The COVID-19 pandemic has thrown a curveball that caused a unique environment in every industry. To most construction companies the pandemic had no significant effect on volume, however most contractors are worried about what the future holds and believe that curveball is still making its way to the plate. While there are theories of how the pandemic will affect the industry in the upcoming months, no one really knows what will happen after this unprecedented event. However, managers should understand how every cycle affects their company’s financial health to better manage how they will approach each changing wave. The changes in market conditions can be divided into three cycles: static cycle, up cycle and down cycle.
During a static cycle, volume stays about the same from one period to the next. There is no motivation to make capital investment, such as buying equipment, hiring people, making upgrades or give salary increases. The longer this cycle lasts performance in all areas decline. This results in having a balance sheet that is also static or slowly declining and an income statements that will show declining profits as productivity slows and overhead slowly increases.
During an up or growth cycle, volume is increasing by at least 15% from one period to the next. During this cycle, there is an increase demand for capital investment, increased challenges to obtain and retain skillful labor, margins begin to fade, cash flow becomes a challenge. This results in a declining balance sheet as companies stretch out their resources. And the income statement looks healthy at the beginning of this cycle because overhead is still about the same. However, profits will typically fade back to normal levels or may even be lower than before depending on how fast the growth happens.
During a down cycle, volume is down by at least 15% from one period to the next. During this cycle, there is no capital investment, margins are lower as companies struggle to get work and start bidding low, creditors reduce credit capacity and issue less favorable terms, overhead becomes too high for the smaller volume, difficult decisions have to be made to reduce overhead. This results in a healthy balance sheet, at least in the beginning of this cycle, but the income statement struggles and shows stress.
At first glance this may seem obvious, however, when it comes down to it, construction companies often do not make the link between their operations and the financial statements. These financial statements are used to obtain credit and bonding, which have a direct impact on their operations. Furthermore, companies are late to react to changes in the market. For example, the industry has seen significant growth in the past three years and there has been a common struggle for skilled labor. In a downturn,even as companies struggle they are very hesitant to let go of their employees. This is because companies are not ready to let go of quality people that they have already struggled to hire and made the investment to train and retain them.
You can still have a positive outcome in every market cycle. In my next blog I will discuss how to manage overhead and managing strategies that can be used in any market cycle. This way, no matter what pitch is thrown your way, you will always have a chance to hit a home run.
Contact your Henry+Horne adviser with any questions regarding this or any accounting issue.
Abel Coronel, CPA