A common investment disclaimer reads, “Past performance is not a guarantee of future results.” The
same applies to the world of construction. Annual and interim financial statements provide valuable
information about a contractor’s past performance and current financial strength, but offer little
clarity when it comes to what investors and lenders can expect going forward. That is why so many users
of a contractor’s financial statements spend more time analyzing the company’s work-in-progress (WIP)
schedule than they do their prior year’s income statement. There is a wealth of information buried in WIP
reports that can be as beneficial to the contractor as those looking to invest in or provide financing for a
project. This tool has proven itself critical to those who supply credit to a contractor (be it their surety or
bank), so why do so many contractors fail to use it to run their businesses?
How WIP Works and What It Means
Under generally accepted accounting
principles (U.S. GAAP), except in
certain limited cases, contractors
must recognize revenue on long-term
contracts under the percentage-of-completion method. Under this
method, revenue is recognized relative
to progress toward completion of a
job. For example, if a contractor has
incurred 50 percent of their total costs
on a project, they are able to recognize
an equal percentage of the contract
price on that job as revenue, regardless
of how much they have billed or
collected. The amount billed to date,
over or under revenue recognized, is
either a contract asset (underbillings)
or contract liability (overbillings) and
is reflected as such on the company
balance sheet.
If a company has a large amount
of underbillings, this can be a red
flag for sureties and bankers, who
may interpret them as potential
future losses. It should also be a
warning sign for the chief financial
officer, controller and project
managers before these figures are
ever released to outside parties. Are
these an indication of poor project
management, delays in the billing
process, or a need to update projected
total costs on a job? Perhaps there
are unapproved change orders for
which work has begun or there are
significant material costs that are not
billable until installed. Each job can
have its own unique situation that
creates an underbilled scenario, so
it is important to evaluate each job
individually. Management should be
prepared to explain underbillings
and their cause while also being able
to determine the proper response to
correct any operational deficiencies
that may have contributed to them.
Overbillings are generally viewed
more favorably by creditors, as
they are a way to have the customer
finance the completion of the project.
However, there are also some concerns
to be aware of when it comes to
overbillings. A WIP schedule with
a combination of jobs with losses
and jobs with large overbillings can
indicate trouble ahead. In such a
case, the billings from one project
are essentially being used to cover
the costs of other projects. This will
create a squeeze on cash flow as
the overbilled projects progress, the
overbilling recedes, and cash received
from one job is used to finance the
completion of another. Think of it
as a Ponzi scheme playing out in the
financial statements. That is how
creditors view it.
Overly Optimistic?
Lenders and surety bonding companies
also focus on projected gross profit
percentages for individual jobs. Are
there any that look out of place given
the contractor’s previous performance?
Some contractors are eternal optimists
and always project a best-case scenario
when it comes to performance. If a
contractor’s completed job schedule
reports average profit margins of
20 percent, the lenders and sureties
are certain to take a close look at
jobs in progress that are projecting
a gross profit of 25 percent or more.
Contractors should ask themselves the
same question and be able to explain
why current jobs will outperform
historical margins. Is there something
different about this job that lends
credence to the elevated gross profit
percentage, or should we take a closer
look at the cost to complete it? “Profit
fade” is a term used to describe when
gross profit from a contract is less
than previously anticipated. Profit
fade resulting from overly optimistic
projections at an interim date will
erode a creditor’s confidence in a
contractor’s ability to estimate their
job costs accurately. This in turn will
result in reduced credit and lower
bonding capacity for a contractor.
Monthly Job Reviews
A WIP schedule that is kept up on
a monthly basis can be a great tool
for measuring job performance. Of
course, like any tool, it is only as
good as the information that is put
into it. If actual and estimated job
costs are not correct, the report will
be inaccurate and misleading, and
the contractor will look incompetent
in front of their surety and banker.
Conversely, if monitored closely,
warning signs, spotted early on,
can help get a job back on track and
avoid continued losses. The better
a contractor becomes at monitoring
their jobs in this fashion, the better
they will be at preventing profit fade
and demonstrating themselves as a
skilled, knowledgeable and financially
savvy player in the construction
industry. Contact a member of HBK’s
Construction Solutions Group for
additional resources.
