Capital Capacity

Thomas C Schleifer, Ph.D.

Will we be running from rampant cost inflation or deeply mired in top-line recession in 2023? No one seems to know. What we do know is that we don’t know, and that’s treacherous turf. How do contractors decide whether to bid aggressively for contracts in 2023 or hold back and cut overhead in advance of a Fed induced recession? If margins are slim and materials and labor costs are escalating will new jobs throw enough early cash to see us through to completion? In every construction market downturn since WWII construction industry profits have plummeted. How much existing balance sheet capital will it take to get through the negative earnings period that will result from a Fed created blend of inflation and recession in 2023? 

Our Industry is Unique

The construction industry is unique among all American industries because it has, for the most part, not been capitalized by public equity. The phenomenal growth that the tech sector has experienced recently, or the energy sector before that, or heavy manufacturing early on was all financed by Wall Street’s ability to tap into the public’s pocketbook. The vast amounts of capital pumped into American industrial balance sheets financed the unfettered growth that fast became a religion in investment circles. For some reason, however, the construction industry was never invited to the party. We had to muddle along on the fuel provided by founders’ savings and banks willing to provide short-term working capital lines of credit. Without a ready external source of growth capital, most of a contractors’ meager earnings had to be reinvested in new equipment and expanded home office facilities rather than retained on the balance sheet for future working capital needs. This is why capital capacity has always been marginalized in the construction industry. We have never had a robust fund of either owner’s equity (stock sold to the public) or retained earnings to comfortably finance the new jobs that are the essential lifeblood of our business.

 Construction Cash Flow 

And so, the cash flow story for the typical construction enterprise during its five stages of growth from startup to maturity goes something like this:

  1. Construction startups often cannot get enough cash and credit resulting in a high failure rate. 
  2. In survival, the challenge is to generate or borrow enough cash to break-even and cover the cost of replacement of equipment, and to eventually earn enough to finance growth to a size that provides an economic return on assets and effort. 
  3. In the success stage, enough cash is earned to reduce or eliminate debt, but overspending is sometimes a problem. 
  4. In the growth stage, cash is short again, and there is a tendency to over-borrow.
  5. In the mature construction company, cash flow meets all business needs and there may be some modest debt in the capital structure.

Managing inadequate cash flow is only possible if there is an understanding and anticipation of the different capital demands in the various stages of the construction company’s growth.

(For an in-depth understanding of the Construction Company Life Cycle, i.e. stages of growth, see chapter 15 of The Secrets To Construction Business Success.) 

Managing Construction Company Cash Flow

In the well-run construction company, the CFO is responsible for cash flow management. At any given time, he or she must discern what stage the company is in, what growth is anticipated, how much capital is available, and how much future cash flow can be relied on. In other words, the CFO is tasked with estimating the “capital capacity” of a construction concern as it goes about its business. Here is a broad outline of the steps required to accomplish this task:

  1. Compile a multi-year quarterly history of the company’s cash flow through various stages of growth.
  2. Research the payment histories of the owners engaged with the company.
  3. Review expected banking CC&Rs (Covenants, Conditions, and Restrictions) for one to two years into the future to estimate the company’s capacity to borrow based on the volume of business activity and the company’s balance sheet position.
  4. Factor in the “front load” and the “duration” of each job.
  5. Limit capital utilization to ongoing business needs by postponing unnecessary capital expenditures. 

During 2023 and 24, it may become critical to match growth plans to capital capacity. I trust that everyone understands by now that attempts to grow during a market slowdown requires almost suicidal pricing to beat everyone else who is desperate for work.

Capacity Risk

The ability to self-finance ongoing business and growth is the trick to being a successful construction contractor. Few, if any, of the famous non-construction industrial companies that now dot the American business landscape would have succeeded without access to abundant equity capital from public capital markets. The contractor has a tough challenge. He or she must constantly acquire new contracts (external growth) without the luxury of abundant “free” equity capital. In other words, we must “self-finance” our ongoing business expansion. The willingness to take on enormous personal risk and somehow wend their way through the minefield of construction is what should make successful contractors the management heroes of American industry. 

(During the week between Christmas and New Year there will be no Weekly Construction Message. See you next year.)

For a deeper look into the role of a CFO,  read more here: CHIEF FINANCIAL OFFICER

For a broader view 2023’S financial landscape, read more here: FUTURE

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