The last two years have exposed remarkable stress levels in the economy—from global institutions to local builders—and the construction industry has been especially hard hit.
While many contractors enjoyed healthy backlogs and margins as the economy faltered, the decline in new residential and commercial projects has reduced new work, increased competition and placed pressure on construction operations in all sectors throughout the country.
At some point—probably sooner than later—all of these factors will affect the profitability and financial strength reflected in contractors’ balance sheets.
Construction accounting has represented as much art as science since the introduction of percentage of completion reporting. Until the move from completed contract methodology to percentage of completion, the quality of a balance sheet could only be gauged by looking at cash, debt and historical trends. Balance sheets looked to be dramatically undercapitalized because no profits were being reflected until final completion of the contract. For credit grantors, including banks, sureties and vendors, financial analysis involved looking only at the results from completed work. The impact of ongoing work and profitability in the backlog was as much about educated guesses as true detailed analysis of the balance sheet.
The Danger of Estimates
Though helpful, today’s evolved reporting tools present a real danger to making the best credit decisions on continuing projects. Revenues on projects in progress combine cost to date and an estimate of the profit earned on those costs. While the cost to date should be known if the accounting systems being used are accurate, the estimates of cost to complete, final contract price to be billed and the resulting profit at completion are merely estimates.
If any issues surround the estimated cost at completion and the potential for variances on the final amount to be billed and paid, then those numbers are in flux. In construction, it is rare to know final numbers until a project is nearing completion. To the extent there are weaknesses in the reporting systems, the potential for impacting the balance sheet is magnified. Even if no doubts exist about the quality of the reporting, it is still imperative that the balance sheet be re-examined to establish the extent to which both liquidity and equity are driven by estimated costs and profits.
For example, if a $1 million project is projected to make a margin of 10 percent or $100,000, and the costs to date at the close of a financial reporting period total $450,000 (half of the total estimated cost of $900,000), then the costs and estimated earnings to date ($50,000) would be $500,000. Depending on the amount billed to that date, the balance sheet would reflect an under- or over-billing as either an asset or a liability. The capital would reflect the estimated profit at that date of $50,000 before overhead, depreciation and taxes.
The important point is that an estimate of final cost, billing and profit is in the equity. If the costs exceed the estimate and the profit recognized at the interim stage was inflated, then the project makes only $50,000 at completion and the financial report (based on the earlier estimates) overstated working capital and equity by $25,000.
Given that the statements of many contracts reflect substantial amounts of estimates of both costs and related profits, there is always the possibility of a shock loss if job profits fade and the earlier estimates are restated. This is the inherent “stress” in a contractor’s balance sheet.
The Weight of Work-in-Progress
Contractor operating results typically are driven by a handful of larger projects at various stages of completion. Depending on a few projects to carry the enterprise places particular emphasis on the accuracy of reporting interim results on those projects. If this handful of larger jobs reflects, in the aggregate, a significant proportionate share of the earned profits being reported in any balance sheet, it is likely that the financial capacity of the firm is tied up in those projects.
It is not uncommon to analyze a balance sheet and find the earned profits on the larger projects in progress represent the strength in the balance sheet. At times, analysis shows the earned profits exceed the working capital—and sometimes the equity—of the contractor. The implications to any credit grantor are clear. They are extending credit on cost and profit estimates.
The implications for contractors are even more critical. As they look to deploy their assets in running and growing their businesses, they need to understand that the foundation of their financial position might be centered in their most current work. The cash on hand may be a function of billing ahead of both their costs and profits. This base may be less certain than the cash resulting from completed projects. Decision-making regarding new work, expansion, equipment purchases and additional staffing may be based on assumptions that relate back to assumptions on the open projects.
While all contractors have some degree of work-in-progress profits in their balance sheets, the more prudent decision-makers continuously stress test their financials. Prudent credit grantors also understand the impact of not yet completed profit recognition when making lending decisions.
With extra pressure on contractors coming from the broader economic climate, a disciplined effort to identify the degree that a balance sheet relies on the work-in-progress estimates can provide valuable insight into financial stress and strength. This insight then can better inform strategic thinking and decision-making by contractors and their surety and banking partners.
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Wednesday, February 8, 2012