Contractor Red Flag Checklist--Mitigate Lending Risks Now Before It's Too Late

Introduction:?Better Late than Never--Nah!!

Yogi Berra once admitted, “We made too many wrong mistakes,” and wrong mistakes in construction lending seem to be too many and too wrong.?? Construction risk never seems to go away, and looking for signs of contractor problems has been a lifelong effort.[i]According to the US Department of Commerce, construction and contracting businesses have the highest failure rate of any other business. Up to 96% of these companies fail before reaching 10 years in business.[ii]? Another survey by the Bureau of Labor Statistics reported that of the 69,296 private construction firms that started operation in 2001, 56% were still around three years later, 26.6% made it to year 10, and only 17.2% were still in operation 20 years later, ?a failure rate of nearly 82.8%.[iii] Clearly, staying in for the long haul is tough for contractors and maybe tougher for their lenders and creditors.? There are several reasons cited for the high body count:

1-overinvestment in fixed assets

2-tying up working capital in projects

3-projects gone bad

4-growing too fast and taking on too much work

5-inability to find adequate construction work force

6-management inability to keep focused[iv]

But what lies behind these reasons.? Bankers and lenders are aware of these causes but given the need for quick evaluations and fast decisions, maybe a red flag checklist could help lenders and creditors cut to the chase more quickly.? Therefore, this article offers readers a checklist that focuses on early indicators of contractor issues that might lead to more serious consequences.? For example, declining cash flow could be the result of customers slowing down progress billings, increased labor and material costs eating into profit margins, or projects facing construction delays.? So, in no particular order, here is a checklist for your consideration.

?Red Flag Indicator Checklist

This 21-point checklist provides you with 21 contractor red flags, the usual source of a red flag’s information, and a short explanation or description to clarify each red flag.? The red flags are generally negative, so a yes response alerts you to possible trouble ahead:

# Red Flag Indicator Source* Yes No Explanation/Description

1 Jobs behind schedule CSR Delayed starts, revised completion dates

2 Jobs out of market CSR Jobs located outside of market

3 Project type out of scope CSR New project types

4 Excessive change orders CSR CO’s totaling 10% or more of original bid

5 Excessive underbillings CSR/BS UB’s at 10% or more of total assets

6 Excessive overbillings CSR/BS OB’s at 10% or more of total assets

7 Pipeline drying up CSR All current jobs 50% or more complete

8 Low Best’s rating of surety Best’s Surety is rated B or worse

9 Reduced or cancelled bond Mgt Surety reduced amt or cancelled bond

10 Higher insurance deductibles Mgt Contractor self-insuring more

11 Supplier payments slowing D&B Contractor slows payments to suppliers

12 Personal credit scores falling CAR Principals’ credit scores deteriorating

13 More external credit checks Bkr Contractor 3rd parties credit resistance

14 Increasing overdrafts Bank Probable insufficient funds to operate

15 Declining Receivables/Payables BS Rec/Pay ratio < 1.0x, past due AP?

16 Delinquent payroll, income taxes BS Risk of tax liens

17 Contractor license Mgt Expired or unlicensed?

18 Declining financial info Mgt Less detailed and delayed financial info

19 Declining gross profit margins P&L/CSR Possible labor productivity decline

20 Chargebacks reducing retention CSR Possible quality problems

25 Management turnover Mgt New CFO, accounting firm, law firm?

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*Likely sources of red flag information:

CSR = contract status report

CSR/BS = CSR or the balance sheet

Best’s = A. M. Best

Mgt = internal contractor management

D&B = Dun & Bradstreet

CAR = credit agency reports, e.g., Exuifax, Experian, Transunion

Bkr = relationship manager, account officer, assigned banker

P&L = income statement

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Let's add some additional detail behind each of the 21 flags:?

1-Job Behind Schedule.? A detailed contract status report (CSR) usually discloses the start date, finish date, and duration of each project.? Look for project start dates that have been rescheduled for later—how will the delay affect the estimated job costs?

