In today’s commercial environment, construction companies need to evaluate their current cash position and near-term cash needs much more regularly than before. So what are their options?
The volume of construction projects and future orders reduced greatly during COVID-19 lockdowns, despite many governments considering construction an essential service and allowing companies in the industry to continue operating.
As restrictions lift, construction companies must evaluate their previous operations. Many will consider all aspects, and some will begin to reinvent themselves.
An important aspect of company management within the construction industry, particularly at the current time, is maintaining the right level of working capital, or access to funds to meet short-term obligations — especially when profit margins generally are very tight.
Liquidity — the ability to meet obligations as they arise — is generally prized as the greatest strength, with leverage and profitability close behind. Working capital — current assets less current liabilities — is a liquidity shown as a dollar figure, as opposed to a ratio. For this reason, bigger is usually better, but the quality of working capital counts too.
It is vital that contractors have sufficient short-term liquidity. Otherwise, their working capital can be stretched by delayed payments from owners, potentially creating a need to finance the delays with debt. This can result in costs that were not factored into the bid price.
Contractors must manage a number of risks that could impact their business’ liquidity, including:
It is generally expected that projects will maintain a positive, or at the very least a neutral, cash position. The payment terms agreed with customers and subcontractors is a key tool used to manage this.
If there is a negative position, the project won’t be able to fund payments to subcontractors (independently). When a construction company is running multiple projects, there is a temptation to borrow liquidity from other projects, but this can be a sign of a company in distress, and possibly on the path to failure.
While all contractors may be impacted by the COVID-19 pandemic, subcontractors are expected to feel the greatest pinch. Many are understandably considering ways to sustain their businesses.
Both traditional and alternative sources of cash provide liquidity options that may support a company’s financial stability. These include:
Most construction contractors need traditional lending support from banks to satisfy typical cash flow management, plus additional capacity to “bond” each project they undertake.
Yet the construction sector faces a unique risk in this respect, which needs to be managed. Most banks combine standard lending with bank guarantee limits under a multi-option facility. Because numerous projects can be underway simultaneously, large aggregate values of bank guarantees are often issued, reducing the amount available in the facility for working capital or to satisfy bank guarantees needed for new contracts. Contractors therefore need to carefully balance their available limits.
Companies use surety bonds as an alternative to bank letters of credit when they need security to meet financial obligations. In the US, where surety bonds are often required by statute, maintaining stable, competitive surety capacity is a contractor’s lifeblood.
Borrowing capacity is a major driver of the demand for surety bonds. Unlike bank guarantees or a letter of credit, a surety bond does not count against a company’s overall borrowing capacity, which means it can free up capital and credit for more productive uses. Generally, surety bonds also enjoy a cost advantage because, unlike letters of credit, their pricing is not tied to interest rate fluctuations.
A surety bond is an undertaking from an insurer to pay a specific sum to a beneficiary on certain specified conditions, such as company insolvency or contractual default. It is a contract involving three parties:
Surety facilities are unsecured and treated as a contingent liability, and are therefore off the balance sheet. The surety company will be placed alongside other unsecured company creditors by way of an indemnity agreement, allowing construction companies to make best use of their assets.
Surety bonds are an alternate way for a construction company to meet a range of commitments, such as:
In summary, surety bonds differ from bank guarantees in a number of ways. They: