based on the financial merits of the company large or small,” Cetto says.
Small, independent rental companies should not be discouraged by the potential of credit available to them versus larger multi-location or national rental companies. To some extent, the size of a rental business does have an effect on its ability to obtain credit, but the line of distinction is not always so black and white. Larger companies, while they have access to more complex financing structures, were impacted to the same extent as their smaller counterparts, if not greater.
“Some smaller businesses had the benefit of being able to react quickly when the downturn first hit, preserving cash and protecting their business,” says Jamie Gibson, director of Capital Markets, Terex Financial Services, Westport, Conn. “This has allowed them to find credit fairly easily as the economy recovers.”
Arness agrees, citing a company's credit worthiness and the amount of money it needs to borrow as more important factors than size for lenders to consider when evaluating risk. “In many instances, the small company can adapt to the changing market faster than the large company. That can be a real advantage.”
Conversely, while large businesses have more assets to pledge, they also require larger loans and larger exposures for lenders. Large or small, Stansberry says, the credit worthiness of the individual business has to be there. Lenders are looking at what they call debt service cover — a ratio of cash flow, usually based on EBITDA, to debt service requirements.
“Most lenders will require a minimum of 1:25 to 1, i.e. EBITDA must be a minimum of 125 percent of debt service requirements,” Stansberry explains. “I have seen that requirement trend upward lately with some lenders requiring a 1:50 to 1 or more ratio. Most lenders also want to see a loan to value of 80 percent or less. This means the balance on the loan should never be more than 80 percent of the fair market value of the equipment.”
Rick Bruflat, marketing segment manager at Johnston, Iowa-based John Deere Financial, advises businesses large and small to raise equity, decrease debt and keep receivables collected. “The outlook is improving and there is light at the end of the tunnel,” Bruflat says.
The current credit world is still one of complicated scoring systems and those scores matter. A lot. If the borrower's combined credit scores don't bring the total score to a number acceptable to the lender, the borrower will be declined for that reason only. Even a point or two below the lender's standard is too much. “Credit officers still do not have any room to make exceptions,” says Schneider. “There are rumors that they will soon loosen their standards, but that is just in the discussion stages and probably won't come to reality until performance levels on present portfolios improve a little.”
In this area, small business owners may encounter a disadvantage because of their size. If a small rental company is performing poorly, it is probably reflected on the owner's credit report. Small business owners are more likely to use personal credit cards to make purchases for the business, and the increase in personal credit card debt negatively affects that business owner's credit score. Larger rental business owners are less likely to rely on personal lines of credit to make purchases to sustain the business, and their lines of credit and company credit cards are generally substantial enough to cover some slow times.
“For those companies that have survived the past three years, the financials and personal credit scores have suffered, which is understandable,” says Cetto. “Those that have survived did so because of strong management and over time the financials and credit scores will right themselves.”
ClearView Financial's Arness warns business owners, however, of the trappings of credit report vendors, noting that billions of dollars have been spent in the past few years by consumers purchasing credit reports on themselves. There are many different types of scores available from several credit bureaus and the results of these reports can vary broadly. “The only one that really matters is the one that the lenders use,” Arness says. “That is generally known as a FICO score, so be aware of being misled by these companies. Don't be surprised if the score you pulled is much different than the one the lender pulls.”
Rental business owners seeking additional financing can only present the facts of their balance sheet to potential lenders, but owners can employ a few strategies to help them put their best face forward to financial institutions.
Owners will need to provide current monthly financial statements to the lender. It is helpful to keep these documents organized and up to date. Having good records on equipment assets to show banks or lenders, including full descriptions such as make, model, serial number, original cost and acquisition date will show that you are an attentive business owner. Some lenders may require an equipment appraisal and others may require regular updates on that appraisal.
“You also have to be prepared to adequately explain any anomolies or big variations in your expense or revenues,” explains Stansberry. “Lenders want to know you are keeping a close watch on your financial data.”
Stansberry also recommends shopping your business around to several lenders to be sure to find the best available terms for your loan. “I've found that some lenders may have reached their lending limits for a month or a quarter and don't have much of an appetite to lend, while others may have more money to lend and are willing to be more aggressive on rates or approval amounts.”
Arness advises that maintaining a reasonable equity position should be a goal. He also notes that a rental business should consider the asset it is purchasing as well as the lines of credit available to it.
“For example, you may have a line of credit with your bank,” Arness says. “These lines can generally be used for any purchase or cash flow need. We suggest you preserve these lines as they can be very valuable in an emergency.”
Financial companies, he notes, are working under different rules today than in years past. Where his company ClearView Financial, could in the past finance anything from heavy equipment to special event place settings, today, because the number of defaults and repossessions are up so much, the asset managers of many lending institutions have become more concerned about the actual asset, making soft costs such as china and linens more difficult to finance than hard costs such as construction equipment and tools. Soft costs are collateral that is more difficult for lenders to repossess or remarket.
Stansberry suggests that rental operators can improve the attractiveness of their balance sheet by making sure that all equipment, even if fully depreciated or previously expensed, remains on the books or at least in the asset records. He recently ran across a company that recorded equipment on its books net of trade-in value. For example, the company had a $100,000 dozer recorded on the books for $30,000 (at original cost).
“The original cost of their assets was understated by hundreds of thousands of dollars,” Stansberry explains. “That can affect their borrowing capacity, can reduce the potential sale price of the company, and also skew their financial metrics.”
The successful owner has been attentive to his or her accounts receivable long before he or she felt the effects of reduced borrowing capacity. According to Stansberry, monitoring the days sales outstanding (DSO) of accounts receivable is a primary metric that should also be monitored by business owners.