2-Jobs out of Market.? Contractors usually take jobs close to home where they know the building codes, they have established supplier and customer relationships, and they have reliable workers.? When contractors step outside their established markets, it is usually because they have run out of local work, but a new market means possible new ground rules for codes, suppliers, customers, and labor.? The contractor status report usually identifies jobs with names that indicate where and what, e.g., Boca Raton Hilton Hotel, Atlanta Marriott.? Is a Boca Raton hotel builder ready to take on a new hotel project in Atlanta?? [v]

3-Project type out of Scope.? Hand in hand with 2-Jobs out of Market is tackling a new project, e.g., a Houston electrical contractor who has discovered there is demand for plumbing contractors in New Orleans.? Hiring a plumbing contractor to head up New Orleans work may win the bid, but it puts another person between the electrical contractor and the new job.? As mentioned earlier, the job name usually indicates the type of project, e.g., Kansas City Water Plant, Seattle Pier Festival Marketplace.? What does a water plant contractor know about converting a pier into a retail shopping market?[vi]

4-Excessive Change Orders.? Revisions to the job occur all the time, but at some point, the change orders may result in a substantial shift from the original project.? Do the changes represent modifications that broaden the appeal of the building or has the owner become concerned that the project is no longer marketable?? Think about the number of condo conversions to apartment buildings and back again.? When change orders amount to ten percent or more of the original cost, that is enough change to ask what is going on.

5-Excessive Underbillings. Underbillings (UBs) occur when a contractor is not being paid for the work completed, e.g., a customer billed for 50% completion is only willing to pay 40%.? In effect, the contractor has 10% of inventory still sitting on the shelf.? The impact is cash absorbing, and RMA industry data has shown that UBs average between 2 to 5 % of total assets, so when this ratio goes double digit, it is time to find out why the contractor is not getting paid for the work done.[vii]

6-Excessive Overbillings.? In contrast to UBs, overbillings (OBs) happen when a contractor bills for more work than actually completed, e.g., a contractor bills a customer for 50% but has done only 40% of the job.? The OB is a legitimate liability because the contractor has not completed all the work, but sometimes a client permits this as a way to provide some temporary financial support to the contractor.? Nevertheless, OB’s run about the same 2 to 5% of total assets as do UBs, so pay close attention to numbers over 10% of total assets.? UBs and OB’s tend to be small because clients usually do not like to be overbilled, and contractors do not like to be underbilled.[viii]

7-Pipeline Drying Up.? The CSR often has a column displaying the percentage of completion (POCs) for each job, and contracts are entered on the CSR as work begins.? As you read down the contract status report, you are likely to see projects with very high POCs at the top and much smaller POCs toward the bottom.? Most jobs are likely to be completed in one or two years, so if you come across a contractor whose jobs are 50% or more complete, it is likely that these jobs will finish up in the next 12 months.? One way to confirm this state of affairs is to check the deferred income tax liability.? If this liability is now classified completely as a current liability, the contractor has run out of new jobs whose operating losses would have tax shielded the profits from completed jobs.

8-Low Best’s Rating of Surety.? A. M. Best rates insurance companies from A+ to D, and most lenders draw the line at A- or B+.? Ratings lower than this reflect that the surety has capital, operating, and other financial weaknesses.? A contractor relying on a low-rated surety carries higher construction risk because of the possible failure of the surety. In times of high construction activity, lesser experienced insurance companies tend to enter the surety industry.

9-Reduced or Cancelled Bond. In its efforts to recover from the Great Depression, the1935 Miller Act required Federal construction projects to be bonded, and throughout the 1930’s, individual states promulgated little Miller Act laws, so that today, local and state construction projects also require bonding.? Further, as private construction projects increase in size and complexity, contractors and major subcontractors usually must be bonded.? The contractor’s insurance agent often works with a surety bond produce[ix]r to find bonding.[x] If a surety bond producer cannot find a surety willing to bond the contractor or even maintain current bonding levels, then the lender should ask why.? Inability to maintain current levels or to obtain bonding is likely to reduce the contractor’s ability to find new jobs.

10 Higher Insurance Deductibles.? One way to cut insurance premiums is to boost deductibles, but boosting deductibles means that the insured party is raising self-insurance exposure.? If a firm’s net worth is its shock absorber for covering unexpected costs, what if the total amount of deductibles exceeds its equity?? Look at all the contractor’s deductibles in its insurance portfolio—liability, property, workers compensation—to see how much it totals.? Also, consider incorporating insurance premium costs into your debt service coverage ratio to make sure that contractor cash flow is sufficient to cover them as well as other liabilities.[xi]

