Contractors should always be prepared for next economic slowdown
INSIGHT ARTICLE |
Despite nearly six years of growth, construction spending is expected to continue climbing next year, although at a more modest rate. Construction starts are expected to increase 5.4 percent in 2017, up from 1.3 percent in 2016.1 Forecasts have construction put-in-place growing another 3.9 percent in 2017, down from a 4.9 percent increase in 2016.2 Single-family housing starts are projected to jump 12.3 percent in 2017 at the same time the multifamily housing starts cool off.3
But for anyone who follows markets of any type, yellow lights should be flashing. With a new president and Congress in place, there are new uncertainties for businesses in 2017.
It’s time, therefore, for all contractors to begin paying greater attention to their equity, particularly cash flow and cash reserves. The time has arrived once again to begin building up reserves and reducing unnecessary overhead. This is important not just for long-term survival, but because sureties already are tightening the reins in anticipation of a possible recession sometime during the next two years.
Maintaining financial viability
At forward-thinking construction firms, periods of prosperity are viewed as something more than just an opportunity to enjoy the fruits of their labor. These firms use periods of high work volume to determine which methods—and people—are producing the most revenue. At the same time, they work to put their financial houses in order. They use strong cash flow to build up reserves, pay down bank debt and other notes payable, purchase equipment, cross-train employees and improve technology.
Whether times are flush or lean, these contractors watch their benchmarks and ratios carefully, and continue to market themselves aggressively.
Leading contractors are always preparing for the next economic cycle, and they know there will be one. To protect themselves, these contractors are always on the lookout for signs they may be slipping out of a positive financial environment. These signs most often show up when:
- Cash flow begins to tighten and shortages are experienced
- Accounts receivable and accounts payable begin to age
- Working capital begins to decline
- Bank lines of credit are increasingly used to pay current bills without subsequent repayment
- Liquidity and debt ratios begin to slide
- Margins on new jobs and revised margins on existing jobs are decreasing
Managing cash flow
For construction company owners, the fastest route to financial security is created by strong cash flow. This cash typically comes from four sources: profitable jobs; equity contributions from the owner; loans from the owner, which inject cash into the company but with no impact on bonding; and outside financing, which usually involves a line of credit, equipment financing or lease-versus-buy decisions on equipment.
To successfully manage cash flow, a contractor must begin by properly budgeting company overhead. Estimating general and administrative expenses for the coming year allows a contractor to determine not only what is needed to break even, but also how to structure each bid in order to provide a sufficient profit margin.
In their effort to accurately project cash flow, contractors need to take into account their workload and whether their labor force is being fully utilized. If so, costs for added labor must be factored into the equation. Contractors must also have some sense of the financial stability of their customers and past payment practices.
Regarding each job as its own profit center can go a long way in helping a contractor strengthen cash flow. There is no room to make up losses on one job with profits from another. It’s important then that cash projections be reviewed in the early stages of each job. To arrive at a net cash flow for any project, contractors must continuously analyze cash receipts—billings, retentions and claims, or change orders—against cash disbursements, which include bid costs, preconstruction costs, labor, materials, subcontractors and overhead.
To avoid shortfalls, contractors should try to prevent them early on. Cash flow begins with billings, and contractors should always seek contract terms that allow them to accelerate cash flow.
It’s important to remember that billings won’t mean anything if a contractor can’t collect. If such instances occur, contractors should communicate immediately with the customer, the project manager and his or her own management team. If the problem can’t be solved quickly, a contractor should have an established procedure for filing liens.
Contractors seeking to increase cash also need to carefully assess under-billings and over-billings. Over-billings are only good if that money is already in the bank or in receivables waiting to be collected, while under-billings indicate the contractor is financing the project.
Another way to bolster cash flow is to closely manage the punch list at the conclusion of a project. Not doing so slows collections and ultimately hurts cash flow.
Staying up to date
Over the past several years, some contractors have handled record workloads. Many of them, however, learned that a heavy load doesn’t always translate into record profits. The climbing cost of construction materials and insurance alone can quickly turn windfalls into negligible gains or losses. That’s why it is critical for managers to never take their eyes off expenses.
To prepare for the possibility of lower future revenues, contractors also need to pay attention to their tax liabilities. They should meet with their certified public accountant to make certain they aren’t paying more in taxes than they should. In the past two years, there have been some major changes in what can be deducted and how revenue is to be recognized. When these changes aren’t accurately reflected in a contractor’s tax filings, the mistakes can prove costly.
Because profit margins are low in the construction industry, contractors always need to maintain a healthy balance between liquid assets and expenses. This is especially true when another economic slowdown may not be far away. At this juncture in the nation’s economic cycle, no one should take anything for granted.
1Dodge Data & Analytics
3National Association of Home Builders
Published In: January 2017 Texas Contractor.
A comprehensive white paper about how construction contractors are affected by the new revenue recognition guidance in ASC 606.
Uncertainty around tariffs will impact middle market businesses looking at narrower profit margins. Will costs get passed to customers?
In addition to displacing people and claiming lives, Hurricane Harvey has caused significant economic damage to the region.