March 16, 2020

Financial Challenges Facing Contractors Today

Douglass F. Wynne, Jr. and Mary Jeanne Anderson

In the normal course of business, a contractor needs the ability to finance work underway guaranteeing the price of the work based on estimates calculated before work commences.  Once work commences, the contractor has to finance labor and materials for the first month before an invoice is sent to the owner.  Payment from the owner may take another 30 to 60 days. Effectively, the contractor needs the liquid resources to finance several months of work on an ongoing basis until it is paid for its work. This timeframe expands even further for subcontractors who must submit invoices through the general contractor, adding another layer of approvals.  Additionally, a lot can change between the time the contractor originally estimates the cost of the work and the time it completes the job.  Consider that most contractors have numerous projects underway at the same time, and the financial demands and potential risks are multiplied accordingly.      

Due to the financial risk inherent in construction, many sophisticated owners prequalify a contractor’s financial position before allowing the contractor to bid on work.  This has been a common practice with some state Departments of Transportation for decades.  Likewise, sureties intensively evaluate contractors’ finances as part of the bond underwriting process.  The purpose of the analysis is to determine whether the contractor has financial staying power in the form of net worth and liquidity.

The financial challenges and risks for construction contractors are myriad, but the biggest risk may be the mindset of the contractor itself.  Most contractors are motivated by the challenge of building something and not by performing the accompanying administrative paperwork.  The way to address this risk is to surround the construction business with the right group of advisors who are knowledgeable about construction within their fields of expertise: Certified Public Accountants (CPAs), lawyers, bankers, insurance and surety agents, and surety underwriters and claims attorneys.  These advisors can anticipate potential issues and coach the contractor on the avoidance and handling of the various risks. 

Several of the more common financial challenges facing contractors and the manner in which advisors can help mitigate the risks follow.

Insufficient Liquidity or Net Worth

There are two points in time where “insufficient” liquidity or worth comes into play.  The first is during the prequalification process for credit by either the bank or the surety; the second is when the contractor literally has insufficient funds to pay its bills.  Focusing on the sufficiency of the liquidity and net worth during the credit prequalification process will hopefully help the contractor avoid having insufficient funds at a later date.                                                           

“Insufficient” will be defined differently by the involved parties.  Banks have guidelines to determine sufficiency of funds and net worth that they use in extending credit.  These guidelines are based on a variety of factors and may differ based on the particular lending institution.  The same is true for surety companies determining whether to extend bonding credit and how much credit is an appropriate risk.  Generally, surety companies evaluate liquidity, called working capital, and net worth as a ratio comparison to the contractor’s entire work program, which is measured by the cost to complete remaining on all jobs underway and under contract.  The exact ratios differ from one surety to the next, but the targeted range is to have working capital and net worth on hand that is equal to or greater than 5–10% of the total work program.  These ratios slide above and below this range based on numerous underwriting factors, including balance-sheet ratios, individual job profit trends, composition of the work underway, and the contractor’s experience.

The contractor can increase working capital and net worth in various ways.  For example, if the owners of the construction company have significant liquid assets in their own name, they could inject funds into the company either as a capital infusion or a long term (three years or more) stockholder loan.  The working capital and possibly the net worth would then be increased by the amount of the loan.

If working capital is an issue but the contractor has a significant amount of unencumbered fixed assets (e.g., equipment and real estate), the contractor could work out a long-term loan secured by the fixed assets with the bank.  In a similar vein, if there are unencumbered assets owned personally, the contractor can borrow using the personal assets as security for the bank loan and then inject those funds into the contracting company on terms noted above.

Slow Accounts Receivable or Non-payment by Owner

The contractor should alert its lawyer, CPA, and surety if the amount of accounts receivable overdue more than 90 days begins to build up.  Most sureties will treat these receivables as questionable assets, which can affect both the contractor’s working capital and net worth and the amount of bond credit available to the contractor.  Communication is important, and a well-placed call from a lawyer or a surety claims attorney to the owner or other party delaying payment may address the problem.  If it does not, the advisors will be in the loop to help consider the contractor’s course of action if the issue is not resolved.

