Thomas C Schleifer, Ph.D.
Thirty-five years ago, I initiated research that resulted in ranking construction contracting #2 in business failure rate (restaurants are #1). That data inspired me to begin ongoing research into the causes of construction business failure.
It’s Not About Failure
The thousands of contractors who attended my seminars on the causes of construction business failure were not out of business. They tended, therefore, to look at my research on contractor failure as pertaining to the “other guy” as if I was talking to their competitors who didn’t make it (who of course were not in attendance). I was trying to teach those in attendance “How to avoid failure in a failure-ridden business”, but I probably should have been teaching “how to mitigate risk in a risky business”. The word “failure” had crept into my lexicon and clouded my message. My mistake.
It’s About Risk Mitigation
Construction business failure ultimately boils down to one cause: unexpectedly running out of cash (working capital). The construction business model assigns an inordinate amount of financial risk to the contractor. This imbalance in risk assignment has been largely ignored until, finally, it has become completely hidden in the bones of the business. As a result, too many contractors are constantly at risk of financial insufficiency. A shortage of working capital is simply part of being in the construction business. My intention has always been to help construction professionals recognize financial risk and learn to utilize management techniques to mitigate its negative impact on their ability to take on new business and grow with a higher degree of stability and confidence.
Obviously, a single-family home builder in New Jersey wouldn’t have bid on the contract for the new Tappan Zee bridge. He or she would know they didn’t have the capacity to complete the project. They wouldn’t even consider it. However, this intuitive audit of capacity applied to building capability is rarely applied to financial capacity when construction professionals are considering new projects they believe are in the realm of their everyday business.
Project selection is a gradual process where contractors take on bigger and more complex projects as they go along. In their mind, each step represents the natural growth they can intuitively match to their team’s current capacity to complete. However, they rarely assess their firm’s financial capacity to complete a project. What most believe is that if they were able to finance similar projects in the past, they can add on a little more and find the working capital to go the distance like they always have. Until, of course, they can’t. Running out of working capital doesn’t happen suddenly. It sneaks up on construction firms as they go about their normal course of business. For example, a company with sales of $10 or $50 million annually, growing to $20 or $100 million in a year, without a corresponding increase in equity, can dramatically increase financial risk without realizing it, even if profitability is maintained.
There are conflicting views on whether financial performance should be measured by profit or by an increase in the value of the firm. The ultimate measure of performance is not what is earned but how the earnings are valued by the investors. A firm’s increase in value, not its profit, is the true measure of a company’s performance and capacity going forward. In other words, it is important, even critical, to measure the risk of capital capacity in the pursuit of profit.
The combination of the fast-paced construction business and the lengthy timeline of major projects makes early detection of financial weakness difficult. This is especially true in a growing business, as growth tends to cover up poor performance. Measuring financial capacity and risk requires a look at: a construction company’s past financial performance, its utilization of earnings to increase capacity, and the projected amount of capital required to complete projects under consideration when combined with the financial requirements of ongoing projects.
Because the availability of outside capital is so limited in the construction industry, contractors must carefully retain earnings to enhance the financial capacity used to fund even modest growth. The amount of money required to run a business varies by company and industry. For a closely held construction company, the portion of profits that must remain in the business to maintain the company’s assets to liability balance is approximated by retaining from net profits the proportion that liabilities represent in the liabilities to assets ratio. For example, if a firm’s liabilities to assets ratio is 1 to 3, roughly one-third of the profits should remain in the operation to support ongoing and future business.
We Have Only Just Begun
This is just one simple example of the first step in recognizing and mitigating the financial risk hidden in the construction transaction. Next week we’ll present more case studies to give you a broader feel for the nature and scope of construction’s financial risk profile.
For a deeper look into financial management & risk, read more here: RISK
For a broader view into business failure, read more here: FAILURE
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Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.