Focusing on Gross Revenues Instead of Net Income Can Be Hazardous to a Contractor’s Health

With the economy sputtering and access to capital shrinking, these aren’t the best of times for go-go contracting firms-the ones that define themselves strictly by growth in volume.

It is no coincidence that these companies also tend to be the ones that have the weakest contingency plans for dealing with economic downturns. To a certain extent, however, that merely reflects the history of the industry. The American construction sector has always been personified by risk takers and strong personalities, which explains in part the obsession with gross revenues. In the minds of many contractors, volume and organizational size always trump profits. It is the top–not bottom–line that draws these contractors’ focus.

Growth Without Profit Can Lead to Failure

Overlooked in all this ambition, however, is the fact that rapidly increasing gross revenues create the need for a larger bureaucracy, which in turn must be fed regardless of current market conditions and costs. Unfortunately, the industry is littered with the graves of bureaucratic monsters that have refused to understand this. One such company was MMR Inc. Created in the early 1980s, MMR was one of the nation’s largest construction firms by 1989. By the end of 1990, however, the company’s debt had driven it out of business. Not long after, Encompass Service Corp, which became one of largest subcontractors in the nation, went bankrupt as well. There have been others since then.

What these companies learned in painful fashion is that constant pursuit of higher revenues does not guarantee a healthy company. In terms of financing, higher revenues do not guarantee improved access to bonding. In fact, a strong bottom line is a key consideration for surety companies and banks when they are deciding whether to approve lines of credit and loans.

Contractors should find their “hot spot.” That is, the range of gross revenues where they are most profitable. For example, growing from $20 million to $30 million may not add significant additional income to the bottom line after accounting for the extra personnel and overhead costs it took to get there.

Each year the Construction Financial Management Association (CFMA) conducts a financial survey. In one of its recent surveys, CFMA looked at net income as a percentage of gross revenues for the “Best in Class” industrial and non-residential contractors. What CFMA found was that among contractors with gross revenues under $50 million, net income was about 3.9 percent of contract revenue.  At the $50 million and above level, net income averaged 2.9 percent. This survey clearly shows that companies don’t always increase their net income-as a percent of revenue-by expanding gross revenues.

In years past, a company with $1 million in working capital, for example, could support a work program of up to $25 million. That’s because many surety companies allowed contractors to have working capital equal to 4 percent of their backlog. But after experiencing losses in recent years and a tightened credit market, many sureties are now requiring working capital of at least 5 to 6 percent of the contractor’s projected work program. Therefore, for the company with working capital of $1 million, the work program falls to around $20 million. But that still allows for healthy net income-if enough of the overhead costs are variable and the contractor is adapting to the changing market.

Net Income Matters to Sureties & Banks

Net income influences not only the volume of work that can be bonded, but also the amount banks will issue in loans and lines of credit. When deciding whether to issue or extend a line of credit, bank loan officers look at net income, cash flow and return on investment. What they want to see is a growing bottom line, not an expanding top line defined strictly by number and size of contracts. Banks want to see rising net income, not rising revenues and flat net income.

In our industry, it’s not uncommon for small and mid-size contractors to chase growth at the exclusion of all else. What these contractors forget, however, is that reckless ambition likely will lead them beyond their natural boundaries. Before they know it, they’ll be outside their comfort zone trying to provide work for which they aren’t highly qualified. What happens next is a series of errors, misjudgments and financial wastes. Meanwhile, to feed the growing bureaucracy, where hidden expenses suddenly are everywhere, all types of work must be pursued, often at lower-than-normal fees.

Net income is critical today for another reason as well. With construction costs climbing as they are, obsessive pursuit of higher volume is like accelerating a car stuck in the mud. The acceleration only accomplishes a deeper hole. Hourly wage rates continue to climb.  Petroleum prices are up over 50 percent during the last twelve months. And steel mills announced recent price increases of more than $100 per ton.

For companies chasing volume like there is no tomorrow, these higher costs are reducing gross revenues so much that little of the added volume shows up on the bottom line. Most of the time, it would have been better for these contractors to focus on their niche, provide exemplary service to existing customers and keep expenses under control. By doing this, net income would be growing properly in step with gross revenues, and these companies would be better poised for long-term success.
 

Construction Business Owners, May 2008