As all businesses continue to adapt to the lingering effects of the COVID-19 pandemic, some general contractors are beginning to see a decline in balance sheet health as their subcontractors face labor shortages, material price volatility, and an uncertain economic outlook. One of the reasons for this situation is the unexpected after-effect of the federal government’s Paycheck Protection Program (PPP).
Companies across all industries took advantage of this program in 2020 to support them during the government-mandated shutdowns from the pandemic – including many construction firms and subcontractors. Subcontractors used these funds over the next three years to grow and expand, especially during the pandemic construction boom across much of the country. Some ventured into new trades and geographic areas where they had minimal experience, hired new employees, and bought new equipment and materials. Some subcontractors took PPP funds out of the company as distributions while others segregated the money in a separate bank account for a future “rainy day.”
Declining Balance Sheet Quality Among Subs
Three years later, many subtractors have fully depleted their PPP and Employee Retention Credit (ERC) funds.
Some subcontractors who received PPP funds had a sense of security knowing they had cash in the bank. In certain instances, this led to a declining level of scrutiny in individual project profitability. Organizations with this false sense of security may have perpetuated bad habits, such as not performing project profitability analysis or applying sufficient diligence to job costing.
Some of this is coming to light now in the form of declining profitability on subcontractors’ jobs. However, they no longer have PPP funds sitting in the bank to help compensate.
Less-sophisticated subcontractors aren’t aware of the rapid material, labor, and indirect cost escalations over the past few years and haven’t done a good job in cost accounting these elements to uncover their true project profitability. So be especially wary of low bids and the assumptions they’re based on to guard against subcontractor failure in the middle of a project.
Unfortunately, the construction industry is a known laggard in the adoption of evolving technology advancements. Many subcontractors tend to use archaic financial reporting systems that don’t provide the transparency or data needed for accurate job costing and transparent financial performance.
New capabilities are being designed into modern contractor accounting systems that allow for seamless and automated information flow through application programming interfaces (API). This helps eliminate data confusion and manual data analysis, leading to faster and more accurate information to drive decisions for increased profitability.
Review Subcontractors’ Financial Information
Given these trends and the uncertain state of the economy, some general contractors are being more proactive in analyzing subcontractors’ financials before accepting bids. This includes reviewing subcontractors’ financial statements based on current assets and liabilities and the size of their backlog to evaluate whether they have the bandwidth to take on another project.
- When reviewing subcontractors’ financial statements, try to determine how easily they can meet the financial demands placed on them during a job. Among other things, you should satisfy yourself that subcontractors you’re considering working with have:
- Strong cash flow and working capital
- A healthy current ratio
- Accounts receivable in line with gross income
- A balanced over/under billing position
- Consistent profitability from one job to the next
- A manageable project pipeline that isn’t going to overextend their human resources and technical capabilities
Audited or reviewed financial statements prepared in accordance with generally accepted accounting principles (GAAP) are preferred for evaluating subcontractors. Ideally, statements will be prepared by a CPA with experience in the construction industry. The following are potential red flags that a financial statement review might uncover:
- Inappropriate or inconsistent revenue recognition practices
- Under-allocation of indirect job costs to individual projects
- Overstatement of the entity’s receivables or contract assets
- Understatement of potential litigation and claims on the entity by third parties
- Too much equity committed to a single project
- Excessive dividends and distributions taken by owners
- Significant early billings on a project that aren’t accounted for as cash or receivables on the balance sheet, which could indicate that the money is being used to cover costs on another job
Other Information to Request
- In addition to financials, it’s also smart to ask potential subcontractors for other information and documentation, including:
- Resumes of management team members and succession plans
- References and letters of recommendation from clients of recently completed jobs
- Area of geographic reach
- Work history, including jobs completed and in progress
- A list of current and upcoming projects (to demonstrate capacity)
- Safety management programs and historical safety records, including OSHA Forms 300 and 300A
- Certificates of insurance and surety bonding capacity
- Any material litigation, claims, bankruptcy, or disputes over previous work
Based on your review, you could develop a rating system for potential subcontractors. Whether it’s a point scale or simply pass/fail, such a system can provide objective criteria and help speed up decision making during the subcontractor bidding process.
You can streamline the subcontractor review process by creating an online portal to which they can submit their information. This way, subcontractors only have to enter their information once, with periodic updates as required. The information will be automatically routed to all the decision-makers at your company, who can assign their own ratings independently.
Dealing with Pushback
Some subcontractors might push back to general contractor requests for financial statements and work in progress reports since they contain sensitive financial information, including gross profit margins on jobs. Many subcontractors also hesitate to share information about owner distributions and company payroll.
In these instances, subcontractors may be able to provide limited financial statements that include a balance sheet and equity statement but exclude the income and cash flow statements and all references to footnotes. This will demonstrate their financial viability without revealing sensitive information like gross margins that many subcontractors would rather keep private.
Regardless of what level of financial information subcontractors provide, assure them that any information or documents they share with you will be confidentially reviewed by a limited number of people at your company and then destroyed.
Uncover Potential Problems at the Start
General contractors should fully vet their project partners before hiring them. Asking the right questions and reviewing current financial information can reveal the answers that may lead to potential problems – problems that can be avoided.
We can help your review of subcontractors. We know what to ask and what to look for. Contact us to make sure you hire the right partner for your job.