Pre-COVID, the NZ construction industry experienced the longest and strongest period of growth in all of our working lives. Most companies’ balance sheets were the strongest they had ever been so generally we entered this next economic phase in a very strong position
However, we are all acutely aware that things can unwind incredibly quickly and certainly the lockdown rapidly stripped some of the strength from the strong balance sheets and weakened some of the fragile balance sheets.
There are many components to financial management and this article focuses on specific actions that you should be considering and taking over the next few months. In reality, they are things you should have been doing already and should continue to do even when things improve.
Cash and reliable information are Kings
It sounds clichéd but in times of crisis or in a downturn it is lack of cash more than anything else that precipitates a business’s demise.
We are entering a period when decisions are going to need to be made quickly and you need quality information to make those decisions. This comes from using all of your project management and job cost recording systems existing properly. Too many companies do not understand how their systems work nor use them correctly, resulting in misleading information relating to how each project is tracking. Resolving this is a critical priority. More than that, efficiencies and profit can be improved by using your systems properly. Everyone who relies on or uses the financial information or forecasts needs to be sceptical.
Learn from the Construction Cycle
Most of you will be familiar with the phases of the construction cycle and most of us have seen one or more cycles. The positive thing about these cycles is that history repeats itself, similar things happen at the same point and we can learn from that and respond accordingly.
We have climbed to the top of the curve and are now in the high risk period. A few companies will have grown beyond their true capacity to manage all the projects and beyond the capacity of their balance sheet so there will be some stress although I think most are going into this in a strong position. Job losses from the high risk period start biting into cash flow and reducing profit. At the moment, most companies have plenty of work from existing projects at prices that were negotiated when everyone was busy and there was no incentive to have silly prices. The profits from these jobs will help through the first phase but as those jobs come to an end, we will start seeing intense competition for new projects. As we start dropping down the curve there will be a drop in volume of work and that encourages some silly pricing. I strongly counsel against that.
Inevitably, there will be some main contractors and sub-contractors who don’t survive. Generally they will have had issues during the high risk period and together with the massive cost caused by the lockdown, directors may need to make a difficult decision, probably triggered when existing projects start ending. The collapse of both main contractors and sub-contractors has a ripple effect through the rest of the sector and is at risk of causing a domino effect. Therefore, we need to be particularly vigilant as to who our clients and suppliers are and closely manage the risks that go with this. There is generally more litigation as we slide down the curve, and with some contractors and sub-contractors no longer in business, there is additional pressure and risk on the companies remaining.
As we move further down the curve all these issues compound, profitability reduces further, balance sheets become particularly weak and vulnerable and cash dries up.
During the lockdown, most of you would have been carefully thinking about which projects will continue, which planned projects may still happen and which ones may get cancelled. You will have been preparing initial forecasts and by the end of the lockdown probably had version three or four as more information was gained. My point is that forecasting is a critical continuous process. It is not an annual or a quarterly process and as we move forward we should be reviewing and updating our forecasts at least monthly.
Forecasts must be integrated. By that I mean contain forecast profit and loss, forecast balance sheets and the forecast cash flow as they all inter-relate. Good forecasting starts with preparation of a schedule of the projects with the months in which they will happen and the likely revenue and costs occurring at each month. In one sense, forecasting in construction is easier than many other businesses because you know what projects you are doing and the project managers have a pretty good idea what will happen each month. That’s where the easy part ends because after that forecasting in construction is challenging. Your base projection should only have confirmed projects. Anything that is not confirmed is currently blue sky due to the risk of planned projects being abandoned or significantly delayed. Once you have got the confirmed projects in your base forecast, by all means put in the other projects but have a colour coding system depending upon the likelihood of them occurring. I would not be putting any blue sky in projections at the moment. We need to be relying on what we are confident is going to happen and make our decisions around that.
Have a separate schedule for the risks and opportunities on your projects, in other words, the things that may happen but are not the conservative base case. Keep updating this continuously.
