By Jack A. Callahan

“I think it’s a myth that expansions die of old age.”  – Former Federal Reserve Chair Janet Yellen

While I am certain this quotation is true, in my 40 years in this industry I have not seen an expansion that hasn’t contracted within 10 years. The construction industry has been strengthening since 2009, with no indicators of a slowdown in sight. Backlogs remain strong, large urban cities continue to see megaprojects transforming neighborhoods, economic forecasts remain positive, and a federal infrastructure bill may be the one thing that politicians can agree upon. A whole generation of young surety professionals has never lived through a downturn in the market.

With all that said, history has shown us that the markets will turn; and when they do, the construction industry will be impacted, ultimately leading to contract failures and surety claims. The time to plan for tough times is now. While backlog is strong and cash flow is positive, contractors need to be taking a hard look at their business, because CPAs will be looking past the current reported results, seeking to gauge their contractor’s preparedness.

These are the questions CPAs will be asking. Have contractors …

• Invested in their people?
• Invested in technology?
• Shown strong cash management skills?
• Surrounded themselves with a strong team of independent and knowledgeable advisors?
• Established strong and trusted banking and surety relationships?
• Shown restraint in growth of overhead?
• Shown the ability to forecast and plan?
• Established clear succession plans?
• Invested in client relationships, where they are viewed as a contractor of choice?
• Built up significant book to tax deferrals?

These are just some of the critical factors that CPAs will need to assess as they look at the long-term viability of their clients to succeed and better thrive in a down market. When markets turn, contractors close shop, retract, or implode. At the same time, work will need to be built; and work outs will be occurring. The well-positioned contractor with the correct team around it can be well-situated to grow.

When a CPA is not able to favorably assess a contractor client’s preparedness, the CPA will need to engage in those discussions now. If the answers are not positive, it will be imperative that the contractor begins the process before it is too late to take effective remedial actions.

First and foremost are the people. Contractors need to have an appropriate balance of younger and more mature workforce. The industry universally is citing an aging workforce and labor shortages as major concerns. The best-in-class contractors have invested in their workforce and have a balance in demographics.

Along with the investment in their people is the investment in technology. The new-age workforce demands access to technology tools that allow them to spend less time on remedial labor-intensive tasks. If the chance is to work in a tech-savvy environment or one mired in ledger sheets, the choice will be clear.

Cash has always been king and will continue as such. As contractors grow and prosper, have they invested in strong cash-management skills? Have they been meticulous in cash collections and timely subcontractor and supplier payments? Have they established sound cash forecasting that is built into their estimating and bidding process? This is essential and will be more so when the market tightens. Best-in-class subcontractors and suppliers will look to work with and provide best pricing to contractors that have treated them well.

I have always contended that the most successful contractors have surrounded themselves with a strong team of core trusted advisors. I have always identified those as an accountant, attorney, bond producer, surety, and banker. Evaluate the strengths of those individuals. In the old days, we would have annual meetings where surety, bond producers, accountants, attorneys, and others would be present. I contend that it is good policy to get back to that practice or make other inquiries to establish the quality and independence of that team.

While all the trusted advisors are critical to success, the banking and surety relationships can often have the biggest immediate impact. We have experienced down markets where banks have redlined the construction industry. We have had sound performing contractors told to close their accounts and move all banking relationships without notice. These types of actions can certainly be repeated. Less reactionary but just as critical is having producer, surety, and banking relationships where the contractor has developed a track record of trust and reliability. There will be a bad job or a bad year. If the relationships are strong and the contractor is trusted, more times than not the producer, bank, and surety will support the contractor.

Overhead is always a major concern for contractors. They need to properly identify what their overhead is and know what their break-even numbers are. When times are good, margins are strong, and volume is growing, overhead management may not be critical. I can assure you that it is, and the evidence lies in the bottom line. If the growth of the overhead has been inconsistent with volume growth, does management have the ability and willingness to correct that change quickly enough?

Forecasting and budgeting are critical to a contractor’s success. Does a contractor have a solid forecasting system that is reliable and responsive? In addition to cash flow, labor, production, material delivery, and backlog runoff are critical to the effective management of a construction company. Reacting to what happens each day or planning week by week is just not acceptable in this challenging environment. Planning ahead will be crucial to a contractor’s ability to survive a downturn.

Careful and thoughtful succession planning has been the key to all mature contractors. The time to set a strategy in place is when times are good and everyone is getting along. We have been through an extended growth cycle. Has ownership taken a hard look at where it wants to go with the business? Is family succession or key employee succession an option? If so, a time of strong earnings and cash flow may be the best time to effectuate that. If the desire is to sell the company, we are in a stronger market than I have witnessed to effectuate a transaction. Any type of succession transaction and plan will take time. Contractors should have things positioned to minimize the disruption of operations should a buyout event occur or be required.

A contractor’s reputation on the street should be evaluated. If it has a reputation of doing good work at a fair price and paying employees, subcontractors, and suppliers fairly and promptly, it will likely have developed a loyal customer base. If the background is to be low bidder, push hard on subcontractors and suppliers, and have an extended track record of claims, change orders, and extras, it will not be looked upon as a preferred vendor. In times of tightening markets, those pure low-bid contractors have proven to be the ones that get impacted most adversely.

Contractors should understand what the magnitude is of their tax deferrals and be certain they have a plan for when these will turn and how those deferred taxes will be paid. When the market tightens and volumes shrink, it is likely that these deferrals will begin to turn around. Think about the cash flow impact of shrinking volume, shrinking margins, and significant cash flow needs to pay taxes; we have seen it take its toll. In the past, contractors were able to carry back losses and obtain refunds of previously paid taxes. The Tax Cuts and Jobs Act of 2017, while providing more favorable tax rates, took away a contractor’s ability to carry back losses. In prior recessions, these tax refunds were often used as a lifeline to get through a crunch, but that option is no longer available. Be sure to ask about the deferrals and obtain a plan for handling them.

I hope that I am being overly cautious and the current market continues to stay strong. If that is the case, the action points I have laid out will still be important to a contractor’s success. If things turn, they will be critical to the contractor’s survival. In the past, we have seen the construction market impacted a year or more after a market correction, due to run off of contracted work. Let’s hope we get that lead time again. It is never too soon to have these discussions with contractors.

Jack A. Callahan, CPA, is a partner with CohnReznick and serves as the firm’s Construction Industry Leader. In this role Callahan is responsible for developing a team of accounting, tax, and consulting professionals dedicated to, and experienced in, servicing contractors. He serves on the NASBP CPA Advisory Council. He can be reached at jack.callahan@cohnreznick.com or 732.380.8685.