If I learned anything from ten years operating the world’s largest workout firm for sureties engaged in construction bonding, it’s that liquidity (or the lack thereof) is the most important predictive metric on a construction company’s balance sheet. Economic conditions, shrinking construction markets, soaring wage inflation, materials costs, and competitive low-bidding are only contributing factors to a construction concern’s financial distress. They are not the causes of ultimate failure. Lack of liquidity is always the final blow.
What is Liquidity?
Construction executives tend to be blasé about financial metrics like balance sheet ratios because, while practicing their mysterious art, financial officers and accountants don’t always highlight for management the practical value of critical financial data like liquidity. Here is a simple definition of liquidity:
Liquidity is the ability to meet short term obligations with existing capital.
Most construction executives and CEOs are so busy they have limited time to study their firm’s liquidity in detail on a continuous basis. In my experience they don’t regularly ask:
- How much cash do we have on hand?
- What is the exact amount of the payroll due at the end of the next pay period?
- How much are our material suppliers owed and how willing are they to extend additional credit?
- Are we current on equipment lease payments? Are we close to default? How much do we need to come up with in the next 30 days?
- Will receivables come in on time? Are my owners paying me routinely? Are we handing in progress billings on a timely basis and how much is contested?
How many construction senior executives and CEOs can answer that question on short notice with any degree of accuracy? Most of the CEOs I interviewed as they left their failed companies were surprised that they were out of business. They didn’t see it coming because they had no idea that they were imminently insolvent. Those painful experiences inspired me to extract the most important predictive ratios from construction contractors’ financial statements and begin to teach how to use them to avoid sudden collapse.
As I have said, the most important ratios for a construction executive to understand and utilize are liquidity ratios. If understood and used correctly, liquidity ratios serve as an early warning bell that alerts the boss to impending going concern problems and motivates him or her to take corrective action. Let’s take a look at the liquidity ratios I utilize.
In my experience,
- An average comfortable liquidity is when the Debt to Worth ratio is around 1 to 1 or less, while the Net Quick ratio is around 1.5 to 1 or more.
- I also use a liquidity test of Total Liabilities to Worth (Equity) which is a broad ratio that ignores internal differences, captures all “debt” and is not easily manipulated.
- For individual companies I use an average of any of these ratios from the prior three year-end financial statements as a benchmark, assuming the company was profitable and increasing in value during those years. If not, I go backwards until there are three consecutive years of increasing value. When this occurs, there will have been cash, cash-equivalents or unused credit available. The average of that amount over the three years is what I refer to as the firm’s historic “Liquidity Reserves” available to pay the bills in the event of unexpected financial difficulty.
Financial Officers of different companies will generate even more closely reasoned liquidity ratios for various contractors. Depending on the short-term capital structure of a firm, the variables may differ substantially making a safe and sound liquidity ratio for one firm quite risky at another. Each company should develop the metrics that work best for them. However, the key to success is to educate the top management in the practical use of liquidity ratios and generate these ratios and other financial metrics frequently. Once a month is barely enough in a complex, busy construction firm. During any growth period I recommend that liquidity warning indicators be generated on a real time basis and formally delivered to top management at least once-a-week and even more frequently in highly volatile firms. Without an alarm it’s always too late.