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August 2012 >>
Financially Evaluating Contractors After the Great Recession
As contractors and specialty subcontractors emerge from the recession, many face equity levels that have eroded during the last three to four years. General contractors and owners need to know more about who they are hiring; simply relying on reputation is no longer good business.
Among other issues, general contractors and owners must know whether subcontractors have the financial resources to complete the project. If subcontractors cannot complete the project, costs will increase and project delays may ensue. It is in everyone’s interest that all contractors are financially stable and capable of completing their respective scopes of work.
Firms without a process in place to review the financial health of prospective contractors should talk to their internal financial manager or an outside CPA firm that specializes in working with contractors. Following are recommended questions to ask potential project partners.
1. Are you bondable? When was the last time you completed a bonded job?
Recognize that all surety bonds are not created equal. Ask what surety the contractor is bonded with and confirm the surety’s rating. Surety programs typically are quoted at two levels: per job and aggregate. For example, a surety would state it will bond each job up to a certain dollar threshold, and in the aggregate will bond total jobs of a certain amount. These levels are useful indicators of the contractor’s financial strength.
2. Can we see your most recent financial statement?
Double check the surety underwriter’s analysis by looking at the contractor’s year-end and semi-annual or quarterly financial statements. Start by determining whether the financial statement was prepared by a CPA firm that specializes in the construction industry. Contractor statements require the percentage-of-completion method, which not all CPA firms understand.
Review the two key indicators evaluated by the surety underwriter: equity (net worth) and working capital. Generally, weak levels of equity inhibit the contractor’s ability to meet its financial obligations. As a rule of thumb (not to be relied on in all situations), bonding capacity can be 10 times equity.
Working capital includes current assets, such as accounts receivable and cash less current liabilities. This is an indicator of the contractor’s ability to meet future obligations. Weak working capital indicates cash flow concerns. To generalize, consider that 10 times adjusted working capital may be an approximation of aggregate surety capacity.
Debt also must be considered. Obviously, a balance sheet with little or no debt is more favorable. At the same time, the availability of a line of credit should be viewed positively because it enables the contractor to meet cash flow requirements early in a job before initial progress payments are received. Likewise, the line of credit temporarily supports cash flow to meet the construction industry’s unique retainage requirements. Of course, leaving the line of credit unpaid for lengthy periods is another indicator of poor cash flow. Review the footnotes in the financial statements for the total available line of credit and the amount drawn down at the balance sheet date. Additionally, consider ratios such as debt-to-equity when evaluating debt levels.
Financially healthy contractors typically reserve (i.e., accrue an expense) before expending funds in the future. For example, a contractor may record an expense for potential warranty work. If the warranty work is required, then the balance sheet reserves can be offset rather than negatively impacting future financial results by taking the expense in a later period. Based on prior experience, the contractor can develop a percentage rate of its annual volume as an estimate of warranty work required in a future period. The mere existence of these reserves reflects a contractor’s conservative financial approach (i.e., matching future costs within the period in which the work is performed and profits are earned).
3. What is your current backlog?
Current work levels can be a key indicator of the contractor’s financial health. This is a difficult issue for many contractors given the diminishing availability of nonresidential construction jobs. Associated Builders and Contractors’ Construction Backlog Indicator for the first quarter of 2012 was 7.4 months, indicating that on average U.S. contractors have signed contracts representing more than seven months of work. (For more information, visit www.abc.org/backlog.) While backlog may not be an absolute indicator of financial health, it’s still valuable to know how many dollars of backlog a contractor has as of a specific date. A financial statement prepared by a CPA will include a backlog schedule in the footnotes.
Keep in mind, too much backlog could strain a company’s management and cash flow. Talk with a financial manager or CPA for guidance on this matter.
4. Can you share some history about your company?
Pertinent facts about the history of a company should be verified. Stories prevail about contractors that continue to bid and take on business even though they owe significant amounts in back payroll taxes. Or consider a contractor that files for bankruptcy and then quickly opens a new entity while continuing to brag about the inflated number of years the business has been operating. The reality is the contractor should be referring to its “businesses” because it has closed and opened operations several times.
5. What litigation have you been involved in recently?
The construction industry is litigious, so this may not be a clear indication that anything is wrong with the prospective contractor, but it’s valuable to know if a potential partner is consistently involved in lawsuits. An attorney can check into this by electronically searching county and state filings.