By Martin C. McCarthy, CPA, CCIFP
Written on March 16, 2020
Numerous macro-economic factors are in play that could cause a change in the economy. These include the ever-increasing U.S. debt, uncertain monetary policies, labor shortages, political instability, tariffs, trade wars, and now the coronavirus (COVID-19).
Anirban Basu, Chairman and CEO of Sage Policy Group, claims that the leading cause of concern for contractors about COVID-19 is the weakness in business investment. Joe Beeton points this out in his article on Basu’s presentation at the Modular Building Institute's World of Modular conference. Entitled “Contractors Should Prepare for a Coronavirus-Triggered Recession” (Construction Executive, March 12, 2020), Basu said: “The risk of recession over the next three to six months is arguably more elevated than at any period since 2007. The U.S. economy has been defying predictions in an extended period of growth that's seemed too good to be true for some time. I knew this period of fragility would leave us susceptible to a trigger, but I didn’t know what that trigger would be. Now we know.” Basu advises “businesses to see how much cash they can raise, determine if their lines of credit are large enough, consider alternative staffing models and ensure the good graces of bankers and insurers."
In just the past few weeks the U.S. economy was strong with job growth, rising wages, and low interest rates. Everything changed due to uncertainty around COVID-19. The Dow Jones Industrial Average suffered its worst loss since 1987, plunging nearly 3,000 points on Monday, March 16. The S&P 500 and NASDAQ experienced losses as well.
The House of Representatives did pass the Families First Coronavirus Response Act (FFCRA, H.R. 6201) on March 14. This bill provides paid sick leave, free coronavirus testing, additional food assistance and unemployment benefits. The bill also provides FY2020 appropriations to the Department of Health and Human Services for nutrition programs that assist the elderly. In addition, the bill requires the Occupational Safety and Health Administration to issue an emergency temporary standard that requires certain employers to develop and implement a comprehensive infectious disease exposure control plan to protect health care workers.
The Federal Reserve Bank also slashed interested rates to nearly 0% on Sunday, March 15 to slow down the effects of COVID-19. Furthermore, the Federal Reserve announced that it will buy at least $700 billion in government and mortgage-related bonds as part of an emergency action plan to protect the economy from the impact of the coronavirus outbreak. At least $500 billion will be U.S. Treasury bonds. The rest will be mortgage-backed securities, an effort to stabilize home loans. The Fed’s actions on Sunday come on the heels of an emergency interest rate cut on March 3 and a large $1.5 trillion injection into the bond market last week to ensure enough liquidity.
The International Monetary Fund is ready to mobilize $1 trillion lending capacity to help nations globally counter the coronavirus outbreak. As you can see, the appropriate agencies are taking action, but the reality is there is a high probability that there will be a recession. Both surety bond professionals and contractors need to be prepared for the economic impact and brace for a slowdown or complete stop on some or all their projects.
Be Proactive
It is important to plan now. Surety bond professionals should take proactive steps to protect their business and their relationships with contractors. As with the Great Recession, the construction industry could be hit hard.
Surety bond producers should talk to the contractors that they work with and advise them to take the appropriate steps now to help them get through a recession. One such step is to review all their contracts to determine if they will be held responsible for delays or cost overruns on current projects. Contractual terms related to schedules, completion dates, delays, liquidated damages and other provisions could be affected. Producers should assist contractors in determining if there are force majeure provisions to provide some type of protection if work needs to be stopped or terminated due to COVID-19.
Producers should remind contractors that their bonding capacity is based on the company’s character, capacity, and capital. The “three Cs” provide a foundation for producers and underwriters to form an opinion on a contractor’s past, current, and future performance. Information on how a contractor handled present and past challenges could go a long way in maintaining a contractor’s bonding capacity, especially if steps are taken now to reduce or control the impact of COVID-19. There will be shortages of materials and labor. Surety professionals should advise contractors to look for alternative suppliers and crews to mitigate the risk that the materials and workers will be available. Contractors will have to adjust project schedules and deliverable dates accordingly.
Surety companies want to know that the contractors they work with are well-managed, profitable, and have measures in place to reduce risks. How a contractor responds to challenges presented by COVID-19 will be important to the future of the relationship. Sureties should advise contractors to review pending projects and bids. Contractors should analyze each project to determine which ones are still viable and will produce the highest return on investment. Projects with tight profit margins should be carefully assessed to determine if they are worth building. Surety bond professionals should warn contractors to avoid taking unnecessary risks so they can focus on projects that are feasible and profitable. Sureties should ask contractors about the feasibility of postponing certain projects if it does not make sense to start them now. Sureties should be prepared to address issues caused by the possibility that financing may no longer be available or contracts may cancelled by the client.
Help Contractors Improve Their Character, Capacity, and Capital
Bond producers should advise their contractor clients to set realistic expectations. In bull markets, contractors may want to take advantage of cash-on-hand to take on new projects or invest in capital expenditures. Now is not the time. Instead, contractors should save their money so they have the cash to fund operations.
Contractors should examine the profit margin on each project. Profits are more important to look at than revenue. Although a project might increase revenue, if the expenses are too high, the profit margin will be too low. Now might be a good time for contractors to pass on projects that will not produce a high enough profit margin.
Contractors should perform a cash flow analysis to determine when and how money moves into and out of their business. Bond producers can suggest that contractors make sure that they are billing according to the contract terms. Sureties can also urge contractors to tighten their credit policies, enforce late fees, and start collection efforts 30 days after an invoice is sent. Contractors should also examine every contract they have with vendors and try to renegotiate the terms and take advantage of discounts for paying early. Bonding professionals can suggest that contractors analyze leasing equipment instead of buying.
Whenever possible, sureties should advise contractors to have a clause in their contracts requiring customers to pay upon completion of certain milestones. Although these milestones might not be met in the near-term, it is still a good practice to include them in future contracts. This will help with cash flow and reduce the need to borrow money to complete projects.
Surety professionals can also advise contractors to sharpen their pencil when estimating job costs. The estimator should outline the scope of work (SOW) and define every aspect of the job. There are so many variables to consider. For example, if construction is going to take place over the winter months, snow removal costs should be factored into the estimate. Indirect costs, such as having a trailer on site, the cost of technology, office overhead costs, and labor, also need to be included.
Bond producers can suggest that the contractor apply lean construction principles on jobs. Lean is the process of standardizing workflow, decentralizing process improvements, implementing just-in-time inventory systems, and working in collaboration as a team. Lean production principles typically result in increases in productivity, improvements in operations, better quality control, and less waste.
In addition, surety bond professionals can advise contractors to meet with their banker to ensure they still have an adequate line of credit. Contractors should carefully assess the need for new long-term debt so that their company is not highly leveraged. Bond producers can also recommend that contractors talk to their insurance broker to make sure they do not have unnecessary coverages.
Even in times of uncertainty, surety companies want a level of assurance that contractors can perform the work they are contracted to do and can pay the bills. By taking the time now to discuss the above-mentioned measures with contractors, bond producers and sureties may help them to maintain or, possibly improve, their bonding capacity. Of course, a bond producer’s or surety’s business will be impacted if the contractors they work with are no longer bond worthy because they did nothing to prepare for an economic downturn. Therefore, it is in everyone’s best interest to address these issues now.
This article is written by Martin C. McCarthy, CPA, CCIFP, is the managing partner of McCarthy & Company, PC. He is well-respected by sureties for the high quality of his work and profound understanding of the construction industry. McCarthy serves on the NASBP’s CPA Advisory Board. He can be contacted at Marty.McCarthy@MCC-CPAs.com or 610.828.1900.