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Prequalification reduces
risk of subcontractor default
Contractor’s Toolbox
The ins and outs of additional
insured endorsements
/USA
Prequalification reduces
risk of subcontractor default
G
eneral contractors can no longer afford Another option is to engage a third party —
to just award subcontracts to the lowest such as a surety company — to prequalify
bidder. In today’s challenging economy, subcontractors on your behalf. One advantage
some subcontractors bid on jobs that are outside of this approach is that subcontractors may be
their comfort zones in terms of skills, capacity or more comfortable sharing financial statements
financial resources. In today’s world, prequalify- and other information with a surety.
ing subcontractors is essential to ensure that sub-
contractors have the wherewithal to complete
their work in a satisfactory manner and to mini-
mize the risk of default.
Review subcontractors’ financial
Prequalification benefits subcontractors as well.
statements or tax returns to
By taking steps to secure a spot on local GCs’ evaluate their financial health and
“preferred subcontractor” lists, they can gain a
competitive edge. verify that financial statements
The prequalification process
conform to Generally Accepted
Consider formalizing the prequalification pro- Accounting Principles.
cess by creating a set of forms, questionnaires
and checklists for gathering information from
prospective subcontractors. Some vendors offer What to look for in a subcontractor
prequalification software that helps streamline There isn’t one right way to prequalify subcon-
and automate the process. tractors. The type of information you gather will
depend, in part, on the nature
of your business and the size
and complexity of your jobs.
Following is a partial list of things
you should look for when vetting
subcontractors:
2
the company’s history and practices. What is its
Workers’ Comp Experience Modification Rating? Key financial ratios
Does it have a history of OSHA violations?
There are several ways you can measure a
Consider visiting a subcontractor’s facilities and subcontractor’s financial health. Here are
speaking to its employees to get a feel for whether just a few:
its operations are well run, organized and safe.
Current ratio (current assets / current liabili-
Work quality. It’s critical to ensure that subcon- ties). Measures the subcontractor’s ability to
tractors have the skills and experience necessary satisfy its short-term liabilities with cash and
to perform the type of work called for on a par- other relatively liquid assets.
ticular job. Ask subcontractors to provide a list of
their jobs in recent years, including the nature of Return on equity (net earnings / total net
the work and the size of the subcontract. Request worth). As a general rule, the higher this
references from GCs and other customers, lend- ratio the better. But in some cases, a high
ers, sureties and suppliers. You might even ask to ratio may indicate that the subcontractor is
visit one or two of their jobsites to examine the undercapitalized or too highly leveraged.
quality of their work firsthand.
Working capital turnover (revenue / work-
Capacity. Even if a subcontractor is competent ing capital). Indicates the amount of revenue
and has a quality management team, it’s risky to supported by each dollar of net working
do business with a company whose workforce is capital used. A higher ratio may signal a
spread too thin. So it’s important to satisfy your- need for additional working capital to sup-
self that prospective subcontractors have the port future growth.
capacity to handle your work. Ask for information
Debt-to-equity (total debt / net worth).
about the size and skills of the subcontractor’s
Some degree of leverage is healthy, but too
workforce, as well as a list of current and upcom-
much is risky.
ing projects. This information, together with
information about the volume of work the sub- Underbilling / overbilling. If a subcontractor is
contractor has handled in the past, will give you underbilled — that is, if billings aren’t keeping
an idea of the subcontractor’s capacity to take pace with its progress on jobs — it may signal
on additional projects. And consider inspecting a cost overruns, lax management or sluggish bill-
subcontractor’s facilities to confirm that it has the ing practices. Financially healthy subcontractors
equipment it needs to handle a job. typically maintain an overbilled status.
Financial resources. Review subcontractors’
financial statements or tax returns to evalu-
maintaining sufficient equity in the company.
ate their financial health. Verify that financial
Finally, get input and assistance from your CPA to
statements conform to Generally Accepted
better analyze and interpret the subcontractor’s
Accounting Principles (GAAP) — preferably
financial data.
audited by, or prepared with the assistance of, a
CPA with construction experience. Extracting key
Managing your risk
ratios from the financial statements can help you
gauge a subcontractor’s financial strength. (See If your due diligence reveals that a subcontractor
“Key financial ratios” at right.) presents a high degree of risk, you might decide
not to do business with that subcontractor.
