With rising interest rates, increasing material and labor costs, changing appetites for risk, and the growth of technology in the workplace, the construction industry has managed a juggling act since before the pandemic. The South Carolina Chapter of the Construction Financial Management Association (CFMA) recently held an educational event on banking, surety/subcontractor default insurance (SDI), and AI. In an effort to share forward-looking strategies, this article highlights the key takeaways from the event.
Banking Beyond the Numbers
Banks have been walking a fine line for months balancing interest rate hikes, pending inflation, and general business growth. While this may sound dire, the good news is that banks appear not to be pulling back on credit or funding projects. Despite credit availability, banks are cautious with the money they lend. Banks carefully review credit requests to avoid getting stuck in a bad situation. Empty office buildings indicate that banks may be less inclined to financially back projects aimed at building office space. However, the boom in warehousing and distribution is an area where banks positively see credit. The money is there, but banks are thinking critically about the projects they support.
The merger and acquisition and large project explosion seen during the pandemic is starting to wane. Banks have more equity requirements for those seeking credit, and higher interest rates are slowing cash flow. Contractors are facing both higher interest rates and material costs which can be tough to stomach at the same time. While these costs can be built into the construction bid, a higher bid can lead to a missed opportunity or postponement of projects. Additionally, even while making a bid, the volatile market makes it difficult to predict how costs could rise over the length of the build. Both banks and construction companies have learned much over the last year about planning for costs in advance, in some cases, the hard way. It is predicted that there will not be a significant reduction in interest rates anytime soon. Contractors and owners will need to get used to the higher cost of capital.
Banks are seeing an uptick in fraud. Because of this increase in fraudulent activity, banks have a reason to want to protect themselves. In the past, the bank would bear the burden if fraudulent charges were on an account. However, banks can’t afford to continue to do so. Banks encourage businesses of all kinds to increase internal controls around cash. Moreover, banks are encouraging construction companies to work with their lenders on a positive pay verification system to decrease fraudulent checks. If companies are not willing to adopt positive pay, banks may begin to pass the fraudulent activity liability back to the account holder. As another protection layer, some banks require in-person wires for further fraud protection. The critical point here is that internal controls around cash flow are in a company’s best interest to protect its future costs.
Surety/Subcontractor Default Insurance (SDI) – The Bonds That Tie
Sureties don’t want to get stuck with an unfinished project because a contractor’s money has dried up. Construction companies might be wondering how to obtain or expand bonding lines. The answer to this lies in a few factors. Owners may consider the size or complexity of the project when deciding if a project needs a bond. If the project is smaller, the surety only looks at credit in most cases. A more straightforward examination of the company’s credit and contracts might be all that is needed. A larger project involves more depth. Not only are financials examined, but the amount of liquidity a company has is important. To prepare financially, a contractor should align with a good bonding agent and a CPA with construction experience. The panel noted that there are no current credit concerns when it comes to bonded projects. While cash positions have dropped over the last ten years, sureties and bonding agents are in a monitoring (or wait-and-see) position. Smaller contractors may need to carefully monitor their bottom lines as Paycheck Protection Program loans and the Employee Retention Credit program are coming to an end. With less government-backed cash on the horizon, contractors may see lean times ahead if not prepared.
The changing economic climate is impacting the surety world too. Interest rate and raw material cost increases impact the bottom line. Balance sheets need to be able to keep up with project size and overall costs. Fewer contractors are bidding on larger jobs because of the risk of the cost of materials or labor rising mid-project. Certain trades have been getting hit harder. For example, copper wiring costs and the risk of theft from the job site have made electrical costs hard to budget and priced out some electricians from seeking bids. While bonds have been required on most government projects for a long time, bonds are being required on more private sector projects. Additionally, bonds and SDI for subcontractors are becoming more commonly required. All these costs impact the ability to make bids on projects. Profit margins are fading as contractors absorb this price escalation. Contractors should be wary of price escalation clauses and change orders when making bids, as these get passed to the project owner.
What is the surety agent looking at when analyzing a contractor’s financial statements? Key ratios on financials are first. These depend on the type of contractor. For example, the working capital for a general contractor should be about 5%. A subcontractor or heavy highway contractor should have closer to 10% working capital. A trade subcontractor should also have closer to 10% working capital. The surety agent is also looking at the debt-to-equity ratio. How heavily is the bank line of credit being used? How does the contractor use their cash? What is the coverage on retainage? The work-in-progress schedule is also examined. Considerations are updated costs to complete, gain/fade analysis, over/under billing, etc. The surety agent wants a complete picture of a contractor’s financial past before making decisions about the future.
Best practices around surety include:
- Perform a financial analysis. Top-performing contractors dig into the project details before bidding to ensure they are not exceeding their risk comfort level before a go/no-go decision.
- Prequalify subcontractors. Doing due diligence on the people a company will hire to complete parts of the overall project can pay off in the end. Questions like “Is the subcontractor strong in their project completion?” and “What is their performance record?” can help keep a project on financial target.
- Utilize peer groups. Best-in-class contractors often find peer groups helpful in learning from others and creating best practices. If you are not in a peer group, look for opportunities to join one. CFMA may be a good place to start.
- Create a succession plan. If there is an ownership or management change soon, plan for that and make the plan clear to all parties involved. No one likes big surprises, so be sure to communicate ahead of time with your bonding agent and surety.
- Get removed from personal indemnity. This may sound overwhelming. However, an excellent first step is to ask to be removed. If the answer is no, ask why. Do you need more liquidity? Work with your surety agent to set goals and targets to get removed from personal indemnity. And remember that communication is vital. Keep an open line of communication with your financial partners so they are aware of any changes to the economic picture.
Artificial Intelligence (AI): The Future Is Now
Given the news lately, it is very apparent that AI is impacting most industries, and construction and finance are not excluded. While much news focuses on computers “taking over,” one should take this news carefully. With the vast volumes of data available and AI’s ability to process this data quickly and cheaply, recognizing this use of AI could help look at trends or see the big picture. In addition, AI can look at specific data for a specific task. For example, with AI, any task using repetitive analysis can become more efficient over time. While this can create a fear of human obsolescence, the worry can be put to rest as humans are needed for the intuitive aspects of tasks. When looked at it this way, AI is here to complement the work of humans. With this said, companies need to start adjusting to AI and plan for it. A way to start is to select data you trust, use AI to extract value from it, and then build a culture that supports experimentation. AI is here and is one of the many tools at your disposal for analyzing your company’s financials.
What Can FORVIS Do to Help?
A good first place to start for any company wanting to tighten its financial situation is to create or shore up internal controls to get a handle on fraud or waste. Create or continue a good relationship with your CPA or accounting firm. Ask questions about other services to help with internal controls, tax savings, or succession planning. Our FORVIS construction team is here to answer your questions and help navigate your business challenges. For more insights, reach out to a professional at FORVIS or fill out the Contact Us form below.