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How Construction Companies Can Manage Their Liquidity Challenges

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.

Why is liquidity a concern?

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:

  • Project delays.
  • Supply chain issues, including extending delays and billing.
  • Slow-paying clients.
  • Shrinking pipelines of work with lower revenue reducing future cash flows.

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.

Options for improving liquidity

Both traditional and alternative sources of cash provide liquidity options that may support a company’s financial stability. These include:

  • Traditional: cash on balance sheet, line of credit, or additional bank financing.
  • Alternate: bonds, government stimulus, or divestiture of assets.

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.

Alternatives to traditional financing

Surety bonds

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:

  • A principal: the party that needs the financial support provided by the bond.
  • An obligee: the party requiring that there be a bond.
  • A surety: an insurer guaranteeing that the principal will be able to meet its obligations to the obligee.

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:

  • Satisfying collateral requirements for various insurance coverages of a major project, including employer-funded, self-insured workers’ compensation programs. 
  • Posting the collateral needed for large plant and equipment leases.
  • Responding to court demands for collateral when the company receives an adverse ruling and wants to appeal.

In summary, surety bonds differ from bank guarantees in a number of ways. They:

  • Are the most efficient form of contingent capital that a contractor can access.
  • Are competitively priced.
  • Enable companies to free up working capital facilities from their bank.
  • Give the company the protection of the underlying contract conditions as they are conditionally worded.
  • Provide an underwritten second opinion, from a third party, that the principal can complete the contract.

Alternative bank finance

Although surety bonds are increasingly common, some beneficiaries still require standby letters of credit (SBLC). These are issued by banks for a number of reasons, including the posting of collateral; caps on surety bonds; internal limit and liquidity constraints; legal/regulatory requirements; and beneficiary preference.

Bank-fronted surety transactions can meet a beneficiary’s requirement of presenting SBLCs, while allowing the company (the principal) to use its surety lines instead of its bank facilities.

Bank-fronted surety solutions offer the following main benefits:

  1. The beneficiary receives a bank-issued SBLC that complies with its requirement, while the surety-backing is not visible.
  2. Bank-fronted surety solutions can improve an applicant’s working capital and liquidity ratios.
  3. They increase availability under credit facilities by using a principal’s surety limits, rather than its bank lines.
  4. They can provide comparable or more competitive pricing, by leveraging the financial strength of highly rated insurers.
  5. A panel of sureties can deliver large capacity.

When work resumes “as normal”

A significant number of projects starting “simultaneously” can pose liquidity, as well as logistical, challenges for construction companies. 

Businesses need to quantify the time and money required to restart projects during a shutdown, and requantify both as things change. An execution plan for start-up should include an ongoing communications plan with all key partners — including equipment suppliers, subcontractors, and owners — to ensure that expectations and resources are aligned. 

The best-prepared companies will have a job ready to “green light” with submissions, requests for information, and/or change orders ready to activate. 

Stabilizing the business comes first, however. By segmenting operational liquidity from strategic liquidity, construction companies are able to understand the funds available for investment. This enables them to take advantage of opportunities that come from a destabilized market, such as improving or expanding talent, entering new markets, or considering vertically integrated opportunities.