While the domestic and international economies still appear to be moving along nicely, there is likely hesitation to admit some type of recessionary activity is on the horizon. Political uncertainty, trade tariffs, a lack of inflation and a very unpredictable interest rate environment have caused trepidation for celebration and provided at least the backdrop for a certain level of caution.
Concerns over an economic pull-back may be making some contractors nervous, but most are simply too busy with day-to-day operations, labor shortages, material price fluctuations and job completion issues to really worry. However, now is the time for company leadership to work on their financial disaster plan and ensure there is a strategy in place to address a potential softening in the construction economy.
The findings discussed at a recent Dodge Data & Analytics Outlook conference made some solid predictions about the stagnation of the United States economy and related construction spending. The reported data reflected relatively flat construction starts of approximately $800 billion in 2019, compared to a similar level in 2018. While the report itself is not necessarily cause for concern, it may be indicative of the construction economy leveling off.
Currently, the financial markets, including banks and surety firms, continue to extend significant credit to financially sound construction firms, while lesser firms have seen a significant tightening in credit approval. With a somewhat booming economy, contractors have been enjoying the benefits of significant backlogs, healthy job margins, tax-cut enhancements, and improved profitability and cash flow.
But, with this level of success comes risks—what goes up must come down. With these conflicting factors at play, construction firms are trying to identify ways to protect the financial stability of their businesses.
Where to Start
The best plan of attack in this economic expansion may be to make your construction company as recession-proof as possible and to protect what you have built since the last recession. The lessons learned and financial distress indicators developed in the last downturn should provide some sound data points to assist in preparing for the turbulence that is eventually coming.
With these lessons in mind, there are five fundamental areas for construction executives to focus on during a strategic review of the company’s operations and the development of a plan for what-if scenarios:
- Develop a list of potential employee reductions for lesser performing workers at the field, operations and administrative levels, as well as any related employee benefits that may be evaluated for modification.
- Establish a detailed financial plan to assess significant operating costs and identify potential areas you can target for reduction in a down economy.
- Ensure your backlog includes solid construction contracts with predictable and profitable margins, and that there is limited exposure to significant profit fade.
- Secure financing that provides long-term credit capacity, such as a 2- or 3-year bank commitment on the company’s line of credit, and begin to develop relationships with alternative lenders and surety firms to develop Plan B financial relationships.
- Maintain a financially sound balance sheet during the good times, and do not remove excess capital from the business for owner compensation. Cash has been and will always be king, regardless of the stability of the construction economy.
How to Assess Financial Distress
It is critically important for construction leaders to understand how to properly deal with a potentially problematic financial situation and understand the key indicators of distress. While it may seem obvious to measure financial distress by a lack of cash to operate the business, there are many warning signs that may be present before the financial storm actually hits.
The five telltale signs of looming financial distress that every construction company should look out for are:
- Fading margins and an inability to complete work within budget, causing cost overruns to become prevalent and losses on jobs to begin showing up
- Inability to consistently secure enough work to generate an adequate backlog to protect current and future balance sheet financial stability
- Difficulty generating the cash flow needed to fund basic operating costs like payroll, payroll taxes, union benefits, health insurance, etc., as well as a significant increase in vendor collection calls
- A balance sheet showing signs of a financial instability, such as minimal working capital, limited cash reserves, deteriorating equity and limited ability to borrow on a bank line of credit
- Inability to secure bid bonds and performance bonds on a consistent basis
What to Do Next
If a construction company finds itself in a financially distressed situation, it is important to chart a proper course of action to address the issues at hand. First, evaluate the degree of the financial distress. If the situation is not lethal, determine how the financial distress and operations can be effectively resolved.
Once a determination has been made, the company will need to prepare a complete and accurate statement of its financial situation. Executive leadership, along with exceptionally proficient financial consultants, will certainly need to be in place to address the fundamental operating and financial issues.
In an economic downturn, leadership must be able to reflect an accurate balance sheet and financial position, and accurately report contract accounts receivable, percentage of completion accounts, contract accounts payable, and final estimated realization of any outstanding disputed change orders and claims. This particular step allows for the company and its advisors to address the reality of the situation and not have a balance sheet cluttered with numbers that are meaningless and will not convert to cash.
During a recession, leadership, along with expert financial consultants, will review all operating costs, including payroll, rent, family perks, insurance and other expenses to determine which expenses will be reduced as part of the monthly operating plan.
From there, a detailed review of the company’s real estate and equipment holdings should be performed in order to determine if any liquidation is needed. If the carrying costs of the building, including debt service, are too high, then sell the building. If certain pieces of equipment are no longer necessary, sell the equipment. Cost reductions, real estate liquidations and excess equipment liquidation will relieve cash-flow strain and allow related bank debt to be reduced.
As the financial crisis plan nears finalization and all major financial matters have been fully addressed, leadership will need to present the plan to the bank and bonding company. It is critical during a pending crisis situation to provide accurate, credible and timely information to key financial partners and to foster open, frequent dialogue.
The company will need to manage the plan and work with its financial advisor on a monthly basis to determine the plan’s level of success and any potential opportunities to improve the plan or reassess the course of action. As with any financially distressful situation, there are no guarantees of success, but if leadership can develop a well-thought-out financial plan, there is a greater likelihood of a successful outcome.
Remember: Success is measured in many ways. For some, it’s improving operations until the business continues to thrive, regardless of the economy. For others, success is limiting the financial hardship caused to family members, banks, surety companies and employees. But for many owners, success is simply a clean scale-down of the business in which the vendors, bank and bonding company all come out unscathed.