What Lenders and Sureties Most Want to See

Prepare Now for Year-End Meetings

With our financial markets in turmoil and credit tighter than ever, it is imperative that owners and advisors coordinate to keep all parties informed about business trends. This environment makes year-end meetings with sureties, bankers and other financial partners even more critical. Before meeting with your bonding agent and banking partners, take the time to think about the following tips that may improve your financial picture.

Manage Cash Flow

Consistent cash flow minimizes debt and keeps work on schedule. Over a five-year period, sound companies tend to maintain a 1-to-1 ratio of net income (excluding depreciation) to cash flows from operations (cash received from customers, minus job costs and overhead, but before asset purchases and repayment). Conserving cash flow will be a primary component of increasing your bonding capacity.

To successfully manage cash flow:

• Use software to calculate actual cash flow on a dependable, month-by-month basis. You can buy it retail or build your own spreadsheet.
• Aggressively pursue cash collections. GCs and owners may want to hold on to money longer these days, but the most successful contractors keep their receivables under an average 40 days.
• Talk with your banker about cash management services and utilization of credit lines.
• Consider whether it is more advantageous to lease equipment instead of buying. Leasing conserves cash by only requiring remittance of periodic payments instead of upfront cash payouts.
  

Review Contracts Closely
Overlooking contract terms can cause big problems even in good times, but in a downturn such mistakes have worse consequences. Owners and GCs are under pressure, and more are writing contracts to delay a contractor’s billing or even eliminate progress billing entirely. Also watch continuing contracts to ensure they carry the same payment terms through each stage.

Missing such a change, and being unable to bill until the project is complete, could cost a contractor substantially. If the amount is small enough and the contractor big enough, the result might not be catastrophic. But even so, can you afford to carry an extra $200,000 for a year?

Trim Overhead Costs
In 2008, most contractors averaged fewer on-site hours. That trend reduces labor costs, of course, but the associated overhead costs don’t come down automatically. It’s time to go over them line by line to decide what can go.

Much of the construction business is conducted over dinners, shows and golf games, and generous year-end gifts are routine. You don’t have to eliminate them, but bring them into line with the new realities. The same is true for all overhead — administration, promotions, marketing, fuel costs and so on. Does every foreman really need a fuel card? Shut down extra cell phones and eliminate unnecessary expenses. And when was the last time you shopped insurance plans? (One silver lining: Better deals are available in a recession.)

Improve Working Capital
Working capital gauges a firm’s ability to finance its operations and indicates the level of protection creditors and surety companies can expect. So, for example, if your company reduced its debt and obtained a higher credit line this year, highlight that in your financial statement.

To determine whether working capital is adequate, sureties and bankers divide a company’s current assets by its current liabilities to calculate its current ratio. A contractor with current assets of $400,000 and current liabilities of $250,000 has a current ratio of 1.6 to 1.

Sureties and lenders hope for a current ratio of 2 to 1 or even 2.5 to 1, but they also take account of a contractor’s size and type of work. In some equipment-intensive trades — heavy highway, for example — a contractor with a ratio of 1.25 to 1 can still be in good financial shape. Taking the steps outlined in this article will help improve this ratio.

Bolster Net Worth
Sureties in particular pay close attention to net worth because it tells them how much loss a contractor can absorb. Bonding agents and bankers want to see that company owners are retaining earnings, not paying disproportionate amounts to shareholders or buying real estate for non-business purposes.

One key component of overall net worth is money on hand. The construction environment has always gone through good years and bad, and those immediately ahead are uncertain at best. Consequently, lenders want assurances that contractors have enough reserves to meet expenses, anticipated and otherwise, over the next 12 months. Two ways to increase a reserve fund are:

• Reduce payroll bonuses to owners. Whether an S corporation pays its owners in shareholder distributions or bonuses, the money is taxed as personal income. But bonuses also cost the company through payroll taxes such as Medicare and local income. Sureties and banks also frown on stripping out corporate profits through bonuses, especially if a company isn’t sufficiently capitalized. A contractor that limits bonuses and makes distributions after the end of the year to fund owners’ tax obligations can show increased profits and cash on hand.
• Reduce debt and raise cash. Selling equipment is one way to do so. Evaluate your inventory to determine if some can be sold to pay down debt. And contractors on thin ice with a surety or lender may find the underwriters approve of leasing more than owning.

