You should understand that the primary considerations in the measurement of risk are the likelihood of the event occurring and the magnitude of the penalty if the event occurs. You can’t measure risk without evaluating the odds and the penalty or reward. For example, if the odds were six to one in your favor would you take the bet? It sounds pretty good, but this can’t sensibly be answered without knowing what the event is. If it is a hundred-dollar bet, it is a good risk that most would take because of the excellent odds and nominal penalty or reward. However, the same odds exist in the game of Russian Roulette. With one bullet in a six-cylinder revolver the game requires you to pull the trigger aimed at your head. Good odds but much too severe a penalty – so bad risk.
In last week’s blog on the R-Score, we isolated the primary cause of construction business failure – the availability of sufficient capital. If we look at our R-Score the way I define odds and risk measurement, we can easily see how the R-Score number represents the likelihood of the event occurring or not. However, no matter what the odds, the magnitude of the penalty – GOING OUT OF BUSINESS – is much too severe – so bad risk.
Why, then, do so many contractors play Russian Roulette by taking the risk of eroding operating capital to the point that they slip into insolvency? If the potential of a decision exposes your life’s work and net worth to disaster, is that a risk you want to take? I don’t see any advantage in betting everything or playing Russian Roulette with your livelihood. Having seen many contractor friends lose it all has turned me into an evangelist promoting the prudent management of liquidity.
Determining Levels of Liquidity
Years of research into the causes of construction business failure have taught me that contractors sail dangerously close to the “liquidity” wind because they don’t realize they are playing Russian Roulette. They all say they wouldn’t have taken the risk of going out of business if they had realized that’s what they were doing.
The concept of appropriate liquidity is too vague in the construction industry.
As I pointed out in last week’s blog, perhaps it’s because there is a wide variety of companies in the construction industry and the level of appropriate liquidity for a heavy highway company, for example, is not comparable to the liquidity needs of a typical Construction Management firm. The size of a company, the size of impending contracts, the stage of a company’s growth, and the credit worthiness of a company are all additional factors in determining the level of liquidity that is appropriate for any company.
Prudent Liquidity Management
Let’s cut to the chase. My research on hundreds of construction companies over the past thirty years reveals that, while it differs for each company, average comfortable liquidity is when:
- Debt to Worth is around 2 to 1 or less.
- Net Quick is around 5 to 1 or more.
Note: These are conservative, but vary by type of company.
Note: For individual companies I use an average from the prior three year-end financial statements as a benchmark, assuming the company was profitable and enjoying consecutive years of level or 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 “Liquidity Reserves”; available to pay the bills in the event of unexpected financial difficulty.
Are You Playing Russian Roulette?
If you’re content with your income and cash flow statements, but unfamiliar or uncomfortable with analyzing your balance sheet to arrive at in-depth management decisions, you are playing Russian Roulette and don’t know it.
Having a firm understanding of the nature and availability of “capital” is the only way to avoid an unforeseen liquidity crisis. We have archived here on the site a wide variety of research on the recognition and avoidance of inordinate risk in the construction industry. Take a look at some of our work on the subject and please share any insights you have developed managing liquidity for your company. Read more about Financial Distress and the Original R-Score Research.