11- Supplier Payments Slowing.? Most contractors operate in local markets with relatively few building materials suppliers, and they are a relatively close-knit group that sometimes meets periodically in trade credit sponsored groups such as NACM’s industry trade groups,[xii] to review payment performance of shared customers.? Another trade credit source is Dun & Bradstreet’s Paydex report that compares the contractor’s payment record to other contractors.? One way to verify if suppliers are being paid slower is to examine the contractor’s monthly accounts payable aging.? Most suppliers extend only 30-day terms, and exceeding 30 days is likely to put the contractor on cash only (COD) terms.? Ideally, contractors are getting monthly progress payments reimbursing them for labor and materials, anyway.? Given the Pandemic’s disruption of supply chains, contractors cannot risk interruption of the delivery of materials to their projects.[xiii]

12- Personal Credit Scores Falling.? An easy and inexpensive credit monitoring tool is monthly or quarterly updates of owner-guarantor credit bureau reports.? If your organization requires the personal guarantors of the owner-operators of your contractor borrower, you ought to be aware of any personal credit distress because it is likely to spill over into the day-to-day operations of the borrowing entity as it starts to distract management.

13-More External Credit Checks.? Another way to gauge the seriousness of supplier concern mentioned in 11-Supplier Payments Slowing is in the number of inquiries posed to the contractor’s banker about the sufficiency of cash balances on which the contractor is writing checks to pay various third parties.? The inquiries tend to start occurring when a vendor gets stuck with a bad check.?

14-Increasing Overdrafts.? Monitoring overdrafts is another way to monitor a contractor’s liquidity.? Besides suppliers and other vendors, if employee paychecks also start to bounce, the contractor’s ability to continue work is in jeopardy.

15-Declining Receivables/Payables. A monthly progress billing represents the contractor’s request for reimbursement of labor and materials, and materials are usually the smaller component. Payment of the progress billing makes it possible for the contractor to pay suppliers, and in order to get a material lien release from the supplier, the contractor is typically paying for materials very quickly.? Therefore, receivables should always be larger than payables, and RMA industry statistics show this ratio has averaged a little more than 2.0x for years.? You can check this ratio yourself by requiring monthly receivables and payables aging's, calculating the ratio, and monitoring its change from month to month.? Act before the ratio drops below 1.0x because by that time, your contractor probably will have been put on COD or sued by its suppliers.[xiv]

16-Delinquent Payroll and Income Taxes.? Businesses sometimes try to generate a little extra cash flow by delaying or deferring the payment of payroll taxes, but this action is illegal and could set in motion shutdown by the IRS.? A simple way to monitor payment is to require the contractor to provide you with a copy of its quarterly 941 form.[xv]? IRS Form 941, the Employer’s Quarterly Federal Tax Return, is how businesses report the income taxes and payroll taxes that they withheld from their employees’ wages as well as calculate and report the employer’s Social Security and Medicare tax liabilities.? Individual taxpayers must file only one tax return per year, but many businesses are required to file quarterly tax returns. Failure to file IRS Form 941 on time or underreporting your tax liability can result in penalties levied by the IRS.? Likewise, require proof that the contractor has also paid its quarterly income taxes.? Do not let federal tax liens get ahead of your payment priority.

17-Contractor License.? A standard condition at closing ought to be proof of a current contractor’s license, but also make sure to monitor its renewal.? Of course, the license should certify that the contractor is allowed to practice its appropriate trade or function, e.g., electrical, plumbing=g, bridge building, etc.? The courts take a dim view of lenders financing unlicensed contractors.

18-Declining Financial Info.? Deterioration in financial condition and operating performance is a disturbing trend and certainly out to be identified and evaluated,[xvi] but as many loan workout officers know, the information itself begins to decline in quality and frequency before reports of shrinking profits, lower liquidity, and higher leverage is evident.? Clear warning signs ahead of financial decline are slowdowns in financial reporting and less detailed financials.? For example, monthly financials become erratic, and when they do arrive, they are missing receivables and payables aging's or the contract status report.?

19- Declining gross profit margins.? Much of the material incorporated into a job is acquired before the job starts, so those costs are generally already set.? However, if the CSR and the income statement report declining gross profit margins (GPM), the likely culprit is higher labor expenses.? For example, if the budget calls for 8 hours to paint each office but the painter is only half finished at the end of the day, the painter has effectively doubled the labor cost by performing at only half the projected productivity.? Assuming that the construction budget has established reasonable times for each activity, construction managers must closely monitor worker performance.? A declining gross profit margin may be another red flag indicating poor field supervision.