Particularly for head contractors, bonds and retentions absorb a phenomenal amount of cash resources and with the banks’ attitudes to the sector, their requirement for more cash backing for bonds is inevitable. List out the projects, the bonds required and the timing that those bonds need to be established and are finally released. Your cash flow statement plus the bond schedule and retention schedule will lead you to a schedule of accessible cash. This is the one to watch because when it starts getting tight it all starts getting particularly difficult. Incorporate a schedule with your bank covenants and key ratios so that you can monitor these and be proactive in talking to the bank if the covenants are unlikely to be achieved rather than waiting for the bank to tell you that you are in breach of covenants and they are changing the rules.
BDO encourage you to have a rolling 13-week detailed cash flow. That way you can identify the tight spots in particular weeks and by going out 13 weeks, it gives you enough time to identify issues and respond accordingly. Forecasting is a team effort, it’s not just for the accountant, it includes the quantity surveyors and the management team at a minimum.
Challenge the information provided and make sure that it is sending the correct message rather than the message you would like to see and when things start heading in the wrong direction and also in the right direction, it is a matter of acting quickly and decisively.
Given I have emphasised how important cash is, let’s look at some of the areas in which we can preserve and generate cash. The one that has the biggest impact is focusing on quality revenue and picking up new projects, but only at good margins. Sales for sales’ sake at poor margins just speeds the race to the bottom. The other area where improvements can be made is improving your margins equates to efficiencies on the projects, really good project management, really good risk management, and being innovative in the way that you run your projects and manage your staff. Depending upon the sector, around 85% of your costs are in cost of sales so that is where the big number is so that’s where the most improvements can potentially be made.
Where possible, fixed costs should be managed or removed from cost of sales. This is particularly relevant to consultants and non-site professionals where your payroll cost is treated as a cost of sale but it is a fixed cost in the sense that it continues whether the staff are generating revenue or not and therefore needs to be actively managed. The same applies in subcontractors and head contractors but to a lesser extent.
Reducing overheads is pretty obvious but most companies are already pretty tight on their management of overheads so it can be challenging to make big changes quickly.
Good management of work in progress has a dramatic impact on cash flow. Any work in progress that is a debit balance or positive balance or appears on the asset side of your balance sheet is a concern and needs to be billed and turned into cash. Most contractors are adept at managing progress billings to keep work in progress at a credit or negative level and whilst the clients may not appreciate this, I encourage it as a way of managing your balance sheet and preserving cash.
For all businesses, it is a matter of invoicing promptly and collecting those receivables promptly. Your credit controllers need to be particularly assertive in managing this. Another easy one is minimising fixed asset acquisitions. Think no new cars, no new computers, office fitouts because that all sucks cash and if you have genuine surplus assets you can generate some cash by selling them. Restructuring debt is pretty obvious and the details there are going to be quite specific to each organisation and their cash flows and securities. There are a few financial products available for small sectors within the building sector. There is a retentions insurance product about to be released that will help free up cash that is otherwise tied up sitting in a retentions trust account. For subcontractors and material suppliers, it is possible to get factoring of their debtors but given the attitude to risks in the sector, there are constraints around the availability of that.
What else should we be thinking about? You should be talking to your bank but never go to the bank telling them you have a problem. You need to go to the bank with a carefully considered solution and projections showing that you can repay any bank facilities and then you can have a worthwhile discussion with them. The situation can deteriorate quickly so it is a matter of going early and going strong. It is a bit like pruning a tree, there is no point playing around with the twigs, you have to go in and remove all the weak branches or you will forever be pruning and not making significant progress.
Communication is key. Communicate with your employees what is happening and what you are doing and you will have their support. They want to preserve their jobs and will normally go well beyond normal expectations to help the company to survive and preserve their jobs. It is the same upstream and downstream with your clients and suppliers.
The moral of the story……Don’t be a Busy Fool
Whilst the best strategy is to secure more work, let’s not be busy fools. Revenue for revenue sake lays a fast track to demise. Revenue needs to be on good projects with good margins with managed risk and an assurance you are going to get paid. Failure to follow those key principles just puts you at a head start in the race to the bottom and that is the last thing the industry needs.
In conclusion, the keys to recovering and developing resilience post-Covid are quality information that can lead to prompt decision making, quickly followed by appropriate prompt actions. And once more, always remember that cash is king!
Contact your local BDO Adviser for more information