Financial questions an owner should ask before contracting

Continued expanding development activity reflects a positive sign for the construction industry.  Our firm has over $700 Million of projects at various development stages, including several hotels, a museum renovation, an entertainment complex and sports facility.

As we work with owners, I often find that a design or construction firm will offer a service proposal at amazing low rates.  The tendency is to want to quickly accept the offer; however we have found that the lowest offer is not always the best offer particularly if that firm doesn’t have the financial strength to work with the owner should a project be delayed by outside forces (financing delays, zoning approvals, land development changes, and government approvals).

The recession has left many design and construction firms in a weak financial condition.   Owners should be careful as they do not want to change a design or construction firm in the middle of a development program.

Our advice has been to obtain financial statements from the Architect and Contractor (year end, last completed quarter and current month).  Reviewing the financial statements against the following guidelines can raise some interesting discussion questions. Below are financial questions an owner should ask before contracting.

Design firm guidelines:

  • Cash balances – a strong cash flow can mean a strong company or a dwindling backlog.  Substantial borrowings on a line of credit can indicate a slow pay clients or poor management decisions.
  • Negative Quick Ratio – greater current liabilities than current assets –typically this is a sign that the firm is over-leveraged and will have difficulty weathering any project delay.
  • Shrinking gross profit margin – usually a sign that the firm has been winning work at lower fees, perhaps lower than costs.  This is often done to keep their staff busy and offices open.
  • Accounts receivables growing faster than sales – a trend here could mean that the firm is carrying too many poor paying accounts or has performance issues on current projects.

Here are some additional guidelines for Contractors

  • Increased ratio of G&A expenses to profits – As workload sags, fixed costs are not reduced raising the ratio.  Fewer projects over which to spread the fixed overhead indicates the new project has a greater burden to carry.
  • Declining equipment value – this can mean that the contractor’s equipment will need replacing or additional maintenance could be chargeable cost to your project.
  • Significant liability changes – taking out a loan to keep the firm afloat is a sign of a contractor in trouble.