Danger Will Robinson, Danger!
Construction is a risky business. Not only because of the occupational hazards associated with the industry, but it’s also risky from a business perspective. New companies, of course, are vulnerable, but even construction companies in business for thirty, forty, fifty years or more are not immune to business failures. I’ve witnessed strong companies, rock-solid for decades, lose half their equity in a year, and be on the rocks with their lenders and surety for years following. It can and does happen. But there are warning signs – some subtle and some in full view, but easy to overlook.
The scary thing about it is this. The financial statements of a construction company rely heavily on estimates. This includes estimates of the contract value, estimates of the amount of variable consideration for unapproved change orders, claims, and early completion bonuses, and estimates of the cost to complete a project. If those estimates are wildly wrong, for whatever reason, the company can be bankrupt long before it is apparent in the numbers.
Generally, there are warning signs. This article will describe some of those warning signs that whisper all is not well.
Exodus of Key Employees. Those closest to the execution of the contracts, such as the project managers, will see a train wreck coming long before it happens. And if it’s bad enough, they often walk. Or perhaps they see something in upper management that keeps them awake at night. Or, on the other hand, it could be they just got a better offer or are disgruntled for some ancillary reason that has little to do with the company’s financial stability. Nevertheless, it should be a heads-up that there may be something rotten in the State of Denmark.
Large Underbillings. Underbillings are not normal, especially if the contract is 50% or more complete. It may indicate that the company has poor billing practices and cash flow issues, which may be why the company has drawn the line of credit to the limit. Or, worst-case scenario, underbillings are concealing significant losses.
Many times, large underbillings are traced to unfavorable contract terms. For example, some specialty trades incur substantial upfront costs. If favorable contract terms have not been negotiated to permit advance payments to cover upfront costs, significant underbillings may precipitate cash flow issues.
The most detrimental issue is that of concealed losses. For example, a project manager rewarded at year-end for contract profitability may intentionally overstate the contract amount for unapproved change orders, knowing that he cannot bill and collect the cost and profit for those change orders. As a result, this deception will increase underbillings or perhaps decrease overbillings as a possible red flag.
Overbillings Collected Are Not in the Bank. The rule of thumb is that the cash flows from a contract overbilled in the early stages should be available to fund the costs in excess of billings during the latter part of contract completion. Of course, many companies will “rob Peter to pay Paul” from time to time. However, in extreme cases, a company in a severe cash crisis may habitability channel overbillings from one contract to cover significant losses on other contracts while running their line of credit to the limit. In the end, they face a cash crunch when it’s time to pay the piper.
Taking on that Big Project Outside the Company’s Area of Expertise. Just because a contractor is a successful home builder does not mean their skills will translate to road building. I’ve seen it before, and it’s painful. Or, taking a contract in your niche in a different area of the country can be a disaster. Too much distance leads to a different labor market, travel costs, and unfamiliarity with local regulations.
If a company is awarded a large project outside their area of expertise, it’s a warning sign if they have not mitigated the danger by recruiting experienced personnel, performing a close review of the contract terms, and seeking advice where needed.
Insufficient Working Capital and Equity. Best of class construction companies maintain a minimum working capital ratio of 5% of contract revenue. Some trades should have more, perhaps up to 10% of revenue as a minimum. Tight working capital is a harbinger of problems to come.
Thin working capital coupled with lines of credit borrowed near or up to the maximum can cause all sorts of headaches. It can absorb all your time. And lead to lost vendor discounts, disruption of the supply chain, loss of credit, and even going concern issues.
Surety companies will also focus on equity. Generally, sureties expect that construction companies will need, as a minimum, equity of 10 to 15% of revenue. When the company’s equity position decreases below those levels, it raises questions. For example, is the company overleveraged, or are the stockholders or members taking too much in distributions? Has the company absorbed too many losses, or was it thinly capitalized at start-up?
Loss of Long-Time and Loyal Customers. It happens to every company, of course. But when many long-time customers leave the fold, that becomes a significant warning sign. It brings into question the company’s ability to honor its commitments, complete projects timely, perform quality work, and retain key employees.
Project Managers Have Unrestricted Rights to Reclassify Job Cost. Project managers should not have unrestricted rights to reclassify costs from one contract to another. But, if they do, they can conceal losses by rolling those losses forward to subsequent years. It’s called cost-shifting and is a form of financial statement fraud. This is possible because of the peculiarities of the cost-to-cost percentage of completion accounting method. (Note: Even though not referred to by name in the ASC 606 revenue standard, the percentage of completion method is alive and well.)
This is done by reclassifying costs from a loss (or soon-to-be-loss) contract to a profitable uncompleted contract. In good times, the loss can be rolled forward for several years. But eventually, when contract backlog drops, it will become apparent. But until then, the concealment can cause significant damage. (See our blog dated March 15, 2021, titled “How About Another Accounting Quiz?” for an example of how cost-shifting can disguise losses as gains.)
Low Profit Margins. A caution flag goes up when the company, to obtain work, is awarded a string of large contracts at below-market margins. That leaves little room for error in executionBut the contract that merits special attention is the large contract that has been reduced to a zero gross margin while in progress. This is because many, if not most contractors, are optimistic by nature. They are confident they can resurrect a diaster from the grave by picking up extra profit at the end of the job. But so many times, I have witnessed a zero gross profit contract not only end up in the red at completion but set records for losses. So, beware of zero-profit contracts.
Subcontractor Problems. It happens. Some contractors rely on vetting their subcontractors instead of bonding. And many do an excellent job and have great success with their subs. However, unbonded subcontractors can fail, walk off the job and leave the general or prime contractor in a lurch. Subcontract failure can even happen with subcontractors that have worked for the company for years. It’s very easy to develop a false sense of security because the sub has performed excellent work in the past.