As you review the financial information, pay Alternatively, there may be steps you can take
particular attention to whether a subcontractor to manage the risk, such as imposing a contract
has enough cash to keep its business going, value limit on that subcontractor, requiring per-
and that its accounts receivable are appropriate formance bonds or letters of credit, or obtaining
to its income level. Make sure the owners are personal guarantees from the owners. n
3
Don’t neglect the cost to complete
O
n long-term construction projects, it’s price is $1 million and the contractor estimates
critical for contractors to have systems in its costs to be $900,000. At the end of year 1, the
place to accurately estimate the cost to contractor has incurred $300,000 in costs and
complete (CTC). Knowing a project’s CTC helps you believes its original cost estimate of $900,000
develop a more accurate picture of the project’s remains accurate — that is, its CTC is $600,000.
performance to date, avoiding surprises that can Based on the costs incurred to date, the project is
hurt your profitability and shake the confidence of one-third complete, so the contractor’s first-year
lenders and sureties. By getting a handle on your profit is $33,000 [$333,000 (33.3% of the contract
CTC early in a project, you have an opportunity to price) - $300,000 in costs].
address problems that are hindering your produc-
tivity or otherwise increasing your costs.
4
sureties. And second, it will provide an opportu- z Holding project managers accountable for
nity for the contractor to address its productivity monitoring a project’s financial performance,
issues or find other ways to reduce costs and z Accurately estimating the direct costs of all
boost its profitability. remaining work, and
There are several steps contractors can take to z Meeting or beating the budget.
ensure they prepare accurate CTCs. These include:
A wise investment
z Developing solid project budgets and labor It pays to invest needed time and resources in
schedules (and updating them to reflect developing accurate CTC estimates for your proj-
change orders and unforeseen developments), ects. The benefits include more accurate financial
z Implementing accurate systems for tracking statements, stronger relationships with banks and
and reporting productivity, sureties, and higher, more consistent profits. n
A
s a contractor, it’s critical that you keep
an eagle eye on a multitude of tasks. But,
one task in particular that’s susceptible
to being overlooked is how you handle your esti-
mates. If you aren’t careful, you might just find
yourself digging a hole into your profits.
5
hurting profitability? Are your fixed-price esti- employing professionals who can visualize proj-
mates using updated materials costs and realistic ect phases in great detail. They should also have
labor data? good organizational and communication skills, a
thorough knowledge of construction materials,
Are your estimations accurate? processes and software, and the ability to under-
Estimates are math — and the more complex stand today’s more detailed drawings and speci-
the calculation, the more likely it will account for fication documents.
the many variables involved. Failing to apply an
No matter how skilled your estimators or what
evolving profit margin calculation algorithm can
methods they use to prepare bids, it doesn’t hurt
reduce the value of jobs over time.
to have another party occasionally check their
For example, if you estimate profitability on a work for accuracy. This person could be you, a
flat, 10% sales price across most projects, you project manager or even an outside consultant.
could lose money as changes and delays occur. When reviewing estimates, verify that the pro-
Breaking down costs more specifically can pre- jected gross profit of each job is in line with your
vent such losses. And there’s no better way to do profitability objectives and the current bid market.
so than with today’s estimating software.
To help ensure accurate reviews of estimates,
Construction-specific estimating applications encourage estimators to work transparently; you
reduce errors and create a historical database to must know how he or she arrived at the quoted
help you refine procedures and generate more job price.
accurate data for future projects. They can also
relieve much of the drudgery associated with Keeping your bottom line healthy
routine, repetitive and time-consuming calcula- After you complete projects, go back and
tions. So make sure your software is up to date. compare estimates with your actual job costs.
Investigate projects that went under or over the
Are your estimators qualified? original estimates to find out what went right or
Your first and last line of defense in generat- wrong and to learn from the process. Remember,
ing accurate estimates is the people doing the the more accurately you estimate projects, the
job. When reviewing estimators’ performance more precisely — and profitably — you can
or when hiring new ones, make sure you’re quote prices for quality workmanship. n
6
Contractor’s Toolbox
The ins and outs of additional
insured endorsements
G
eneral contractors (GCs) typically require
subcontractors to procure a commercial
general liability (CGL) policy and to name
the GC as an “additional insured” under the
policy. This practice is intended to protect the
GC against liability in connection with the sub-
contractor’s activities.
7
Helping Contractors Build Success
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