Owning a construction company is a high-risk investment. Owners need to manage risk in the field, and also in the office, in order to succeed and prosper. A company that does not proactively manage risk faces the possibility of underachieving results, with an ongoing battle of job fade and lost profits. There are three major areas to focus on that will help reduce risk and retain profits in the business:
- Balance sheet strength
- Internal controls over jobs
Balance sheet strength
The balance sheet is like the report card of a construction company. Users of the financial statements look at the balance sheet, and its demonstrated liquidity, and leverage to determine the financial strength of the organization. A contractor with a strong balance sheet is better able to withstand a recession or an underperforming job, obtain better financing, and increase bonding capacity. Ample working capital (current assets minus current liabilities) of the organization is of vital importance for a construction company who requisitions monthly but pays its workforce weekly or biweekly. Thin working capital tells potential customers that you may not be able to complete a job, pay your employees or subcontractors timely, or obtain bonding.
Evaluating the quality of your working capital is also important. Carrying soft assets – such as large, under-billed amounts, or related party loans that may not get paid back - may boost your working capital ratios, but they are not likely to be a liquid asset, which will convert to cash. A continual evaluation of working capital is imperative for a well-managed construction company.
Financial analysts will look at whether a company is highly leveraged. Leverage ratios are calculated by dividing total liabilities by total capital. Equipment intensive companies tend to carry more long-term debt, which can have a significant impact on leverage ratios. A healthy relationship between liabilities and capital is evidenced by a debt-to-equity ratio of no greater than 3:1. Business owners need to actively manage and build their balance sheets, ensuring a healthy company before considering excess capital distributions.
Internal controls over jobs
Internal control can be defined as systematic measures instituted by an organization to (1) conduct its business in an orderly and efficient manner; (2) safeguard its assets and resources; (3) deter and detect errors, fraud, and theft; (4) ensure accuracy and completeness of financial data; (5) produce reliable and timely financial information to decision makers; and ,(6) ensure adherence to policies and plans.
Internal control within a construction company needs to go beyond the controls over banking transactions. A good internal control structure needs buy in from top management to hold people accountable when a process is not followed. For a contractor, a strong control system over job performance can strengthen the process, from the estimating department to the wrap up, in the field.
During the estimating and bidding process, many contractors chase work to drive the top line and keep employees working instead of developing a system that dictates what type of jobs they should bid. Historical data will help a company determine what types of jobs they perform well. Some key items to evaluate include (1) Public vs private, (2) Prequalification of the owner, (3) Scope of work, and (4) Jurisdiction of work (consider mobilization costs). Strong organizations have a process in place which will dictate whether it is in the best interest of the company to move forward with an estimate.
Once the decision is made to bid a job, there should be a process to evaluate the estimate before the bid is complete. For general contractors, this process should involve a prequalification of subcontractors to be used. A formal prequalification process includes evaluating the subcontractor’s financial status and job history. The lowest bid is not always the best bid. A subcontractor default will affect the profitability of the job and negatively impact the general contractor’s reputation.
Subcontractors will want to focus on their labor and equipment burden rates, updating these semi-annually at a minimum, to ensure the costs used in the bid are aligned with actual costs. A bad number in a burden rate used on an estimate can cost a contractor millions.
If the bid is accepted, the contractor should have a policy of obtaining legal review of the key clauses in the contract, and negotiate some of the key terms and conditions, before the contract is signed.
Current technology, such as document management systems, estimating software, and payroll applications, allow project managers to manage jobs on a real-time basis. With this information readily available, it is suggested that monthly job meetings be held to review the status of every ongoing contract. The project manager should report an executive summary at these meetings, communicating the following key contract items:
- Billings to date
- Cash received
- Accounts receivable
- Contract value
- Approved change orders
- Unapproved change orders
- Costs to date
- Accounts payable
- Remaining costs for job
- Budget to actual
- Spike/fade on profit margins
It is never too early for business owners to develop a succession plan, which may be evaluated and changed as time goes on. Early planning is essential for the company owners, and their families, to be able to navigate the course of unanticipated life events.
One wrong step can have a reputational impact that can jeopardize a lifetime of work. The complex operating environment of construction companies requires strategic management of risk. Proactively addressing risks is the contractor’s best defense for long-term success and viability.