Red Flags in Contractors Financial Statements

by Tim Ayler, CPA, Partner, Director of the Construction Services Group and Brian Enright, CPA, Member of Construction Services Group

In general, contractors’ financial statements and job schedules look very different than they did a few years ago. Few contractors came away from the initial downturn in the economy unscathed, and are now feeling the effects of the ‘new’ normal. In most cases, all components of the balance sheet have declined as contract volume has declined and margins have been squeezed.

Changes in Assets:

During the first part of a down cycle, a contractor’s cash may appear in good shape. This is because prior billings and retainages are being collected and there is less new work, and therefore less expenses incurred that use cash. While cash may look strong, this situation can actually signal a lull in new work and the beginnings of strained finances. After several months of reduced job volume, which causes a significant decline in receivables as well, the borrowing base on a line of credit can shrink, further reducing available operating cash. Additional decline in assets is possible as net equipment decreases as a result of continuing depreciation expense and the limited ability to purchase new equipment.

Changes in Liabilities:

Liabilities may be on the decline as well if related assets have been sold and there has been a reduction in new work, which in turn has reduced payables just as it reduced receivables. However, in the worst circumstances the opposite is true. If expense reductions do not happen quickly enough, liabilities may grow, usually in the form of payables and an increased line of credit. Some contractors refinanced to pull additional cash into the company prior to the downturn. Another scenario that we have seen is payables become inflated due to a lack of cash to pay down job costs from projects that have budget overruns.

Changes in the P&L:

The income statement (revenues and expenses) should shrink when the job volume decreases, but other changes occur as well for most contractors. In the current bid environment, gross margins have decreased. Additionally, if management has not implemented significant cost cutting, the ratio of general and administrative (G&A) costs to gross profit will be significantly higher as G&A expenses are largely fixed costs and will not respond the same as direct costs to a decline in revenue without additional action by management. A common indication of pending decline in finances is an increase in indirect job costs on individual contracts. Indirect costs, much like G&A expenses, do not decline at the same rate as direct costs relative to a decline in contract price. Indirect costs are allocated to jobs, which if not cut timely, results in the same dollar amount of allocation of indirect costs over fewer contracts. This can lead to a decrease in contract profit and possible contact loss if margins were tight on the contract from the start.

Changes in Backlog:

A decrease in backlog is generally the biggest red flag to contractors. This red flag may remain largely unnoticed for a long period of time if the contractor has an extended project cycle. The longer a company’s projects last, the longer the financials will remain looking strong, when in reality there is hidden danger around the corner when work levels reduce dramatically. In the current economic environment it is important for contractors to have a better understanding of their backlog. For example, a large contract on backlog due to start in the distant future may not be as much benefit to the contractor as several smaller contracts beginning in the near future depending on the contractor’s current or future financial condition. Additionally the contractor should consider the gross margin on backlog contracts. A large contract with little margin may not be in the best interest of the contractor compared to several smaller contracts with more comfortable margins and a quicker collection of retainage receivables. All scenarios and analysis of backlog information should be considered when determining jobs to bid on in the future, given current and anticipated financial health.

By being cognizant of the red flags that a reading and analysis of financial statements and job schedules can provide, contractors can prepare for financial struggles that may be imminent.