Looking for a Vital Sign in Contractor Accounts: The Receivables/Payables Ratio
By Dev Strischek 1
page 1 of 4
page 1 | 2 | 3 | 4
In his Devil's Dictionary, Ambrose Bierce defined a road as a strip of land along which one may pass from where it is too tiresome to be to where it is too futile to go. As the economy rolls down its cyclical path, the construction industry often finds this unhappy trail both tiresome and futile in its twists and turns. As fellow travelers on the contractor road trip, their lenders and creditors naturally look ahead for any warning signs of potential financial hazards. This article evaluates one possible traffic signal for the performance pike—the receivables/payables ratio.
A contractor's receivables and payables represent two significant elements of contractor cash flow and working capital. Receivables constitute the major source of cash inflow, and payables absorb a big share of cash outflow. A construction company's ability to extend credit to its customers depends on its own trade creditors' willingness to wait for their payments from the contractor's collection of its progress billing receivables. The delicate balance of receivables and payables is key to the financial success of the contractor. As will be explained later, contractor receivables take longer to collect, and the trade creditors expect prompt payment.
As a contractor bills his customer for the percentage of work completed for the month, he multiplies the percentage of completion by the value of the contract. The resulting dollar value of the billing covers both costs and gross profit. A typical contractor's gross profit averages around 20% of revenues, and the remaining 80% represents construction costs, of which labor and materials are the two primary components. Labor is usually the larger of the two, often 50%, leaving 30% for materials. Consequently, materials usually amount to only about a third of a typical progress billing.
For example, suppose High Road Construction Company has a $1-million contract to build a 728- yard access road up Bald Mountain to Lucifer Hot Springs Resort. HRC's owner, Pete Mussogorsky, estimates his total costs will be $800,000; materials are projected at $300,000 and labor at $500,000. His gross profit is pegged at 20%, or $200,000 for the 666 meters of roadwork. Pete starts work in May, and completes one-tenth of a mile that month. HRC has completed 10% of the road, so Pete's May billing charges the Resort $100,000 for the work to date. That $100,000 represents $30,000 of materials, $50,000 of labor, and $20,000 of gross profit.
1 © 2001 by RMA. Strischek is managing director, corporate and commercial credit policy, asset quality/credit policy division, SunTrust Banks, Inc., Atlanta, Georgia. A former RMA president, he serves on the Editorial Advisory Board of The RMA Journal and has contributed numerous articles on the construction industry as well as "spilled milk" and other articles.
REFERENCES
Contractor statistics taken from 1981 through 2000-2001 editions of Annual Statement Studies, Philadelphia: RMA— The Risk Management Association.
Dev Strischek, Analyzing Construction Contractors, Second Edition, Philadelphia: Robert Morris Associates, 1996.
«HOME