Maximizing Credit in a. CFMA October 19, 2010 By Robert Mercado, CPA, CCIFP Partner, Marcum LLP

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1 Maximizing Credit in a Down Economy CFMA October 19, 2010 By Robert Mercado, CPA, CCIFP Partner, Marcum LLP 1

2 The Construction Industry Second Largest Sector (second only to government) Second Highest Failure Rate (to restaurants) Higher Risk Should Equal Higher Rewards 2

Ten Most Common Causes of Construction Contractor Failures 1 6 2 Obtaining work in a new ggeographic g p region. g 7 3 Dramatic increase in single job size. 8 Obtaining new types of work.

3 Ten Most Common Causes of Construction Contractor Failures Obtaining work in a new ggeographic g p region. g 7 3 Dramatic increase in single job size. 8 Obtaining new types of work Growing too fast. Inadequate capitalization. Poor estimating and job costing. Poor accounting system. Poor cash flow. Buying dumb stuff: High employee turnover. 10 Fast Cars Restaurants

4 Ten Things You Need To Know About Construction Industry Accounting Construction industry accounting and taxation is unique. Both the CPA and the Contractor s Controller must have education and experience with contractors. The AICPA Construction Contractors Audit and Accounting Guide is U.S. GAAP. The percentage of completion method is really the only acceptable U.S. GAAP method. Tax reporting and financial reporting methods should always be different. Estimation of gross profit and percent complete is the essential component of financial i reporting for a contractor. Working capital, equity and income are all derived from those estimates. 4 4

5 Ten Things You Need To Know About Construction Industry Accounting Underbilling is not normal. Overbilling should be represented by cash in the bank. Knowledge of job costing principles is critical. Working capital is the primary basis for surety credit. Contractors need proactive Controller and CPA involvement in preliminary year-end tax and financial planning. Surety/bonding companies, banks, regulatory boards, creditors, and customer/owner are users of contractor financial statements. 5 5

6 Financial Statement Disclosure Operations Surety Bonds Purchased Estimates Changes in job performance Balance Sheet Classifications Revenue and Cost Recognition Income Taxes 6

7 Financial Statement Disclosure -Continued Contracts Receivable Breakout Costs and Estimated Earnings on Uncompleted Contracts Accounts and Subcontractors Payable Backlog recommended disclosure Significant Estimated Revisions on Contract Income Tax Disclosure Comparing Entity to a C-Corp 7

8 Income Tax Disclosure Comparing to C-Corp The Company has elected to have its income taxed under the provision of Subchapter S of the Internal Revenue Code, which provide that, in lieu of corporation income taxes, the stockholders separately account for the Company's items of income, deduction, losses and credits. Therefore, these statements do not include any provision for income taxes. Had the Company been taxed as a C-Corporation the deferred tax liability related primarily to the use of the completed contract method of accounting for tax purposes would have amounted to $1,000,000 in 2009 and $850,000 in

9 Financial Statement Disclosure Supplemental Information Earnings from Contracts Contracts Completed Contracts in Progress Cost of Revenues Earned and General and Administrative Expenses Accounts Receivable Aging Subsequent Collections 9

10 MARITIME CONSTRUCTION COMPANY, INC. SCHEDULE I - EARNINGS FROM CONTRACTS AND COSTS OF REVENUES EARNED Year ended December 31, 2009 EARNINGS FROM CONTRACTS Cost of Revenues Revenues Gross Profit Earned Earned Amount Percentage Contracts completed during the year $ 4,272,000 $ 3,356,000 $ 916, Contracts in progress at year end 4,459,000 3,850, , Service and time and material jobs 2,643,000 2,260, , Accrued loss on uncompleted contracts - 15,000 (15,000) $ 11,374,000 $ 9,481,000 $ 1,893, COST OF REVENUES EARNED Materials $ 3,055,000 Direct labor and payroll taxes 2,350,000 Employee benefits 1,900,000 Subcontractors 1,249,000 Insurance 610,000 Depreciation 110,000 Equipment rental 65,000 Licenses, permits and bonds 52,000 Auto and truck 45,000 Rent 30,000 Tools and supplies 15,000 $ 9,481,000 10

11 What is a Surety Bond A surety bond is a guarantee of the contractor s performance Reasons why owner requires a bond Ensures owner will receive finished product at negotiated price Surety s due diligence to determine the competency of the contractor 11

12 Surety Relationship Understanding Surety Credit Surety Reimburses surety for payment to owner Pays owner for damages Contractor Fails to perform Owner 12

13 What a Surety Looks For Three Cs Character of Contractor Capacity with regard to skills, experience, knowledge, and equipment Capital (Working Capital) to finance the project and ability to absorb a reasonable loss on one or more projects pojects 13 13

14 Working Capital and Cash Flow Acme Contractors starts a new job. They incur $10 of precontract costs, and are awarded the bid. In February and March they incur $30 and $40, respectively of job costs. Acme bills in the middle of the month based on an unbalanced bid. In mid-february they prepare and send a bill for $50. The owner pays promptly and in five weeks Acme receives a check for $45 (progress billing less the 10% retention). The cash flow for the first three months of this job are summarized as follows: January February March Outflows (10) (40) Precontract (30) Monthly job cost Inflows Mid-February billing 50 Less: retainage - - (5) Net Cash Flow (10) (30) 5 Thus, for the first three months of the job, Acme has a cash flow deficit of $35. The job will be financed out of the contractor's own working capital. 14

