Capital Is King: During COVID
Years of research into the causes of construction business failure confirms that throughout history the sudden collapse of construction firms, large and small, comes down to one factor: the slow and sometimes invisible erosion of the firm’s capital position.
A dramatic example is the recent collapse of Britain’s oldest construction firm, R. Durtnell and Sons, founded in 1591. Continuously in business for 428 years, the firm suddenly collapsed this past year. When asked what happened, the CEO said simply that the firm “ran out of money.” Really? After 428 years in business?
The sudden evaporation of capital in the oldest continuously operated construction firm in the world alarms me. It should alarm and pique the curiosity of every construction professional in the industry.
Balance Sheet Vs. Income Statement
I have been raising the red flag of capital erosion since the onset of this current pandemic. I am concerned that industry management is looking at the wrong metrics as they attempt to navigate this sudden market downturn. Many in senior management are looking to the income statement for protection and not to the balance sheet.
Capital Is King
Let me say it again. Only preventing an erosion of your company’s capital (a balance sheet metric) during a downturn will keep your company from following R. Durtnell and Sons into the pages of history. Because “cash flow” is the life blood of the construction industry, most contractors focus on getting the next job to keep the company going. It is the nature of the industry. However, in a cyclical market environment, when “the next job” might not be there or might not be there at a profit, a contractor’s capital position is the safety valve that insures survival.
Capital – A Closer L00k
Capital is more than cash in the bank. It is, rather, the total financial “capability” that a firm has built up over time composed of the following:
- Retained Earnings – Small and medium privately-owned construction businesses do not necessarily build retain earnings. The owner usually considers earnings their individual property apart from the “firm” that generated them. Therefore, they often remove them for personal use, leaving some contracting firms with less than optimal retained earnings.
- After-Tax Profits – Because most contractors operate multiple jobs at the same time and one job flows seamlessly into the next, a laser focus on individual project profitability is sometimes lost in the continuous flow of cash in and out of the firm. However, genuine after-tax profits from each job are the fuel of balance sheet capital. Under these circumstances, it is easy to see how capital can become dangerously eroded without management being alerted in time.
- Credit – Although classical accounting does not consider credit part of capital, it is part of the capital structure. Contractors who survive market downturns always have very good banking relationships built up over years of operating efficiency. As we enter another potentially prolonged market decline, it is advisable to spend time shoring up your banking relationships.
- Receivables – I suggest taking this most recent pandemic downturn as a sharp reminder of the importance of cash collection and liquidity. Strong liquidity is a critical hedge against economic uncertainty. (more about how to get paid on time coming up)
- Contract Terms – This unprecedented environment reinforces the need for thorough contract analysis to ensure appropriately mitigated risk. Awareness and strict adherence to contractual notification provisions are essential, especially in light of the delays and additional costs caused by the pandemic. Prior to signing a construction contract, it is important to focus on force majeure, delay damages and related clauses, and other contractual provisions that directly impact a firm’s risk and bottom-line during periods of economic and operational uncertainties.
Quotes from Surety Professionals
“Sureties will provide a no-expense review of contracts highlighting provisions that may be problematical and possibly deserving of reconsideration. A surety might be in a position to assist the contractor, at times, in a renegotiation of undesirable terms. If a dispute arises during the course of a project, the surety, as a party to the contract, may play an assisting role to its contractor in reaching a settlement compromise in a dispute.”
“A difficult cash-flow situation might arise as a result of a notice to proceed on performing a significant and costly change to the contract, with pricing of such change and the payment thereof to follow, as outlined under the contract. The surety may decide to temporarily advance funds to the contractor to perform the extra work for the contractor to remain compliant with the contract terms. The surety would thence be reimbursed once payment is made.”
Focus on Capital
Focusing on the balance sheet in times of market stress is a critical management skill that is not routine in the construction industry. Let’s change that.