In light of the issues being faced by Aussie home builders – and a possible recession – now is the optimal time for residential home builders to take stock of their businesses and cash flow to avoid facing a risky financial future. The last 12 months have been tough on builders. Around 80% of them are using their own funds in order to complete a client’s home.
Some of the building companies we’re seeing in the US are struggling to implement cost escalation clauses which is causing a myriad of issues. If their losses continue unchecked, they will eventually be unable to pay their bills and will be forced to call the liquidators in. This trend may be migrating to the US market soon, if builders miss these key warning signs.
What are the five stages of decline?
Consumers are already being hit hard by inflation and interest rate rises and are not in the position to cover the increase in the cost of construction materials. Here are five stages of decline that residential home builders need to be aware as they are managing operations:
Potential loss on a contract
This is stage 0, the first sign of trouble. This happens when a building company has an unprofitable contract that has not yet started. An unprofitable contract is one where the gross profit on the contract does not cover the proportional company overheads.
If a building company, for example, completes 12 projects a year and has annual overheads of $1 million, they will need to generate $83,333 in gross profit from each job to break even.
If the company does not reach that gross profit target, which can be seriously eroded by the rising construction costs, then they lose money. Builders should reprice their projects before construction commences to make sure they are still profitable; if not, it’s important to renegotiate with the client. If the client won’t renegotiate, home builder professional should seek expert legal advice from a construction lawyer that will act in their best interests.
Actual loss on a contract
This stage is one where the building company for whatever reason has lost money on a project once their proportional fixed expenses were factored in. This is a possibility even when the market price of the construction materials are not increasing.
Often, it can be a result of estimating errors or prolonged delays which increase the proportional fixed expenses or errors and omissions in the plans and specifications. Also as a result of the rise in the cost of construction during 2021, many building companies ended up losing money on a project even before their proportional fixed expenses were factored in.
Company lost money
If proportional fixed expenses were not factored in, the next stage of decline for a building company is an overall loss from all of their activity during a financial or calendar year. When a business loses money, they begin eroding their reserves which also reduces their working capital, thus making the business even more vulnerable to future black swan events.
This is where additional funding in the form of a loan or an injection of shareholder capital in order for it to continue trading. Speed is the most important tool here. How badly affected the firm is by a trading loss depends on the size of its loss versus the size of the reserves.
This stage can be deceiving for builders as the company may still be cash-flow positive. Most building companies can absorb a trading loss while still paying their suppliers and subcontractors, however, they are dipping into their reserves at this point. If a firm loses enough money to wipe out its entire reserves in a single year, or it accumulates losses over multiple years that exceed its reserves, then it will begin the journey into negative equity.
At this stage, building firms are extremely high risk and vulnerable because their liabilities exceed their assets. They are able to still trade legally as they have a positive cash flow which allows them to pay suppliers and subcontractors on time classifying them as trading solvent.
In reality, they are operating as Ponzi schemes, using cash inflows from project A to pay creditors on project B. When a company reaches this stage, all too often the firm executives bury their heads in the sand and work flat out in the hope they can turn things around.
Lacking the financial knowledge that is needed here to understand the gravity of the situation they find themselves in is a fast deteriorating situation which can quickly spiral out of control.
Once a firm reaches this stage and is no longer able to pay their invoices on time, they are classified as insolvent. Often, firms will enter into payment plans with the tax office deferring their due dates while pouring in every cent available to them in a desperate attempt to keep their company open. Unfortunately, this is the most dire stage of decline for a building firm, which could have also been avoided had they sought help and changed direction earlier.
Some of the best run businesses get caught in this due to fast changing market conditions – ultimately resulting in a situation where they did not have the tools to see what’s coming.
What is the market offering of APB?
The Association of Professional Builders (APB) offers a range of builder resources to help guide companies in growing and building their firms safely and securely. Currently the firm offers a range of free training including “Pricing for Profit” which includes a three-step process to help residential home builders price new home construction projects and renovations.
Other free trainings include, “Systemizing A Residential Building Company,” “Growing Margins,” “Crisis Management For Custom Home Builders,” “Cash Flow Management For Custom Home Builders,” and “90 Day Planning for Builders,” among other key topics. The Association of Professional Builders encourages residential home builders to check out the free resources, and contact the company should they be in need of additional custom support and coaching.
Russ Stephens is the co-founder of APB. The Association of Professional Builders (APB) is a leading business coaching service for custom home builders, with members in the United States, Canada, Australia and New Zealand.