Q: Is it possible to have too much in overbillings? Is so, how much would be considered a red flag?
A: Yes. Too much in overbillings can indeed be considered a red flag.
First of all, keep in mind that some contracts do not allow billings in excess of costs because the client does not want to provide project working capital for the contractor.
If overbillings are allowed in the contract, overbillings in excess of 15% to 20% may signal financial difficulties on the part of the contractor. There is no rule of thumb about this issue, but anything in this range of overbillings – billings in excess of cost and profits – should indeed get the lender’s attention.
Recall that excess billings over costs and profits are not profit. Rather, they are simply a positive cash flow timing difference that will change from time to time. The schedule of closed jobs and estimated costs to complete open jobs should be prepared more than once a year by the contractor and its accountants.
The liberal use of billings in excess of cost and profits may provide sufficient cash for a project, but such front-loading also means that contractors must have a clear idea of how much cash is required to complete a project. Otherwise, they may have billed and received all the cash available under the contract and exhausted cash available to pay subcontractors and building materials near the end of the project.
To use billings in excess of cost and profits under the percent of completion method of accounting demands that the contractor take the time to carefully estimate project needs. Mistakes in such estimates can harm a contractor’s financial health, especially if contracts do not provide much flexibility in adjusting for changes in materials costs.
Course overview: Understanding and Analyzing Contractor Financial Statements: Part I of II