Capital Reserves
Contractor’s Last Line of Defense
For the past three weeks we have been discussing the nature of capital reserves and their importance to contractors trying to manage through the depth and breadth of the current COVIDeconomic downturn.
Construction Industry Business Model
The business model ingrained in the industry back through ancient times is a straight-forward “cash flow” model where current jobs finance the recently past work in progress, thereby keeping the bills paid. Because of the complex nature of the construction business, the accountants are tasked with reporting the individual profitability of each job while senior management ensures positive cash flow considered more important than after-tax job-by-job profitability. They spend their efforts on the bidding and cost-cutting activities that effect positive cash flow. Many feel that GAAP profitability on each job is too hard to calculate and often comes too late to make any real difference to the going concern. Many construction companies can’t be certain if they’re making or losing money until the end of the project. In some cases senior management is too busy billing their work, completing construction, and estimating for new projects to be paying attention to each job’s actual profitability.
Importance of Capital
This can lead to less attention paid to the importance of accumulating retained earnings. Thirty years of research into the multiple causes of contractor business failure suggests that many contractors operate with insufficient capital which is part of the reason the industry has the highest failure rate of any industry second only to the restaurant industry. Contractors operate on thin margins making slim profit on a portion of their work with an occasional loss. Constant top-line expansion has allowed some to operate complex construction concerns for years without ever making much profit which leaves them with little capital to finance an extended market downturn.
Different Forms of Capital
Beyond cash and other liquid assets:
- Owner’s Equity – The capital contributed to start the firm combined with any stock sales over the life of the company.
- Retained Earnings – The profits from ongoing work that are not distributed to the owners in the form of wages, bonuses, perks, or dividends.
- Professional Reputation – Although this “source of capital” is not recognized by traditional accounting, it is critical to maintaining lines of credit at the bank and support from sureties which goes a long way in keeping a contractor in business during lean times.
NOTE: Cash on hand and the quick ratio may be measurements of liquidity but do not mistake those metrics for available capital. Make sure that current “accounts payable and mortgages, equipment leases, and rents due within 30 days do not automatically cancel the value of “cash on hand, and don’t forget to offset certain deferred taxes such as accumulated income taxes not due and payable within thirty days but definitely an accumulated burden on capital over the course of a cyclical downturn.
Because construction is so capital intensive, often past earnings are invested in fixed assets that cannot be called upon to supplement a limited cash flow imposed by a shrinking market.
Isn’t This Obvious?
I am aware that these discussions about the causes of contractor failure might seem obvious to some and beside the point to others, but keep in mind that the senior management of large legacy construction firms that suddenly failed were “surprised” when they ran out of money.
“Contractors build things, they don’t keep books.” You know who said that? I did, forty years ago, when my brother and I were running our own contracting business which is still in business today. I was not aware that I should have spent more time on accounting. Contractors are naturally looking at their businesses as going concerns and rarely consider a catastrophe until it happens. This view is part of our belief system, and we are often blinded to the alerts of balance sheet metrics.
In lean times, however, studying your capital position and understanding how to carefully manage your way through a sudden and dramatic construction market downturn is the critical management skill that I encourage all construction professionals to hone during the economic downturn that is suddenly upon us.
Don’t worry so much about the “top line” when markets turn down. Keep a more careful eye on the “bottom line” to assure at least a modest profit and avoid the risk of too much low-margin work. This shift in emphasis might be one of the best defenses you have.
