Wednesday, March 26, 2014

Don’t Make These Mistakes in a Recovering Economy.

An Improving Economy.  We are finally starting to see signs of improvement in the economy and more project opportunities are slowly appearing. An improving construction economy is good for everyone but there are risks for contractors coming out of this cycle as history has a way of repeating itself. This seems to be especially true in the construction industry. Ranked only behind the restaurant industry in terms of failure, the field of construction carriers a great deal of risk and reward.  It’s important to understand the common reasons why too much work can cause contractors fail coming out of a recession and why a surety bond underwriter might see this as a red flag.

This may be the most difficult for most contractors to understand and swallow. More work translates into more revenue and more profit right? Not necessarily. Believe it or not, more surety claims come during recovery than during a recession. There can be several reasons for this. First of all, many contractors have to cut employees and overhead. Once the work comes back, former employees have often found other work or left the industry completely. This can make it difficult to take on and manage the additional work. Along the same lines is equipment. Does the company still have adequate equipment to handle the additional work load? These things are important but the biggest reason contractors fail coming out of a recession is that their balance sheets have been depleted.

Reduced Working Capital.  For most contractors, the recession has significantly reduced their total contract volume and overall profit margins. This is turn causes losses and reduced working capital and equity. Consider that contractors typically have to internally finance their work. They perform their scope of work and may not get paid from an owner for 30 days or more. Add retention to that and you can see that each job has the potential to create a cash crunch that has to be financed by the contractor’s own funds or by an outside party such as a bank line of credit. The more work performed, the more financing you will need. Contractors typically fail when they run out of cash and underestimate their cash flow needs.

Steps to Take. So how can these risks are avoided? First of all, make sure your banker understands your growth plan and can support your needs. An adequate line of credit can be vital to taking on additional work. While you are talking to your banker, ask about taking outstanding short term debt and converting it into a long term note. This free up cash and ensures they will not call your line when if you get into a crunch.

Avoid the urge to purchase new equipment right away. New opportunity creates optimism and it becomes very easy to succumb to new purchases. However, it’s much easier to return a piece of rented equipment if needed verses selling one.

Finally, when loading up on new work, stick to what you know. It may be tempting to take work for unfamiliar general contractors, take work in new locations or venture in to new specialties. However, these are all items that add risk and this risk is magnified in a recovery period. Contract bonds, which are used broadly in the construction sector by universal contractors, are a pledge from a surety bond company to a job’s owner.

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