Boom or Bust?: Preparing for What’s Next
How long will the good times continue? After a half-dozen years of relatively steady industry growth, many contractors are wondering if it’s time to start preparing for the next phase of the business cycle. On the other hand, no one wants to apply the brakes too soon if a slowdown is still years away.
How can you prepare for the possibility of slowing growth while maintaining forward momentum? Begin by shoring up your company’s fundamentals. Here are five basic steps you can take.
Step 1: Control costs
When revenues are growing, it’s easy to let overhead expenses creep upward. That can be a difficult habit to break when growth slows, so now is the time to take a careful look at costs.
Start with your job-costing program. Most contractors keep a close eye on direct job costs such as labor and materials, but it’s equally important to have a clear understanding of indirect costs such as rent, utilities, taxes, and insurance. These costs must be accurately and consistently allocated among projects.
After you’ve put together a comprehensive checklist of overhead expenses, track and analyze them monthly. Get your employees involved too. Establish a strong cost-control committee with company-wide participation, documented meetings, and specific cost-saving targets.
Step 2: Build up the balance sheet
Adding personnel and investing in additional equipment are often necessary, but the best-managed companies try to keep debt down. If a downturn comes, you don’t want to be burdened with debt—or with a lot of costly equipment that can be difficult to dispose of.
Pay close attention to the basic balance-sheet metrics such as debt-to-equity ratio, backlog, current ratio, and return on assets. Don’t view such ratios in isolation; rather, compare them to industry benchmarks and monitor them over time to identify trends and changes.
Shrinking profit margins are the most obvious warning sign, so monitor margin trends especially closely. When margins start to get squeezed it’s time to be extra cautious.
Step 3: Keep up the cash flow
Pay close attention to your working capital levels, comparing them to both annual revenue and backlog. If backlog exceeds 12–15 times working capital, it could indicate cash flow problems ahead—especially if there is inadequate credit capacity to help cover shortfalls.
Watch your receivables turnover ratio and days receivable outstanding too. When the payment cycle starts to slow down, it can be a sign that business in general is starting to slow as well.
Now is also a good time to make sure you are following recognized best practices for maintaining cash flow. Check that you are invoicing promptly in sync with your customers’ payment cycles, documenting change orders thoroughly, tracking collections closely, and protecting your rights by filing liens promptly if needed.
Step 4: Monitor contractor and subcontractor performance
If business slows, subcontractor risk becomes an increasingly significant concern for general contractors. Performance bonds can mitigate some of this risk, but you should augment a surety’s investigation with additional research of your own and periodically check subcontractors’ financial status.
On the other hand, if you’re a subcontractor, you’re exposed to risks related to the GC’s financial strength, which is why you should always perform due diligence on both the GC and the project owners before signing on to a project.
In one sense, the vetting process serves the interests of GCs and subs alike. Verifying that everyone is performing effective prequalification is a good indicator of all parties’ overall competence.
Step 5: Double-check project funding
Now is no time to get complacent about ensuring that funding is in place before you take on a project. If you haven’t done so already, establish a thorough, step-by-step process for confirming financing at the outset of every project—and then follow that process consistently.
If possible, get permission to confirm the project’s funding directly with the financing source. Ideally, the final contract should also provide for regular updates about the owner’s financial condition.
Obviously, maintaining financial strength is an ongoing priority and these five steps are only a starting point. But they can provide a useful framework to help you prepare for changing conditions in the future.