Return on investment. One of the most difficult questions faced by the board of directors and management of any corporation is what the right balance is between capital retained and risks assumed. We’ve all heard the comments—“this company is overcapitalized,” “this company is stretched to its limits,” “this company’s capital base is in line with its backlog.” These are perceptions of investors, creditors, competitors, employees, management, directors, analysts, etc. At the end of the day they are perceptions largely based on historical business norms. In today’s construction marketplace, what is an adequate capital balance based on the risks taken on by a construction company?
This question becomes much more intriguing when you consider all of the options that construction contractors have available when they are fortunate enough to be faced with excess capital. They could dividend the capital to shareholders, acquire a construction company, buy back their shares, invest equity in projects, acquire a facilities management contractor, or leave the capital within the company to absorb unforeseen events. The temptation to do something more active with your capital is growing.
So what’s the right level of capital based on the risks at your company? That’s a question that several of your business partners will most definitely have an opinion on. Without a doubt there isn’t one answer. Several factors need to be considered to determine whether the capitalization of your company is adequate, too low or too high. Some of these factors include:
The nature of your backlog – What type of risk is your company exposed to through contracts? There are several contract models used in today’s marketplace and they all have varying levels of risk. Through construction management agency obligations you may be taking on very little risk. Through design-build fixed-price contracts you may be taking on significant risk. In some cases, a fixed-price contract could be less risky than a construction management contract simply because of the risks you control. For instance, a well-planned fixed-price contract where the contractor procures the design, ensuring buildability, could present far less risk than a construction management at risk obligation whereby design control is in the owner’s hands. Detail on the nature of risk in the contracts taken on by your company is absolutely vital in determining adequate capital levels. In addition to your upstream contracts to owners, be aware of how you transfer risk via your downstream contracts to subcontractors, sub-consultants and suppliers.
Your risk controls or best practices – Often overlooked, the operational practices your company has in place to manage risk are crucial in determining capital adequacy levels. These are practices that include design procurement practices, project go or no go assessment, subcontractor prequalification practices, subcontractor award practices, subcontractor management practices, etc. Having these risk controls in place is important, but actually executing these practices in the field will help determine how much capital is needed on your balance sheet to absorb unexpected risks.
The nature of the risk transfer solutions – To protect your capital from risks taken on through contract, you purchase insurance and you have subcontractor and supplier performance security. These risk transfer solutions can cover everything from faulty design risk, to property damage, to faulty materials delivered to your project, to your company being sued for causing damage to a third party. What these forms of “balance sheet insulation” cover and how they interact and respond is a crucial aspect of determining how exposed your company is to the risks it has taken on.
The level of your company’s unsecured and secured corporate guarantees – Your company has several guarantees that constrain your balance sheet to varying levels. These could be guarantees to owners to secure project performance, guarantees to banks to secure lines of credit or a letter of credit facility, and guarantees to surety companies to secure your surety facility. These guarantees allow your company to operate and win business. The severity of these guarantees relative to what you are getting could constrain your balance sheet more than necessary; requiring higher levels of capitalization than your company may need. Do everything you can to minimize the constraints these guarantees impose on your balance sheet.
The greater the clarity you have on these items within your company, the easier it will be to arrive at the ideal capitalization level. Arriving at that optimum capitalization level should ensure your ROI is best in class.
David Bowcott is senior vice-president, national director of large/strategic accounts, AON Reed Stenhouse Inc. Send comments to editor@on-sitemag.com.