Owners should also consider the cost of their physical plant. As property taxes and insurance costs rise, consider enterprise zones that offer tax advantages that can improve net worth. These advantages can apply whether or not the company owns the real estate.

Manage Overbillings and Underbillings
Financial underwriters get nervous when a construction company is overbilling or underbilling. Underbilling in particular raises a red flag, because it can indicate an unprofitable job or poor management practices. Underbillings that reach 25 percent of working capital are particularly troubling to sureties.

Underwriters much prefer that a contractor bill (and be paid) consistent with the project’s schedule, and they favor the percentage-of-completion method for recognizing income. On a $1 million job with expenses of $800,000, for example, a contractor should have billed $400,000 when the job is 40 percent complete.

Before year end, contractors should send out all invoices that can be billed and pursue payment. This will not only improve cash flow and increase liquidity on year-end financial statements, but will also reduce any current underbillings on the balance sheet.

Accurately Account for Profit Fade
Surety companies and lenders want to see evidence that a construction company operates at a steady rate and with accurate work-in-process estimates. Reductions in gross margins from the beginning to the end of jobs indicate poor estimating. For these estimates to mean anything, they must include both an accurate jobs-in-process schedule and a completed-contracts schedule. Essentially, sureties and bankers want to know if a construction company’s books accurately reflect any profit fade. Sureties and lenders look to profit fades to determine whether or not a contractor can consistently estimate jobs.

Before meeting with your lenders and underwriters, determine whether carry-over expenses from previous years have created unexpected profit fade. A review of the additional costs and the construction contract may reveal opportunities to bill for the additional work and reduce or eliminate the fade. If fade did occur, update financial statements quickly and develop a detailed strategy for avoiding it going forward.

Reduce Management and Employee Turnover
Due to small margins in the construction industry, losing valued workers can wreak havoc not only on operations, but on your financial position as well. One study showed that a construction company can save 2.5 percent of its payroll costs by reducing turnover by 10 percent. If a contractor has a profit margin of only 5 percent, that’s an impressive savings.

Bonding agents and lenders want to see a construction company that retains its top managers and valued employees. They also want to know how long top managers have been with the company and how profitable it has been under their direction. If you lost top managers this year, discuss the problem openly with bonding agents and lenders so they thoroughly understand why the managers left.

If the employees are leaving primarily because of inadequate compensation, discuss the issue with an accountant specializing in the construction industry. With such help, you might find a way to raise pay, offer bonuses, create stock option plans or employ other incentives to make employees feel more like stakeholders and stick around for the long haul.

It may be difficult to insulate yourself against pay raises offered by competitors, so minimize risk by cross-training your employees and properly documenting processes and procedures.

Get Assurance
One final comment for those planning end-of-year meetings with bonding agents and bankers: Before such a meeting can take place, financial statements should be reviewed, if not audited, by a CPA. If you act quickly, there is still time to have a CPA review profit-and-loss statements and other reports and help you prepare for year end.

To discuss strategies on how to maximize your bonding capacity while reducing your tax burden, contact the author of this article, Adam Polakov, CPA, Manager and Practice Leader of Real Estate and Construction Services with Porter Keadle Moore, LLP.

Porter Keadle Moore, LLP is a founding member of ProfitCrew, an association of accountants and business advisors dedicated to helping construction companies build profitable businesses. For information, contact Adam Polakov at apolakov@pkm.com or Arvil Stanford at astanford@pkm.com or visit www.pkm.com.