Protect and project: Why construction companies need to leverage their balance sheets
Many of the habits acquired by best-in-class contractors in recent decades will continue to be cornerstones of their success. One such habit is the intentional management of the corporate balance sheet.
Balance sheets not only reflect assets, liabilities, and equity as of a moment in time. They also bring balance between income statements and cash flow projections, and can be used to project future balance sheets with a few financial ratios. A solid balance sheet and accurate projection should be the foundation of all financial goal setting.
The value of projections
We often hear, “Why do I need to project my balance sheet? Aren’t my income statement and cash flow projections enough to project success?” Unfortunately, no. Best-in-class class contractors know what level of work program and investments their balance sheet can support, and they know what kind of return on assets and equity to achieve for the risk they take on. As a result, they can build a balance sheet that can weather tough times and take advantage of opportunities in a down market.
If this is so important, why aren’t balance sheet projections a more common practice? Well, projecting the balance sheet is more complex than just forecasting revenue, gross margin, net income, and cash flow. The good news is that if you can project revenue, gross margin, net income, and cash flow, then you have all the elements needed to project the balance sheet. Cash flow projections are simply the exercise of converting net income to cash flow through the customer billing cycle and the employee/vendor/subcontractor payment cycle.
A solid balance sheet and accurate projection should be the foundation of all financial goal setting.
Balance sheet projections begin with net income and cash flow projections, and use anticipated days in accounts receivable, accounts payable, and typical days in net under/over billings. Accounts receivable is based on a relationship to revenue; accounts payable is based on a relationship to cost of construction and operating costs; and under/over billings is based on a relationship to revenue in conjunction with expectations of jobs to be net under/over billed. Other balance sheet variables that would need to be addressed include capital expenditures, use of borrowing, and capital contributions and distributions.
The effect of optimizing billings, accounts receivable management, and accounts payable management can be best expressed by projecting the overall impacts to the balance sheet forecast. Once your company develops their version of a balance sheet forecast, it’s easier to create goals and benchmarks that allow for grounded decision-making on acceptable levels of work program, investments, and capital infusions and distributions.
Benchmarks to use for strategic planning
Benchmarks will help management facilitate strategic and work program-planning decisions as we move into the “new normal” as well as help strengthen relationships with your financial partners — they’ll know you’re monitoring the same metrics and have your pulse on how each decision impacts the balance sheet.
Working capital leverage, tangible working capital leverage, equity leverage, return on equity, and return on assets should be cornerstones of your balance sheet-focused benchmarks. Cash as a percentage of revenue is also an important ratio to include in your balance sheet goal setting — many successful contractors aim for 5% of revenue in cash.
Once your company develops their version of a balance sheet forecast, it’s easier to create goals and benchmarks that allow for grounded decision-making.
Working capital leverage is calculated by comparing your working capital (current assets minus current liabilities) to your backlog. Tangible working capital is a modification of working capital less prepaids, other current assets/related party receivables and >90 AR. These leverage ratios can be expressed as a percentage or a multiple.
The chart below shows balances of backlog, working capital, tangible working capital, and the related revenue in backlog multiplier and leverage ratios. The calculations are just examples, but when measured and compared to goal ratios, the company can make decisions on work program, investment, and capital needs, knowing that the balance sheet will meet targeted benchmarks.
|Revenue in backlog||$300M|
|Tangible working capital||$20M|
|Working capital as a % of revenue||10%|
|Revenue as a multiple of working capital||10x|
|Tangible working capital as a % of revenue||6.7%|
|Revenue as a multiple of working capital||15x|
The “right ratios,” in terms of numbers, are highly dependent on the type of work in your program — there are higher levels of capital required for equipment-intensive work and self-perform work. These drive the required working capital as a percentage of revenue in backlog up and multipliers down. The key is to set goals that are accurate for your industry, your company, and your type of work program. The goals should be developed in collaboration with your financial partners, such as bonding agents, sureties, and banks.
The key is to set goals that are accurate for your industry, your company, and your type of work program.
These ratios won’t necessarily reveal and guarantee you a set amount of “bonding credit,” but are guidelines that will be used in setting goals in any environment. Setting balance sheet goals will help keep your company realistic and will illustrate that there is a finite amount of revenue your company should be tracking, which means your company should be pursuing the best possible margin-producing jobs within those revenue thresholds. Remember, high top-line revenue doesn’t always equate to high bottom-line results.
Ensure long-term sustainability
Knowing your right ratios and understanding benchmarks by using your balance sheet will allow you the opportunity to pursue investment opportunities with confidence. You’ll know that you have the financial strength to support your anticipated work program and make measured investments within your balance sheet capacity while staying true to your non-negotiable balance sheet ratios. In times of uncertainly, best-in-class contractors rely on tried-and-true processes that ensure their long-term success. Using balance sheet projections to drive your strategy will help make sure your restart plans are feasible and accurate.