Recovery and the danger of overtrading

Peter Vinden, managing director of The Vinden Partnership, talks readers through recovery and the danger of overtrading

As the construction sector’s recovery finally gains traction, the cliché that “the path to success rarely runs smoothly” has never seemed more relevant.

These are words that contractors and sub-contractors would do well to keep in mind, not just when dealing with the immediate problems facing them but also in the handling of positive developments that have the potential to take a very dangerous turn.

Despite a number of pressing issues that are attracting widespread attention, from unpredictable weather to shortages in skills and raw materials, construction companies also remain vulnerable to the threat of overtrading.

The problem of overtrading and losing control of your working capital requirements is a particularly tricky one, as the illusion of a return to stability may actually prove to be a destructive reality.

After a difficult few years, the temptation to take on the offer of seemingly profitable work is hard to resist. The problem with this is that the desire to take on additional projects can be at odds with your company´s working capital availability. Companies need working capital to fund day-to-day activities and, as workload and turnover increase, so too does the need for working capital to pay your trading bills, salaries and other expenses.

Overtrading manifests itself in an inability to pay creditors as and when their payments fall due, which incidentally is one of the very definitions of insolvency set out in the Insolvency Act 1986. Past experiences show that emerging from recessions can be a particularly vulnerable time for businesses who struggle to resist the temptation of what appears to be higher margin work that, in reality, cannot be funded.

Companies, large and small, need to be quick to spot the symptoms of overtrading. Symptoms will include overdraft levels rising month on month and a deterioration in operating margins. Other red flags will include mounting pressure from nervous suppliers, threatening to put you on stop, and your accounts team spending more time fending off suppliers and sub-contractors as they chase payment.

It is not difficult to see how these symptoms could lead to failure if not checked. What is less widely understood is that these problems are preventable provided the mantra of “cash flow analysis, projection and control” is rigidly adhered to.

It is essential that a business understands the cash inflow and outflow on every project that it is working on, as well as the outflow of cash required to fund operating overheads such as rent, rates, heating, lighting, administrative salaries, insurances, vehicle costs and so on.

From this information you should be able to produce a company model which shows on a week by week basis what your income and expenditure looks like and, in doing so, project and control what working capital is required by way of bank overdraft, loans or similar.

Each new contract win should be analysed on the same basis and integrated with your operating model. Any potential contract needs to be analysed and fed into the company model before it is accepted.

This might mean that you can only accept a new contract if advantageous payment terms can be negotiated with your client and/or with key suppliers and sub-contractors. It also might mean that it cannot be funded at all.

It should also never be assumed that the safety nets of increased bank funding and/or the extension of credit lines will be available. Being complacent, particularly where financial support will be required, is a dangerous strategy. Assuming that your bank will provide an increase in facilities to overcome the shortfall in capital working requirements is a gamble that simply may not pay off.

These guidelines might seem to express the values that any company should have at its core, but unfortunately history has proven that failure to understand cash requirements has caused the undoing of many a business. There is simply no excuse for not knowing how the cash demands of a new contract will impact on your business and its working capital requirements, before you pass the point of no return.

The construction sector has navigated some dark waters, including low demand, lack of investment and restricted access to bank funding. However, we have not yet overcome all of these challenges, meaning optimism cannot be an adequate excuse for failing to understand your business and its cash requirements.

Businesses must keep an eye on sustaining long-term growth in order to avoid heading towards insolvency in the later stages of recovery. It is by maintaining financial analysis and control procedures that companies in the construction sector can still sail around the overtrading crisis that could be waiting on the horizon.