15 Financial Ratios Profitability Liquidity and cash management Fixed assets Debt Equity General and administrative expenses Officers salaries 15

16 Financial Info Accounts receivable aging Marketable securities (available-for-sale) Overbillings and job borrow Property and equipment Debt Underbillings Profitability on a job-by-job basis looking for profit fade Statement of cash flows 16

17 Surety Credit Ten times adjusted working capital for surety credit for an individual project Ten times net worth for a maximum credit for a work program 17

18 Market Conditions - Effect on Your Company 1. Less bonding capacity Old days = 20 times working capital and/or equity to Today = 10 times working capital and/or equity 2. Higher underwriting standards Upgrade of CPA statements to Audit from Review Upgrade of CPA firm, required industry experience Personal guarantee are back to stay Reporting on personal financial statements Monthly internal reporting WIP Financial Statements 18

19 Surety Adjustments Accounts and notes receivable from officers, employees, or owners Notes receivable Inventory Prepaid expenses Cash value of life insurance Current liabilities 19

20 Current Assets Exhibit 3-3 Determining Working Capital for Surety Credit Current Assets - GAAP-basis $ X,XXX Subtract: Receivables from officers, employees, owners (XXX) 50% of inventory not at job site (XXX) Prepaid expenses (XX) Add: Cash surrender value of life insurance XX Current Assets - Surety Credit Purposes Current Liabilities X,XXX Current liabilities - GAAP-basis (X,XXX) Adjusted Working Capital for Surety Credit $ XXX 20

21 Maximize Surety Credit 1. Understand how your surety company underwrites your firm. 2. Balancing tax and estate planning with business and surety interests. 3. Reliance on bank debt to a minimum. 4. Manage your balance sheet, especially at year end (cash, debt, A/R). 1. Line of credit Is this really a long-term liability 5. Rapid reduction of overhead. 6. Invest in the relationship of your surety agent and underwriter. 7. Be easy to deal with 1. Provide timely information 2. Provide quality information 3. Deliver bad news early. 21

22 Working Capital & Stockholder's Equity 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000, ,763,236 7,365,025 4,908,407 4,382,635 2,969,227 3,835,091 2,518, ,810, Industry Average Working capital Stockholders' equity Working capital is the most important contractor ratio. It is a direct indicator of a contractor's short-term financial strength and is used to help evaluate a contractor's ability to fund construction projects. Generally, bonding and licensing capacity is determined by multiplying working capital by a factor between 10 and 20. Stockholders' equity, often referred to as book value or net worth, represents the accumulated earnings and invested capital since the inception of the company. Bonding companies usually allow a minimum of ten times the lesser of working capital or stockholder's s equity for a bonding program. 22

23 Debt to Equity Ratios / Debt Coverage Ratio Industry Average Interest debt to equity Total liabilities to equity Debt coverage ratio Interest bearing debt to equity represents interest bearing debt including installment notes, bank loans or short term borrowing and occasionally non-cancelable lease payments. A.8 to 1.0 or less is considered acceptable by most sureties. Total liability to equity represents all liabilities including interest bearing debt, accounts payable, amounts owed to subcontractors, accrued expenses, and income tax liability to stockholder's equity. A 4 to 1 ratio is considered acceptable by most sureties. The debt coverage ratio represents the level of total cash flow, including net income, plus depreciation and amortization, supporting each $1 of current debt. Generally, a ratio of 1.25 and above is considered acceptable. 23

24 Gross Profit Percentage 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Industry Average Gross profit percentage Gross profit percentage, net of sub. Completed contract gross profit % Net income as a percent of revenue Gross profit percentage is a direct reflection on a contractor's ability to maintain consistent profitability and the ability to control costs. Completed contract gross profit percentage should be comparable to the overall gross profit percentage on a historical basis. 24

25 Income Statement Analysis 50,000,000 45,000,000 40,000,000 35,000,000 30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000, Industry Average Total revenue Direct Costs Gross Profit 25

26 General and Administrative i ti Expenses Analysis % % % % % % % % 0.00% 14.02% 14.02% 8.93% 9.32% 7.42% 7.81% 8.31% 6.84% Industry Average 2005 Total revenue 2004 Direct Costs 2003 Gross Profit Industry Average Total G & A expense as a % of revenue G & A less officer's salaries as a % of rev 26

27 Total Backlog & Backlog Gross Profit 25,000,000 20,000,000 15,000,000 10,000,000 5,000, Industry Average Total Backlog Backlog Gross Profit Total backlog is the amount of work under contract not yet completed. 27

28 Backlog Gross Profit as a Percent of General and Administrative Expense 70.00% 00% 64.88% 60.00% 50.00% 34.85% 42.07% 40.00% 00% 30.00% 20.00% 10.00% 00% 0.00% 0.00% Industry Average Backlog gross profit represents the amount of future gross profit not yet earned on uncompleted contracts. Generally, backlog gross profit should exceed 50 percent of general and administrative expenses. 28

