The R-Score
Thomas C Schleifer, Ph.D.
I repeat from my blog a few weeks ago, Cash is King: “For the duration of this disrupted market, move cash flow management to the top of your CFO’s priority list.”
Winners and Losers in 2023
Rising interest rates, inflation, and a possible recession continue to top the list of forecasters’ concerns for the coming year.
“The key issue facing the economy now is inflation, (which is) determining its path as we move forward,” says Richard Branch, chief economist at Dodge Construction Network. The central bank is aggressively raising rates to reign in further inflation impacts. Should this be successful, Dodge expects rates to steady in the first quarter. “That should allow the economy to stabilize and start to recover in the back half of 2023,” Branch says. His forecast expects the U.S. to avoid a technical recession, but in many construction sectors he says, “it is going to feel recessionary”.
FMI, which forecasts put-in-place construction, estimates a 7.8% total construction hike in 2022, with a 1.3% decline in 2023.
According to Dodge the manufacturing sector of construction will still be at a “historically high” level of activity.” (ENR, 2023 Economic Forecast, 12/5/22)
Keeping An Eye on the Ball
It looks like 2023 and 24 will be a wild ride for contractors in all segments of the industry. If cost inflation persists, the risk of losses eroding cash balances becomes the number one risk factor. The shortage of skilled labor will continue to delay work and inflate costs as well. These two factors alone will put enormous pressure on cash flow even if the economy stabilizes. In other words, “For the duration of this disrupted market, move cash flow management to the top of your CFO’s priority list.”
No Surprises
Following more than 30 years of researching, identifying, and cataloging the causes of construction business failures and participating in the resolution of hundreds of distressed firms, I discovered a remarkable truth: Many of the contractors who had suddenly failed mid-project were surprised that they had run out of cash. What they did not know was there was nothing “sudden” about it. Construction company failures were predictable, and in many cases, the in-house accounting staff saw it coming two to three years before it happened. It was all about cash flow. They could have seen it coming and taken corrective action. The fact that they didn’t take corrective action proves that they never saw it coming and weren’t listening to their CFOs.
Utilizing Financial Reports
It is no secret that many contractors, as a class of business professionals, tend to view formal financial reporting as “after the fact” reports mandated by government entities like the Internal Revenue Service and do not utilize financial reports as critical management tools. This is an oversight and is why the contractors are often the last to know what their accounting professionals have known all along.
It is also no secret that there are conflicting views about whether financial performance should be measured by profit or by an increase in the value of the firm. The ultimate measure of performance is not what is earned but how the earnings are applied to enhance the firm’s capital position and shelter it from the risk of running out of money.
The R-Score Formula
During my years of research one key question repeatedly came up for me: Why didn’t contractors utilize traditional financial ratios to manage their business on a day-to-day basis? After analyzing hundreds of failed companies, I realized that measuring the financial performance and risk of a construction organization required combining standard financial ratios in a holistic manner to provide an accurate insight into its financial strengths and weaknesses. This discovery led to the development of the R-score formula, which:
- Measures an organization’s current financial performance.
- Compares an organization’s current performance to past performance.
- Identifies an organization’s financial risks, strengths, and weaknesses going forward.
Key Elements of the R-Score
To evaluate a closely held construction company several variables must be considered.
- Sales-to-Total Assets: The turnover ratio is a measure of operational efficiency.
- Net Profit-to-Sales: The net profit margin is a measure of operating efficiency after all costs and expenses have been accounted for.
- Total Liabilities-to-Equity: The debt ratio tests long term liquidity.
These key elements are combined to develop the risk factor score (R-score formula).
A Handy Management Tool
From a financial accounting perspective, the construction business is one of the most complicated enterprises in the world. This is why otherwise knowledgeable contractors tend to use instinct rather than financial reports to manage their business, and why I came up with the R-Score to help construction professionals and contractors keep a close eye on their capital position and risk potential.
Next week we’ll take a little deeper dive into the R-Score and how it can save us from unpleasant surprises.
For a deeper look into the R-Score, read more here: THE R-SCORE
For a broader view into financial management, read more here: FINANCIAL MANAGEMENT
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