Use Financial and Accounting Tools to Manage Risk

To many contractors, the term “risk management” means buying adequate insurance for their businesses. In fact, risk management is much more than insurance management.

In addition to commonly insurable risks such as liability, equipment loss and worker injuries, comprehensive risk management also addresses a wide range of other financial and performance issues that can affect your business – from customers who fail to pay on time to onerous contract terms that make it impossible to complete a job at a profit.

To successfully manage these types of risk, depend on your company’s accounting systems. Here are just a few of the common financial and performance risks contractors may face, along with the key financial indicators (KFIs) and accounting tools that you can use to recognize and manage those risks:

• Inadequate cash flow – Regularly monitoring of days in accounts receivable and days in accounts payable can help you spot imminent cash flow problems early, before they become a crisis.  Savvy owners also keep a close eye on overbillings and underbillings, with the goal of minimizing underbillings and maximizing overbillings.
• Overleveraged, default risk – Key ratios here include debt to equity and revenue to equity.  These indicators are of particular interest to your company’s  creditors and surety, as well, because highly leveraged companies have less flexibility to absorb project losses.
• Lack of liquidity – The current ratio (current assets/current liabilities) is probably the most widely known indicator of a business’ ability to meet its short-term obligations. Working capital and working capital turnover are also important liquidity indicators.
• Excessive overhead/inadequate profits – Return on equity, along with gross profit and net profit, are among the clearest and most widely recognized indicators of a business’ success.
• Poor estimating and project management – In addition to warning you of possible cash flow issues, monitoring overbillings and underbillings can also alert you to recurring performance issues on the job. Be particularly alert to underbillings in the latter stages of a job.

As we said, these are just a few of the financial and performance risks contractors face every day, and only a partial list of the KFIs that can alert you to them.  Talk to your accountant about how to calculate these metrics, and to discuss other critical metrics you should monitor. It is important to view all of your company’s KFIs collectively – no single indicator gives you the whole picture.

In addition, remember that risk management is not a one-time event. Ongoing and regular monitoring of KFIs enables you to identify and analyze trends, which are much more meaningful than the one-time calculations themselves. 

Case in Point: An Early Warning Saves the Company. Click here to read more 

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