Managing Capital Risk
Recognizing the reality that there are multiple types and magnitudes of capital risk in construction is the first step in risk management. You may be familiar with the term risk prevention, but in fact, we can’t prevent risks from existing. The only thing we can do is reduce the likelihood of a risk occurring or minimize the impact if a risk does occur.
Recognizing Capital Risk
The fast pace of construction and the lengthy timeline of major projects complicate the detection of financial risk, particularly in a growing business because growth tends to cover up poor financial performance.
- The two major risk factors built into contracting are undercapitalization and highly complex transactions.
- Just about every contractor we’ve worked with over the years has been distracted by cash flow problems at one time or another because construction companies rarely retain enough earnings to accumulate abundant working capital.
- Since ongoing business for contractors is often new business, earnings are rarely stabilized and are often unpredictable. The situation is further complicated because cash flow requirements differ widely from project to project.
- Most banks secure lines of credit on the tangible net worth of the company and its owners. This is problematic because the net worth of a construction firm has little or nothing to do with the amount of working capital required to see a particular project to completion.
- In effect, contractors must build and finance the work with limited access to capital.
Operational and Financial Interdependence
Operational performance (gross profit) and financial performance (capital capacity) are interdependent.
- Because operational performance must be funded it cannot exist without positive financial performance.
- Financial performance is totally dependent on operational performance for funding through profits earned.
- Poor financial performance affects operational performance funding when working capital decreases for any reason such as over investing in assets or owners taking too much money out of the company.
Controlling Financial Performance
The first step in controlling financial performance is early detection of financial weakness to provide management time to take defensive action. The system should be easy to use and not too labor intensive. An accurate and sometimes informal Sources and Uses of Funds report is a good example of such a system.
- Your comptroller keeps a cash ledger classifying every transaction as it occurs as either a source or a use of funds.
- Sources include all actual payments from owners (not invoices submitted for payment), working capital line of credit withdrawals, payments from asset sales, and any cash equity contributions.
- Uses include all actual cash payments for expenses (including materials, subcontractor payments, licenses and fees, payments for additions to assets, and any distribution of retained earnings to owners).
- The periodic balance (either an increase or decrease in available working capital) is that period’s financial performance.
It seems as if, one way or another, every bookkeeping department keeps track of cash flow. Why, then, do so many contractors suddenly run out of cash?
Controlling Operational Performance
Using traditional financial statements to measure operational performance (profit and loss) is a bit more complicated but somewhat less urgent. As we have said, the complexity of the construction business transaction makes the production of traditional financial statements less exact and immediate. In the long run they do capture the financial condition of the enterprise and give outside third parties who have a financial stake in the company (banks and sureties) a useful financial picture. However, they can easily misstate interim profitability and mislead management’s view of their capital position.
It is the responsibility of the CFO to not only compile accurate financial statements but also to interpret the data to inform management decision making by:
- Subjecting all financial statement data to a reasonableness test informed by company experience. (If the company never produced a 20% gross profit, the CFO must question and adjust the data that produces such an out of the ordinary statistic.)
- Analyze current financial data for trends that foretell financial pitfalls.
- Assure that financial performance does not negatively impact operational performance.
- Correlate financial and operational performance by analyzing how one may be negatively impacting the other throughout each project’s life and recommend or take the necessary corrective action.
Next week we’ll dig a little deeper into timely corrective action and how to prevent surprises.
For more information on financial performance, click here: PERFORMANCE
For a broader view of managing financial risk, read more at: MANAGING
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