Experienced contractors never forget the inherently cyclical nature of the construction business. After each boom and bust cycle, surviving contractors invariably promise themselves they will not be caught by surprise again and they’ll be more watchful for early signs of another slowdown.
Yet the most common indicators of construction industry activity like housing starts and building permits are, by their very nature, backward-looking. They measure activity in the recent past, but do not necessarily provide timely insights into coming conditions.
What’s more, many economic indicators are broad and general in nature. They do not reflect local conditions, and may not pick up on smaller-scale trends that affect a particular type of project or a specific contractor or subcontractor specialty.
Useful Individual Indicators
No one can predict the future, of course, but there are some individual indicators that can help you track the health of your business. These indicators – especially changes in trends from month to month – can provide useful early-warning signs that tell you if you’re growing too fast or getting too far out on a limb. Some examples include:
• Balance Sheet Indicators – Wise contractors always keep an eye on the balance sheet. Adding personnel and investing in additional equipment are necessary, but the best-managed companies try to keep debt down to reasonable levels and pay close attention to their debt-to-equity ratio.
• Cash Flow Modeling – When things slow down, the debt you incurred during boom times will still need to be serviced, even though your cash flow will be reduced. By projecting the impact your debt load will have on your ability to survive a possible slowdown, cash flow modeling can provide another important warning if you’re taking on more debt than is advisable.
• Receivables Monitoring – Pay special attention to indicators such as your receivables turnover ratio and days receivable outstanding. When the payment cycle from project owner to general contractor to subcontractor starts to slow down, it can be a sign that business in general is starting to slow.
• Customer and Project Mix – Contractors and subcontractors naturally seek to cultivate good relationships with large customers, but it’s wise to avoid becoming too dependent on just one or two sources of revenue. Similarly, it can be tempting to leap at the chance to take on a large new project, but be sure you have the financial wherewithal to handle the job without drawing too heavily on your credit lines.
• Competitive Bidding Pressures – When things are booming, competitive pressures ease as project owners and general contractors focus on just getting the job done. Conversely, if project owners start becoming more price conscious, or when general contractors start asking subcontractors to bid on work that once was theirs for the asking, this can be another early indicator that business is slowing.
• Profit Margins – Shrinking profit margins are perhaps the most widely recognized warning sign of all. Compare financial statements from quarter to quarter and monitor the trend in profit margins closely. When margins start to get squeezed it’s time to be extra cautious.
Don’t Get Distracted
As memories of the last recession begin to fade, it’s easy to get distracted from the need to pay close attention to financial indicators. The natural tendency is to focus on gearing up for more work and seeking out additional opportunities.
But a steady flow of business actually makes it even more important to monitor financials closely. Strong cash flows and a growing backlog can give you the leverage you need to prepare for the next slowdown.
Do you have questions about key business indicators? We can help you find the answers. Please call us for an appointment.
Norman L. Myers, CPA, CCIP, CGMA, Manages the PKS office in Ocean City, MD and is a Certified Construction Industry Financial Professional with more than 40 years of experience. PKS & Company, P.A., Certified Public Accountants, a full service accounting firm with offices in Salisbury, Ocean City, MD and Lewes, DE. PKS provides traditional accounting services as well as specialized services in the areas of retirement plan audits and administration, medical practice consulting, estate and trust services, fraud and forensic services and payroll services and offers financial planning and investments through PKS Investment Advisors, LLC. Visit www.pkscpa.com or call 1-800-274-2564.