What’s the key to financial health for the modern electrical contractor? While stakeholders value liquidity the most, it is not what electrical contracting firms build on to become successful. Look at your last balance sheet. If it’s weighted toward the “bottom” (heavy on fixed assets), then you’re typical. Most companies accumulate fixed assets as they grow.
A balance sheet with a growing asset base was once a clear measure of success. Now, however, as the banking industry continually consolidates, lending to contractors is a “policy exception” rather than a preferred category. Low liquidity, volatile profits, and over-leveraging all make construction unattractive to lenders. Asset-based lending (i.e., using fixed assets as collateral) is history; the game is about liquidity.
In “liquefying” your balance sheet, it’s easy to start leasing vehicles, and even renting equipment. The current owner may have made a sale and leaseback deal, removing the company building from the balance sheet, and providing rental income to fund his or her retirement. Unloading fixed assets increases your liquidity if not done all at once. Liquidation of assets is a red flag to stakeholders––a company converting assets to cash is usually in trouble.
Measuring liquidity usually begins with the current ratio (current assets ÷ current liabilities). This key measure of solvency indicates your ability to pay your bills from cash and accounts receivable. A healthy target is a ratio of $2 in current assets for each $1 in current liabilities (i.e., trade payables and current payments on debt). Why not settle for a 1:1 ratio? You need a “liquidity cushion” in case those receivables (especially retainage) are delayed.
Another key liquidity measure is working capital (current assets - current liabilities). This is your safety net in dollars. In general, keep working capital below 10 percent of total sales revenue. When your sales increase, you need more cash to fund projects prior to the first payment. Working capital is a source of funds for that growth, so monitor it carefully. Pay close attention to the relationship between accounts receivable and accounts payable. With the accounts receivable ÷ accounts payable formula, banks and other stakeholders would like to see the level of accounts receivable be no greater in dollars than two to three times the level of accounts payable. Average receivable days (collection period) - average payable days (payment period) should be a maximum of 30 to 45 days. You’re financing customer jobs, but you want to minimize your role as “banker.”
Of course, you can control this difference by collecting sooner or paying later. Actually, the difference in average receivable days between high-profit firms and all firms submitting information for the 2000 NECA Financial Performance Report is barely three days. Smaller firms (< $2 million in sales) have the shortest cycle (about 36 days) and the largest (> $20 million in sales) show 72 days. Growth equals risk––when you’re dealing with new customers, you tend to let collections slide because cash flow increases. It’s a false sense of security.
The flip side of collections is the payment cycle, which averages 21.6 days for NECA firms. If you’re taking supplier discounts, such as 2 percent for paying within the first 10 days, then you’re using cash wisely. Just don’t pay bills between the discount period and the due date (probably 30 days). Paying too early doesn’t improve your credit rating significantly, and you’re increasing the difference between the collections and payment cycles unnecessarily. If you show about 40 days between the accounts receivable collection period and the accounts payable payment period, then you fit the NECA profile, but there’s room for improvement.
Reconsider your banking relationship, and remember that your deposited funds help your bank maintain the necessary loan-to-deposit ratios, which save it from paying interest on funds borrowed the Federal Reserve. If you run several million dollars per year through your checking account, then you should be getting some perks.
Investigate sweep accounts, which earn interest until your cash is needed to pay checks from your account. Ask about a “lock box” deal, in which the bank collects payments directly from a post office box in exchange for an administrative fee, expediting your use of receivables by an average of three to four days (remember, that’s the difference between the NECA average and high-profit firms). Also, negotiate a better deal on those ever-proliferating fees and service charges.
Facing the trend toward fast-track projects with extended payment cycles, it’s critical to invest your resources in those who give you the most profit and best cash flow. Negotiating work as a prime shortens collection cycles and reduces retainage. Ultimately, making fair deals with profitable customers is the real key to improving liquidity. EC
NORBERG is a management instructor with the NECA Management Education Institute and past president of two national construction associations. “Project Finance” and “The Human Resource” are her newest seminars. She can be e-mailed at firstname.lastname@example.org.