29 Months in Backlog Industry Average Months in backlog indicates the number of months it will normally take to complete all work under contract. A ratio of less than 12 could indicate that a contractor needs to secure more in order to maintain current volume. 29

Pe rce ntage of Comple tion Adjus tme nt/es timate d Pe rmane nt Job B orrow 3,500,000 000 3,075,868 3,000,000 2,500,000 1,931,201 2,000,000 1,518,970 1,500,000 1,095,674 902,335 1,128,546 1,000,000

30 Pe rce ntage of Comple tion Adjus tme nt/es timate d Pe rmane nt Job B orrow 3,500, ,075,868 3,000,000 2,500,000 1,931,201 2,000,000 1,518,970 1,500,000 1,095, ,335 1,128,546 1,000, , , Industry Average - Total job borrow Estim ated perm anent job borrow Total job borrow indicates the net percentage of completion adjustment. A positive number represents a net overbilling. This indicates that the contractor has bid its work in which the contract owner assists the contractor in financing the job. A negative number represents a net underbilling, which is considered unusual by most sureties. Net underbillings may indicate poor billing or bidding practices or may also indicate overly aggressive profitability forecasts. Estimated permanent job borrow represents the portion of overbillings (job borrow) which is made up of estimated gross profit (gross profit backlog). This amount is calculated on a job-by-job by basis and represents the amount of the contract which has already been billed and which will become equity if the contract is completed at or above the estimated gross profit. 30

31 Underbilling Ratios 48.19% 50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 36.07% 27.70% 70% 27.41% 21.82% 12.94% 10.81% 9.08% Industry Average Ratio of underbillings to equity Ratio of underbillings to working capital Ratio of underbillings to equity is the percentage of the contractor's net worth which is represented by work which has been performed but not yet billed. A ratio in excess of 20% is considered unusual by most sureties. Underbillings to working capital represents the portion of the contractor's working capital which is comprised of underbillings. A ratio in excess of 25% is considered unusual by most sureties. 31

32 Cash to Overbillings Industry Average The ratio of cash to overbillings represents the amount of cash in the bank as a ratio of billings in excess of costs and estimated earnings on uncompleted contracts. All overbilled amounts should be represented by cash in the bank. Therefore, an acceptable ratio of cash to overbillings is generally 1 or higher. 32

33 Analysis of Receivables and Payables 10,000,000 8,000,000 6,000,000 7,348,367 8,253,378 8,407,429 6,405,984 4,000,000 2,000,000 2,281,848 2,513,328 1,315,927 1,639, Industry Average Net of current receivables and payables Net of retainage receivable & payable The net current receivables and payables is an indicator of how a contractor is managing its cash flow. An unusually low number could indicate that a contractor has experienced cash flow problems. Retainages are typically receivable or payable upon completion of a contract. Because retainages are receivable or payable within the contractor's operating cycle, the amounts are generally considered current assets and liabilities even if due after one year. 33

34 Liquidity Ratios Industry Average Quick ratio Current Ratio The quick ratio indicates the extent to which the more liquid assets are available to satisfy current liabilities. Usually stated in terms of absolute values, a quick ratio of 1.0 is generally considered a liquid position. The current ratio indicates the extent to which current assets are available to satisfy current liabilities. Usually stated in terms of absolute values, a minimum current ratio is generally

35 Contract Gain / (Fade) 800, , , , , , , , , , ,000-1,000, Industry Average Contract gain or fade Gain/(Fade) Current Year Impact Contract gain or fade is the net change in estimated contract profitability from year to year. A contract fade could indicate poor contract profit estimating i or unforeseen jobsite conditions. i 35

36 Additional Things To Be Aware Of Overhead budgets Have reduction plan ready! Review employee responsibilities look for overlapping duties Fixed assets Book vs. tax depreciation methods and lives Correction of an error vs. change in estimate Variable interest entities (FIN 46) Joint ventures 36

37 New Accounting Pronouncements Around The Corner Multi-Employer Pension plan disclosure Operating Lease vs. Capital Lease Revenue Recognition (IFRS) 37

38 Evaluating A Contractors Ability to Continue As A Going Concern Analysis unique for construction contractors: 1. Estimate fixed overhead contractor must cover 2. Determine amount of pre-tax income contractor needs Sum of these two is gross profit from jobs the contractor must generate in coming year 3. Estimate gross profit remaining on jobs in progress. In making this estimate, use historical gross profit percentages on completed contracts. 4. Is gross profit remaining on jobs in progress enough to cover gross profit determined in step 1? If not, how much gross profit is needed from new work? 5. Using historical gross profit percentages, estimate how much volume the contractor will have to do to make the required gross profit. Given the contractor s past history, does this volume level seem reasonable? 38

39 Questions? com/maximize 39

What Sureties Want To See In Financial Statements

What Sureties Want To See In Financial Statements October 28, 2010 John Reed, CPA, CCIFP Construction and Real Estate Group Principal, LarsonAllen LLP Nick Costa Account Executive, The Travelers Companies,