“It's hard to ‘dress-up’ or prepare a balance sheet in the short term,” says Stansberry. “The biggest positive impact on a balance sheet is the culmination of good, long-term fundamental management and profitability. Keep your rental fleet well utilized, don't buy too much resale inventory, manage your accounts receivables and collections, don't go overboard on owners' salaries and distributions, and constantly work to maximize your EBITDA cash flow.”
Rental companies seeking financing for new equipment purchases can expect to find several potential solutions from the lending community. ClearView Financial offers an application-only loan for clients whose financials have deteriorated due to the harsh realities of the economy over the past couple of years, but who are still deemed credit worthy.
“The client may still be credit worthy, but his financials won't pass the test as many of the ratios looked at may be out of line,” explains Arness. “We look at the client's personal credit, business credit, and bank balances and make a credit decision with that information. This is very valuable to a borrower who has maintained good credit, but his balance sheet numbers are down. If you have had slow payments or repossessions, we may still be able to secure some funds but the price will be higher and the lender may want to structure the transaction by asking for a down payment or extra collateral.”
More than one lending expert RER interviewed stated that there are no “magic” programs out there to “fix” a rental business owner's credit challenges. But focusing on the fundamentals of good business practices can have a positive impact on one's ability to obtain credit in a tough credit market. And a little healthy profit certainly never hurt the perceptions made by a lender's scrutiny of a rental company's balance sheet.
“The reality of the situation is this: Most of the smaller rental companies are not going to be able to rely on their balance sheet for credit,” says Schneider, who, like Arness, suggests that these companies will have to present their requests on an application-only basis, having to split their purchases to meet the requirements of the application-only lenders. While most of those lenders have credit available from $75,000 to $150,000 under their standard application-only programs, business owners must be aware that interest rates on these application-only approvals will be higher. Still, for owners who have maintained a respectable personal credit score and paid on the business debt reasonably well, the credit will likely be available to purchase the equipment needed.
Owners seeking credit for important equipment purchases may opt to use a broker to assist with the application process and amassing of funds. Schneider's company, Allied Financial Solutions, is both a broker and a funding source, which provides a one-stop shop for the rental business owner seeking funding. “We are tied to several funding sources and have our own funds to lend,” Schneider explains. “If we use the example that a rental company wants to purchase $200,000 in equipment, but the balance sheet won't support that from one lender, the rental company would complete one application for AFS and we would then do the legwork to find the $200,000 for them from several sources on an application-only basis. We are one of the few sources that have funding support that will allow up to $150,000 application-only. So we have a good shot at getting it done, provided the customer's personal and business credit is good.”
Rental industry consultant Stansberry expects credit to become more plentiful and more widely available in the next year in spite of the recent credit woes of the U.S. government, noting that a lot of what happens will depend on the financial results of the national rental companies. “Like it or not, they are the ‘face’ of the industry and lenders will closely monitor their results. The fundamentals of revenues, cash flow, equipment pricing and fleet utilization are all on the upswing. Continuing improvement in those fundamentals bode well for credit availability within the market. Interest rates are still fairly cheap, but I see rates rising.”
Prior to the debt ceiling crisis and subsequent vote by Congress to raise it by as much as $2.4 trillion, Allied Financial's Schneider was guardedly optimistic about the economic recovery, opining that the slow resuscitation would continue, that smaller rental companies would continue to face challenges in their businesses, but that credit would become slightly easier to obtain if the economy continued to improve. Since the most recent havoc that swept through Washington and down Wall Street, Schneider is frustrated and less hopeful, but not hopeless.
“The stock market does not concern me as much as the lack of urgency that has been shown by our leaders in Washington,” Schneider says. “I honestly think that the downgrade of the U.S. S&P rating was a result of that same lack of urgency. There was small compromise, but there was not a long-term solution provided. Without a long-term solution we can only tread water or sink further into debt. Banks and other lending institutions are not likely to loosen their lending practices with this continuing crisis facing us. So, it may still be difficult, but not impossible for the rental industry to find lenders.”
Schneider says AFS has found several new lenders who are willing to lend to the rental industry. While the rates are not as low as the ultra-low rates of the past few years, they are competitive.
Like his peers, Clearview Financial's Arness thinks the availability of credit will only improve going forward, barring any further disaster. “I don't think that the political games and posturing in Washington will have a lot of effect on the borrowing related to the rental industry. The good news is that I think we have weathered the worst of the storm. Our defaults have leveled out to a curve much closer to pre-recession levels again, which is a very, very good sign. As defaults level out, the lenders are more apt to deploy their funds.”
Stansberry points to two reasons why credit got tight for rental businesses: the general climate of the banking industry tightened up and then for reasons specific to the rental industry, including declining revenues and cash flow, and the widespread plummet of used equipment prices. With these fundamental rental industry dynamics on the mend, Stansberry sees reason to be upbeat despite the latest turmoil.
“I don't see the overall credit markets becoming as tight as they were a few years ago when the financial infrastructure was in ruins,” Stansberry says. “As of the latest results of publicly traded rental companies as well as results of privately held rental companies I see, the fundamentals of the industry are on the upswing. Revenues are improving, cash flow is increasing and used equipment pricing is increasing. Most rental companies reduced their operating costs during the downturn and today are still running leaner than they were in 2007. While I don't see a tightening of credit for rental companies as long as fundamental results remain strong, I do think we will see higher interest rates for all companies and consumers.”
But funds are flowing again.