“Equipment Poor” Companies

Certain types of construction require the use of heavy machinery and equipment, such as road work, paving, or grading.  Many of these heavy-equipment contractors fall into the trap of buying and financing too much equipment, leaving the construction company with a heavy debt load to service, and the need to keep the equipment working constantly to pay that debt.  Often, a contractor may need to purchase a large piece of equipment for a specific project. If the contractor cannot find a use for the equipment after the project ends, then it may end up saddled with  payments for equipment that is not generating any revenue.                                                                

Too much equipment debt can leverage the contractor financially and impact the ability to obtain bond credit.  Additionally, heavy equipment debt often means that working capital has been depleted in the acquisition and debt service of the equipment.  Surety companies consider a number of factors when determining leverage, but a general rule of thumb is that the total debt of the construction company should be no more than three times the net worth of the company.  Other factors will be considered in determining the appropriate amount of leverage, including the actual appraisal value of the equipment compared to the depreciated book value, the terms of the bank debt, and the contractor’s history of repaying debt.                                                                                           

The challenge is to obtain the equipment needed to execute the work without becoming leveraged in the first place.  One option is to lease required equipment in lieu of purchasing it outright.  There are different types of leases, both operating and capital leases, and the contractor should carefully consider which best meets its needs.  An operating lease is treated like renting, as payments are considered operational expenses and the asset being leased stays off the balance sheet. In contrast, a capital lease is more like a loan; the asset is treated as being owned by the lessee, so it stays on the balance sheet. 

There are financial advantages to leasing rather than acquiring equipment.  Typically, it is easier to get a lease than it is to get a traditional loan to purchase equipment, and initial cash outlay and monthly payments tend to be lower as well. There are some disadvantages as the financing rates may be higher, and the actual terms of the lease may make it costly to terminate the lease.  New Financial Accounting Standards Board (FASB) lease accounting standards were implemented starting in 2019. As such, it is imperative that the contractor involve its CPA in any leasing decisions to ascertain how the lease will affect the company’s balance sheet.                         

The contractor who is already leveraged by equipment debt should evaluate the benefits of selling some of the equipment pieces that are not critical to the success of the company.  This will reduce the debt load and therefore reduce leverage.    As a final option, the contractor can explore refinancing the existing debt to generate additional cash and working capital.  The banker can outline options, but the CPA and surety underwriters should be involved in any major decisions to advise what the impact will be on the balance sheet and bonding credit.

The Challenge of Profit and the Risk of Loss

Most small- and medium-sized contractors perform minimal if any strategic analysis and planning due to the time requirements and the perceived complexity of the undertaking.  Those contractors that do invest the time and money often fail to implement the strategy. Many strategic plans end up gathering dust on a shelf instead of providing guidance for the contractor’s daily operations.   These contractors tend to address issues reactively as challenges are presented.

For example, one of the most critical times to ensure that a contractor has well-developed strategic plans is when the contractor approaches growth.  Many contractors live by the “if you’re not growing, you’re dying” mantra and take every job that comes their way.  However, growing too quickly poses a great danger for contractors and is one of the most common causes of contractor failure.  Growth eats capital, increases overhead, and can turn what was once considered a small cash flow problem a possibly fatal issue.  Further, growth forces the contractor to spread its core management team thin and hire new, untrained employees.  As a result, it is critical for all contractors – especially those considering growth – to understand their finances.  In order to do this, the contractor needs to have and use good quality internal accounting systems and a construction-oriented CPA who reviews the books and prepares financial reports.

A CPA financial statement is basically a report card on the contractor’s operations for a specific time period and as of a specific date.  The financial statements are generated using the data provided by the contractor from the internal accounting system. The statement shows the assets, liabilities, and net worth at that date, as well as cash flow and a profit and loss statement for the reporting time period.  Most CPA statements include a schedule of the contractor’s jobs in progress and completed during the period, reflecting contract price, cost, and billing information on each job.

While there is useful information in a single financial statement, there is even greater value in having an analysis of trends using financial statements and schedules prepared at different time periods.  A financial trend analysis can inform the contractor of specific strengths and weaknesses and provide an early warning of problems brewing.  For example, if the contractor’s revenues have grown at a rapid rate over a series of years but the gross profit percentage has decreased over the same period, it raises the question of why.  Would the contractor actually be more efficient and make better profit at a lower revenue volume, or is there another explanation? If a job schedule shows that the estimated profit percentage on jobs decreases on every job in the last 10% of completion, the question might be whether the contractor has trouble closing out jobs effectively, or are the profit estimates during construction overstated?                                                                         

There are many different ratios and analysis tools available for evaluating a contractor’s financial information.  Good resources for learning and discussing financial analysis and trends and their meaning include the CPA, as well as the surety agent and underwriter, who deal with these financial evaluations every day.  In addition to looking back at trends, they can assist the contractor in putting together projections for the future, as well to help guide business decisions.     

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