Contractors handle large amounts of money but get to keep only a very small portion. In this way, the construction financial transaction imposes yet another unintended role and risk on contractors. They are functioning as fiduciaries at great expense to themselves.
As we discussed last week, the accounting practices required in construction companies result in estimated interim statements rather than hard data. The large amounts of other people’s money flowing through the business, mixed with the financing provided by the contractor, results in considerable commingling of funds. This makes it easy to overstate profitability and the contractor’s overall net worth at any given point along the way.
Unintended Risk
Construction business failures ultimately boil down to one cause: unexpectedly running out of cash (working capital). Construction contracts assign an inordinate amount of financial risk to contractors. This forces them to not only build the projects but also finance them and act as a fiduciary for the owners’ partial payments. This imbalance in risk assignment has gone largely unnoticed to the point that it has become hidden in the bones of the business. As a result, contractors are constantly at risk of having insufficient cash flow. In fact, a shortage of working capital seems to simply be part of being in construction. It affects the ability to take on new business and to grow with confidence and stability.
Contractors
The late Dennis Birsch, a well-respected construction accountant, argued that many US contractors are watchers instead of managers of their financial affairs. He claimed that they (contractors) do a lot of responding to things that happen to them but don’t have much control over what’s happening or going to happen because they don’t have the appropriate financial information in the right place at the right time…
Contractors suffer from a lack of information and insight into their capital capacity as they take on new work and the attendant financial risk. As we discussed last week, construction interim financial statements are only estimates (best guesses) that often misstate a contractor’s capital capacity as multiple jobs at varying stages of completion may, or may not, be profitable.
- Until a job is complete and all the invoices submitted and paid for, as well as all the job-related payables cleared, do contractors know for certain if that job was profitable and made a positive contribution to the firm’s gross profit.
- Imagine the challenge of arriving at an accurate measure of a firm’s capital capacity working with estimated financial statements when the firm has multiple projects going at varying stages of completion.
- Since all projects do not finish at the same time, the assignment of overhead costs to each job’s gross profit must again be an educated estimate. This affects the accuracy of the firm’s resulting capital capacity calculation at the end of each accounting period.
That’s Not My Job
Construction companies are service providers. We are providing construction services to the owners of the assets we have been hired to improve. We are not selling a finished product to the eventual owner for a fixed price determined in advance of knowing the actual cost.
However, we’ve inadvertently allowed the industry to twist us into acting exactly like that.
- We sign contracts with government agencies, private owners, and developers that require us to construct, finance, and pay for the work before we get paid.
- The owner, not us, has legal possession of the product from the minute it’s put in place because the owner owns or controls the underlying property our work is placed on.
- We’re not paid at the time of the sale or in advance of delivery. We’re paid in weeks or sometimes months after the work is put in place.
- We pass through large amounts of owners’ money to skilled labor, material suppliers, and subcontractors without being able to invoice for our services at the same time. Our payment is built into an estimated profit at the end of the job.
- This is why it is impossible to determine positive cash flow or a firm’s capital capacity (do we have enough liquid capital on the interim balance sheet to complete all projects in progress, and what is the cost of that capital).
(If you had trouble following my reasoning above, you are in danger of running out of working capital at any moment.)
Next Week
Next week we’ll begin a discussion of the most effective accounting procedures for dealing with diminishing cash flow, project profitability, and company capital capacity. See you then.
For more information on financial management, read more at: FINANCIAL
For a broader view of construction accounting, read more at: ACCOUNTING
To receive the free weekly Construction Messages, ask questions, or make comments contact me at research@simplarfoundation.org.
Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.
Contractors handle large amounts of money but get to keep only a very small portion. In this way, the construction financial transaction imposes yet another unintended role and risk on contractors. They are functioning as fiduciaries at great expense to themselves.
As we discussed last week, the accounting practices required in construction companies result in estimated interim statements rather than hard data. The large amounts of other people’s money flowing through the business, mixed with the financing provided by the contractor, results in considerable commingling of funds. This makes it easy to overstate profitability and the contractor’s overall net worth at any given point along the way.
Unintended Risk
Construction business failures ultimately boil down to one cause: unexpectedly running out of cash (working capital). Construction contracts assign an inordinate amount of financial risk to contractors. This forces them to not only build the projects but also finance them and act as a fiduciary for the owners’ partial payments. This imbalance in risk assignment has gone largely unnoticed to the point that it has become hidden in the bones of the business. As a result, contractors are constantly at risk of having insufficient cash flow. In fact, a shortage of working capital seems to simply be part of being in construction. It affects the ability to take on new business and to grow with confidence and stability.
Contractors
The late Dennis Birsch, a well-respected construction accountant, argued that many US contractors are watchers instead of managers of their financial affairs. He claimed that they (contractors) do a lot of responding to things that happen to them but don’t have much control over what’s happening or going to happen because they don’t have the appropriate financial information in the right place at the right time…
Contractors suffer from a lack of information and insight into their capital capacity as they take on new work and the attendant financial risk. As we discussed last week, construction interim financial statements are only estimates (best guesses) that often misstate a contractor’s capital capacity as multiple jobs at varying stages of completion may, or may not, be profitable.
- Until a job is complete and all the invoices submitted and paid for, as well as all the job-related payables cleared, do contractors know for certain if that job was profitable and made a positive contribution to the firm’s gross profit.
- Imagine the challenge of arriving at an accurate measure of a firm’s capital capacity working with estimated financial statements when the firm has multiple projects going at varying stages of completion.
- Since all projects do not finish at the same time, the assignment of overhead costs to each job’s gross profit must again be an educated estimate. This affects the accuracy of the firm’s resulting capital capacity calculation at the end of each accounting period.
That’s Not My Job
Construction companies are service providers. We are providing construction services to the owners of the assets we have been hired to improve. We are not selling a finished product to the eventual owner for a fixed price determined in advance of knowing the actual cost.
However, we’ve inadvertently allowed the industry to twist us into acting exactly like that.
- We sign contracts with government agencies, private owners, and developers that require us to construct, finance, and pay for the work before we get paid.
- The owner, not us, has legal possession of the product from the minute it’s put in place because the owner owns or controls the underlying property our work is placed on.
- We’re not paid at the time of the sale or in advance of delivery. We’re paid in weeks or sometimes months after the work is put in place.
- We pass through large amounts of owners’ money to skilled labor, material suppliers, and subcontractors without being able to invoice for our services at the same time. Our payment is built into an estimated profit at the end of the job.
- This is why it is impossible to determine positive cash flow or a firm’s capital capacity (do we have enough liquid capital on the interim balance sheet to complete all projects in progress, and what is the cost of that capital).
(If you had trouble following my reasoning above, you are in danger of running out of working capital at any moment.)
Next Week
Next week we’ll begin a discussion of the most effective accounting procedures for dealing with diminishing cash flow, project profitability, and company capital capacity. See you then.
For more information on financial management, read more at: FINANCIAL
For a broader view of construction accounting, read more at: ACCOUNTING
To receive the free weekly Construction Messages, ask questions, or make comments contact me at research@simplarfoundation.org.
Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.
