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Be sure of your balance sheet before bidding for work

Assessing a company’s strength is not all about cash, but it plays a big part.

Having listened to the seller’s team for two hours on the strengths and performance of the contracting company up for sale, the chief executive of the potential buyer asked, “What about the cash?”

There was a long pause followed by the extraordinary statement: “We are not measured on cash performance.”

We all knew, by that statement alone, that the deal had just become considerably cheaper: the vendors did not understand their cash position or projections.

As an auditor I am often asked, and with more frequency over the past three years, how I would assess the strength of a construction company. The answer is not all about cash, but a large part of it is.

Firstly, I would like to know the strength of the forward order book, and not just one figure.

By major division, and possibly by branch, I would like to see the trends of the forward order book over the last three years, where it stands by year of expected execution, the forward margin associated with those positions, as opposed to just the activity level, and, critically because a number of variations exist, how backlogs are defined.

This analysis gives the clearest indication of where the company has been and where it is going.

Evidently the above has nothing to do with cash, but the second bit of analysis I would look for is the backlog and forward order book from a cash perspective.

In reality I have never seen this produced. But if you know how much profit is to come from a contract you will know how much cash still has to come.

Any company that has a contract ledger detailing the current contract position against forecast, and the associated balance sheet for that contract, will be able to extract the future cash inflow or outflow expected.

Finally, a large advanced payment can mask the true operating cashflow conversion of a company and true operating profit performance.

Again, by division or branch, I would want to see cumulative operating profit mapped against cumulative operating cashflow for the last five years, along with the advanced payment and provision position.

So what would this graph highlight? If operating cashflow is consistently above operating profit, the company should be conservative because its operating profit is cash-backed.

Although the cash backlog will inevitably be less than the operating profit backlog, the tendency would be to consider that the company manages its working capital well.

On the other hand, if the operating profit is consistently ahead of operating cashflow you would be concerned that irrecoverable assets had been recognised.

While the cashflow backlog would be strong, questions about potential non-realisation would have to be asked. Has too much unearned variation and claim income been recognised?

The conversation recalled in the opening paragraph was 10 years ago. I would hope in today’s environment that every contracting company is examining management on a cash, as well as profit, basis.

But too many companies would still struggle to quickly put all three pieces of analysis together.

In an environment where you need to feel secure about your balance sheet before you bid, where banks and credit agencies seem to have lost flexibility and companies are disappearing in hours, not weeks or months, this type of analysis can make all the difference.

Jack Kelly is head of contractors groups at Deloitte

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