Thomas C Schleifer, Ph.D.
After New Year’s, prognosticators gave up pretense and predicted recession for 2023. The Fed, they now admit, waited too long to take action and its current aggressive interest rate hikes are pushing the economy into a recession while not yet tamping down inflation to their acceptable level (2-3%). In other words, contractors will likely have to navigate an economy in 2023 plagued by both inflation and recession.
A One/Two Punch
That is a deadly combination for construction. The trap is set for losses when inflation in costs is overlapped by revenue recession. Due to the unique transactional nature of our industry, we cannot instantly raise our selling price to cover inflated costs of production. We are even limited in our ability to raise future selling prices to adjust for inflated costs because of the fierce competitive nature of low-bid contracting. Inflated costs call for inflated selling prices, but deflating market opportunities call for deflated (lower) bids to compete for scarce business. That is the profit beartrap set for construction in 2023. We can be forced into a “Buy high/sell low; and try to make it up in volume” business model that has put so many contractors out of business.
What Can Be Done
In order to survive the one/two punch of the inflation/recession market that is evolving in 2023, contractors need to focus on managing their capital position with great care. As costs creep up and selling prices creep down, positive cash flow is in jeopardy. My years of experience in the “failure” business revealed that contractors who failed simply ran out of money (cash flow), and most had no idea they were in jeopardy. When asked how this could happen, my research revealed that contractors were not financial executives and rarely placed their financial professionals in top management decision-making positions. Too often these contractors did not produce accurate profit and loss statements and seldom used the balance sheet to manage the business. In other words, they were good constructors and leaders but not well versed in, or highly competent in, capital management.
Put simply, but to the point for contractors –
Capital Management is the process of monitoring and adjusting liquidity monthly to maintain “going concern” status over prolonged periods of delayed payment and contentious retainage. (the business environment we work in.)
The key here is “liquidity”.
Most contractors are hypersensitive to cash flow because front loading and billings in excess of cost get their firms from one job to the next. They see these techniques as essential elements of “cash flow”. Traditional accountants produce a formal cash flow statement (referred to as “sources and uses of funds”) alongside the profit and loss statement and the balance sheet. These reports monitor cash flow from all sources and track where the cash is spent during the same accounting period. Although they are useful reports for understanding where your flow of funds is coming from and where it is going, they do not inform you how much capital you have available to survive “over prolonged periods of delayed payment and contentious retainage”. In other words, they tell you what has happened to your money in the past but offer no insight into what will happen to cash flow in the future. They don’t tell you how “liquid” you are or tell you how much “capital” it will take to get you from point A to point B in the future. This is where “capital management” comes in.
The CFO’s Role
And this is where your CFO comes in. Accountants are not trained to simply add and subtract. They are trained to analyze and use financial data to manage a business going forward. They know how, for example, to extract liquidity from an arcane mountain of financial data and predict how much liquidity your firm will require to execute the existing business plan and estimate how much future business your current capital position will support. In other words, they can estimate at what vector point you will run out of cash. If the hundreds of distressed construction enterprises that I worked with in the failure business had used their CFOs to identify liquidity and capital position and had listened to their advice, they would be in business to this day.
A Deeper Dive in 2023
For the next three weeks, we will be taking a closer look at how to use your balance sheet, and not just your income statement, to manage your business. What exactly are the elements of liquidity? How do you determine your capital position? How does the unique transactional nature of contracting effect cash flow? What is the critical contribution that accounting makes to the business plan? Watch this space.
For a deeper look into The many roles of a Chief Financial Officer, read more here: CFO
For a broader view into construction inflation, read more here: CONSTRUCTION INFLATION
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