Is Your Company Forsaking Net Income for Higher Gross Revenues?

By Jim Jordan

Jim Jordan

Some companies focus on growth to such a degree they defeat themselves. Net income is critical. It influences not only the volume of work that can be bonded but the amount banks will issue in loans and lines of credit.

Is bigger always better when it comes to operating a construction company? The answer is a resounding no, but some company leaders continue to believe otherwise. That's not surprising, given that the construction industry has always been personified by risk takers and strong personalities. But some executives continue to believe success is measured only by gross revenues. In their pursuit of success, they believe volume and organizational size always trump profits.

Essentially what these contractors do is focus on their top, not bottom, lines. That's risky, during even the best of times. They often forget that rapidly increasing gross revenues create the need for a larger bureaucracy, which in turn must be fed regardless of current market conditions and costs.

One doesn't have to look far into the past to see the remains of bureaucratic monsters that starved. MMR Inc., for example, was one of the first roll-ups in the 1980s, and by 1989 was one of America's largest construction firms. It crashed and burned in 1990. Not long after, Encompass Service Corp, which became one of largest subcontractors in the nation, went bankrupt. Granted there were other causes for their demise, but some companies focus on growth to such a degree they defeat themselves.

What these companies learned the hard way is that constantly increasing revenues do not guarantee a healthy bottom line. And a strong bottom line is all that matters to surety companies and banks when they are deciding whether to approve lines of credit and loans.

Each year the Construction Financial Management Association conducts a financial survey. In one of its recent surveys, CFMA looked at net income as a percentage of gross revenues for industrial and non-residential contractors. What CFMA found was that among contractors with gross revenues of $10 to $25 million, net income was about 1.9 percent. Among companies with revenues of $25 to $50 million, net income was 1.7 percent. At the $50 million and above level, net income averaged 1.6 percent. What the study clearly shows is companies don't always increase their net income -- as a percent of revenue -- by expanding gross revenues.

In years past, a company with, say, $600,000 in working capital could support a work program of up to $20 million. That's because many surety companies allowed contractors to have working capital equal to 3 percent of their backlog. But after experiencing huge losses in recent years, many sureties are now requiring working capital of at least 5 percent of the contractor's projected work program. Therefore, for the company with working capital of $600,000, the work program falls to $12 million. As a result, the contractor is faced with lower future revenues but still must realize a healthy net income.

Net income is critical. It influences not only the volume of work that can be bonded, but the amount banks will issue in loans and lines of credit. When deciding whether to issue or extend a line of credit, bank loan officers look at net income, cash flow and return on investment. What they want to see is a growing bottom line, not an expanding top line defined strictly by number and size of contracts. Banks want to see rising net income, not rising revenues and flat net income.

It is not uncommon in the construction industry for small and mid-size companies to yearn to be bigger and bigger. But what many companies find is that once they take on major growth, they may not be qualified to produce what is expected of them. That is, they no longer are masters of their own ship because they don't have the skills and acumen to run a much larger operation. Fast growth can push a successful company out of its comfort zone quickly. And with that come errors, misjudgments and financial waste. Meanwhile, to feed the growing bureaucracy, where hidden expenses suddenly are everywhere, all types of work must be pursued, many times at lower-than-normal fees.

In today's construction industry, net income is the key to longevity. That's not to say growth shouldn't be pursued, but if net income is not growing in step with overall gross revenues, that growth is out of kilter. Due to tightening surety requirements, the high cost of borrowing and growing operational expenses, not many construction companies can stay out of kilter very long. Clearly the time has arrived for construction businesses to focus more on the bottom rather than the top line.