20-Chargebacks reducing retention.? Construction contracts routinely call for retention to be held back from each progress billing, typically at 10% of the contract total.? The purpose of retention is to set aside funds for addressing an owner’s punch list of items that need to be fixed or addressed.? Presumably, the contractor will address and resolve the punch list items.? If the contractor is unable or unwilling to take care of these items, the owner can call in another contractor to fix the items, and the replacement contractor’s fee will be charged back against the original contractor’s retention.? Contractors who do sloppy work tend to move on to the next job and leave fixes to others, so their retention checks are likely to be dinged more.? Therefore, an inverse measure of quality is how much the contractor’s retention check has been reduced.? Sometimes, all the contractors on a job have their retention checks reduced by some shared expense not in the original master contract, e.g., trash removal, flood damage, but most contractors should expect to get 90 to 95% of their retention back.? Watch out for the careless contractor who is receiving only 50 or 60% of his retention check.

21-Management Turnover.? There are some key players inside and outside the borrower’s organization—not just job managers but also chief financial officers and head bookkeepers, warehouse manager, accounting firm, insurance agent, law firm.? A little turnover is expected, but churn in the CFO role, replacement of an accounting firm, or hiring a new law firm create serious disruptions that lenders should watch.? Why did this happen?? What are the credentials of the replacements?

Summary and Closing:? Don’t Get Flagged Down

?Comedian Will Rogers once warned, “The problem in America isn’t so much what people don’t know; the problem is what people think they know that just ain’t so.”? The checklist’s Yes and No columns are intended to help you find out what you know or do not know about your contractor.? A lot of yes responses will quickly show you how many potential problems you face.? Feel free to reconfigure this list to reflect your own organization’s experiences with your contractors.? There is nothing sacred about these 21 flags—your list might settle on a magnificent 7, a dirty dozen, a reliable 47, or a triumphant 76.? The one essential ingredient should be that you check your flags far enough ahead to allow you to work with your contractor in a positive environment, not in desperate circumstances.? Finally, relax, as Mark Twain counselled, “I’ve had a lot of worries in my life, most of which never happened.”? Maybe your own contractor checklist will help dispel some of your worries.

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[i] Dev Strischek, “Red Flags and Warning Signs of Contractor Failure,” The Risk Management Journal, March 2008, pp. 72-76.

[ii] Kurt Clayson, “8 Reasons Why Construction Companies Fail,” Dec 9, 2019, ( https://projul.com/blog/8-reasons-why-construction-companies-fail/ )

[iii] Kendall Jones, “6 Reasons Why Construction Companies Fail, September 16, 2022, (https://www.constructconnect.com/blog/6-reasons-why-construction-companies-fail )

[iv] Kevin McLaughlin and Dev Strischek, “Why Do Contractors Really Go Under?” The Risk Management Journal, October 2008, pp. 22-27.

[v] Dev Strischek, “Putting a Name to Construction Risk:? Where and What,” RMA Journal, Nov 2006.

[vi] Ibid.

[vii] Dev Strischek, “Contractor Small Talk: A Little Guidance on Underbillings and Overbillings,” RMA Journal, April 2012, pp. 41-46.

[viii] Ibid.

[ix] More information on surety bond producers, bonding, the surety industry, and construction activity can be found at the Surety Information Office (https://suretyinfo.org/ )

[x] Marla McIntyre and Dev Strischek, “Mitigating Real Estate Construction Risk:? How Surety Bonds Protect Borrowers and Bankers, RMA Journal, November 2005, pp.46-55.

[xi] Dev Strischek, “Risky Business: Assessing the Insurance Risk of a Contractor,” Part 1 in Feb 2017 RMA Journal, pp. 26-33; Part 2 in Mar 2017 RMA Journal, pp. 34-40; Part 3 in April 2017 RMA Journal, pp. 38-43.

[xii] See NACM’s website for more information on its industry trade groups at? https://nacm.org/industry-credit-groups.html

[xiii] Dev Strischek, Analyzing Construction Contractors, 3rd Edition, RMA: 2005, pp.59-60.

[xiv] Dev Strischek, “Looking for a Vital Sign in Contractor Accounts: The Receivables/Payables Ratio,” RMA Journal, July/August 2001, pp. 62-66.

[xv] For more information on the quarterly 941 payroll tax form, see ?https://www.irs.gov/forms-pubs/about-form-941

[xvi] Strischek, Analyzing Construction Contractors, 3rd Edition, offers instruction on how to evaluate a contractor’s financial condition and performance.