Peter Vinden FCIOB warns contractors against taking on more work than they can finance and losing control of the balance sheet.
As the construction sector’s recovery gains traction, the cliche that “the path to success rarely runs smoothly” has never seemed more relevant. Contractors and subcontractors would do well to keep these words in mind, not just when dealing with the immediate problems facing them but also in the handling of positive developments that have the potential to take a very dangerous turn.
Despite a number of pressing issues that are attracting widespread attention, from unpredictable weather to shortages in skills and raw materials, construction companies also remain vulnerable to the threat of overtrading.
The problem of overtrading and losing control of your working capital requirements is a particularly tricky one, as the illusion of a return to stability may actually prove to be the harbinger of new problems.
After a difficult few years, the temptation to take on seemingly profitable work is hard to resist. The problem with this is that taking on additional projects can be at odds with your company’s working capital availability. Companies need working capital to fund daily activities and, as workload and turnover increase, so too does the need for working capital to pay your trading bills, salaries and other expenses.
Past experiences show that emerging from recessions can be a particularly vulnerable time for businesses which struggle to resist the temptation of what appears to be higher margin work that, in reality, cannot be funded.
Companies, large and small, need to be quick to spot the symptoms of overtrading. These will include overdraft levels rising month on month and a deterioration in operating margins. Other red flags will include mounting pressure from nervous suppliers, threatening to put you on stop, and your accounts team spending more time fending off suppliers and subcontractors chasing payment.
It is not difficult to see how these symptoms could lead to failure if not checked. What is less widely understood is that these problems are preventable provided the mantra of “cash flow analysis, projection and control” is rigidly adhered to.
Peter Vinden
It is essential that a business understands the cash inflow and outflow on every project that it is working on, as well as the outflow of cash required to fund operating overheads such as rent, rates, heating, lighting, administrative salaries, insurances and vehicles.
From this information you should be able to produce a company model which shows on a week-by-week basis what your income and expenditure looks like and, in doing so, project and control what working capital is required by way of bank overdraft, loans or similar.
Each new contract win should be analysed on the same basis and integrated with your operating model. Any potential contract needs to be analysed and fed into the company model before it is accepted.
This might mean that you can only accept a new contract if advantageous payment terms can be negotiated with your client and/or with key suppliers and subcontractors. It also might mean that it cannot be funded at all. It should also never be assumed that the safety nets of increased bank funding and/or the extension of credit lines will be available. Assuming that your bank will provide an increase in facilities to overcome the shortfall in capital working requirements is a gamble that may not pay off.
These guidelines might seem to express the values that any company should have at its core, but history shows that failure to understand cash requirements has caused the undoing of many a business. There is no excuse for not knowing how the cash demands of a new contract will impact on your business and its working capital requirements.
The construction sector has navigated some dark waters, including low demand, lack of investment and restricted access to bank funding. However, we have not yet overcome all of these challenges, and optimism cannot be an adequate excuse for failing to understand your business and its cash requirements.
Businesses must keep an eye on sustaining long-term growth to avoid possible insolvency in the later stages of recovery. It is by maintaining financial analysis and control procedures that companies in the construction sector can still avoid the overtrading crisis that could be waiting on the horizon.
Peter Vinden FIOCB is managing director of Manchester-based construction and property consultancy The Vinden Partnership
Peter makes the great – and oft proven – point that rapid business growth can be the death of a company.
There is also another angle to the overtrading risk that is not to do with lack of money. The lack of human capital.
Companies that grow quickly, or take on one project too many, run the risk of serious quality and financial problems. The most common risks are having to give a job to an unproven manager (often a new hire or temp) coupled with your senior managers having too much to oversee. Mistakes that in the past would be picked up when they are small, grow. For many contractors it only takes one bad job to turn a profit into a loss.