The first quarter of each year is a good time for contractors to meet with their sureties and bankers so everyone can review the company’s financial outlook for the remainder of the year. For a contractor’s financial partners, the meeting is important because it helps them measure their level of risk, and also determine whether they are providing sufficient bonding and lending.
In particular, a contractor’s financial partners want to explore six key areas, ranging from working capital to management turnover. We will get to those in a moment. In a more general sense, however, contractors should have their financial records organized so they are always able to easily show:
Documentation of profitability and a history of successful projects.
Work experience and a description of past, ongoing, and future work.
- A comprehensive business plan.
- Forecasts for short- and long-term strategies.
- For sureties, documentation of banking relationships.
- Business perpetuation plans in the event of the death of key personnel.
- Financial statements prepared by a CPA.
- A description of what form of ownership is in place.
- Disclosure of any joint ventures and subsidiaries.
WORKING CAPITAL
Now back to the specifics. If there is one area of a contractor’s business that is likely to draw the most scrutiny from financial partners, it is working capital. Essentially, working capital is defined as current assets minus current liabilities. Current assets include cash, receivables under 90 days, and some inventory—assets that can be turned into cash within a year—as opposed to property, plant, equipment, and other long-term resources.
Working capital indicates how well a construction company can fund its volume of work. To determine whether there is adequate working capital, sureties and bankers calculate a Quick Asset Ratio or what is sometimes called a “Quick Acid Test Ratio.’’ To derive the ratio, they simply divide current assets by liabilities. For example, let’s say a contractor has current assets of $400,000 and current liabilities of $250,000. Dividing $400,000 by $250,000 shows a working capital ratio of 1.6 to 1.
In general, sureties and lenders hope to see a ratio of 2 to 1 or even 2.5 to 1. However, a contracting company can have a ratio of 1.25 to 1 and still be in good financial shape, depending on the size and type of work it most often conducts.
CASH FLOW
Perhaps next in importance to sureties and bankers is a contractor’s cash flow. For contractors, cash flow is what makes the world turn. In an inordinately cash-intensive business, consistent cash flow is mandatory if debt is to be kept in check and work is to continue on schedule.
Over 5 or more years, cash flows from operations should approximate net income before depreciation. Financially sound companies tend to have a ratio of net income (excluding depreciation) to cash flows from operations that are close to 1 to 1 over a 5-year period. Companies that aren’t faring well tend to have a high ratio of net income to cash flows from operations. To successfully manage cash flow, company executives should establish systems that calculate cash flow on a regular, dependable basis. The best of these systems delineate cash flow month by month.
OVER- AND UNDER-BILLINGS
Another area important to sureties and bankers is over-billings and under-billings. Underwriters get nervous when a construction company is over-billing or under-bulling. Under-billing in particular raises a red flag because it indicates the possibility of a lost job or poor management practices. Under-billings that reach 25 percent of working capital are especially troubling for sureties. Bonding companies and banks much prefer to see over-billing because it demonstrates that the contractor is using the project owner’s money to complete the job, not the contractor’s line of credit.
WORK-IN-PROGRESS CALCULATIONS
Another important function that contractors will need to discuss with financial partners is work-in-progress calculations. Sureties and lenders want to see evidence that a contracting firm operates at a steady rate and with accurate work-in-progress estimates. For these estimates to mean anything, they must include both an accurate jobs-in-process schedule and a completed-contracts schedule.
Before meeting with their financial partners, contractors need to go over their books carefully and make sure that carry-over expenses from previous years have not created unexpected profit fade. If such fade somehow managed to squeeze through unknowingly, financial statements need to be updated quickly.
MANAGEMENT TURNOVER
The final area that contractors need to be able to discuss with financial partners is management turnover. Losing valued workers is problematic in any industry, but it’s especially troublesome in the construction industry because profit margins tend to be small. One study showed that a construction company can save 2.5 percent of its payroll costs by reducing turnover by 10 percent. If a contractor has a profit margin of only 5 percent, that is an impressive savings.
Moreover, financial partners want to see how long top managers have been with the company and how profitable the company has been under their direction. If some of these top managers left during the past year, contractors should be willing to explain why they were unable to keep the managers.
FINANCIAL ACUMEN
In an era when sureties and banks are scrutinizing financials like never before, contractors need to be proactive in presenting a clear and accurate accounting of their financial operations. A great place to demonstrate such financial acumen is the first-of-year review with bonding agents and lenders.
By the way, this meeting should not be seen by contractors as nothing more than a job performance review conducted by financial partners. For contractors who have their finances in order, the review session is also an opportunity to receive input from other business experts. ■
About The Author:
Leslie Guajardo, CPA, CCIFP, has more than 20 years of experience in public accounting. She is the leader in both the construction and employee benefit plan niches for Padgett Stratemann & Co., LLP, one of Texas’ largest, locally owned CPA and business advisory firms. For more, visit www.padgett-cpa.com.
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Modern Contractor Solutions, March 2015
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