Understanding and Analyzing Contractor Financial Statements: Part II of II
Q: How would the agreed-upon contract change during the life of the contract?
A: Either the client or the contractor – or both in some circumstances – may initiate contract changes. The essence of the business dynamics at play is this:
The client may request adjustments to the original contract that expand or reduce the scope of the project. In this circumstance, the client may request a change and negotiate a change order regarding the nature of the newly identified work and the associated change in pricing with the contractor. In the case of a paving contract, the client may seek to reconfigure the shape or size of the area being paved or seek higher quality paving material.
In a similar way, the contractor may encounter impediments that are either totally unexpected or beyond the contractor’s control. The necessary changes are defined and the parties negotiate a change order to accommodate the additional work and cost. Change to a paving contract may come as a result of discovering unexpected subsurface conditions or the impact of regulatory compliance coupled with the composition of paving materials.
Q: Which is the more accurate way to measure backlog: a) contract price minus earned revenue or b) contract price minus billings to date?
A: Backlog is generally defined as a buildup of work that needs to be completed. A related definition describes backlog as existing contracted workload that exceeds the production capacity of a firm and causes even initiating the work to be postponed. Yet another way is to characterize backlog as that portion of contracted work underway that is not yet completed. As you might guess, the term is often used in construction or manufacturing. It’s important that conversation with the borrower
explore how the firm defines backlog.
Since the contract price is carefully defined in bidding the work to be contracted, it’s appropriate that the contract’s agreed upon value be the start point in calculating the financial impact of a backlog. Since the contract value includes both estimated cost and profit, contracts not yet underway should be included in backlog at full value. If your client’s definition of backlog includes work underway, but not yet complete, it seems any adjustments should be for the full amount of revenues not yet earned.
Billings is a contract feature completely separate from defining the value of a contract and any associated backlog, since billings may be greater than the value of the contract completed or less than the value of the contract completed. Under this logic, billings do not enter into calculating backlog.
Q: What are some red flags on financial statements of which we should be aware?
A: Broadly stated a financial statement red flag is any indication of deteriorating performance presented “in the numbers”. Our approach in seeking red flag warnings should center on all income statement and balance sheet counterpart indicators, trends, and less-than-adequate performance based on a comparison industry standards.
Be particularly aware of movements and shifts in a contractor’s gross margin and other profit measures. In many ways gross profit is an early tipping point in establishing the borrower’s accrual and cash flow performance. In addition, it's disturbing if the balance in the Cost and Profits in Excess of Billings account is substantial and increasing. Such a trend simply means that the contractor is falling behind in billing and, therefore, falling behind in receiving cash from clients that help fund its projects. In taking advantage of another important source of contractor financial information, monitor all the elements in the Contract Status Report. The quality of a Contract Status Report is usually a good indicator of a contractor's ability to correctly track and report expenses and the resulting status of projects.