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Prequalification Reduces Risk of Subcontractor Default

By MarksNelson on February 16, 2016 in Angie McElhaney CPA, CCIFP, Articles, Assurance Services, Construction
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General contractors can no longer afford to just award subcontracts to the lowest bidder. In today’s challenging economy, some subcontractors bid on jobs that are outside their comfort zones in terms of skills, capacity or financial resources. In today’s world, prequalifying subcontractors is essential to ensure that subcontractors have the wherewithal to complete their work in a satisfactory manner and to minimize the risk of default.

Prequalification benefits subcontractors as well. By taking steps to secure a spot on local GCs’ “preferred subcontractor” lists, they can gain a competitive edge.

The prequalification process

Consider formalizing the prequalification process by creating a set of forms, questionnaires and checklists for gathering information from prospective subcontractors. Some vendors offer prequalification software that helps streamline and automate the process.

Another option is to engage a third party — such as a surety company — to prequalify subcontractors on your behalf. One advantage of this approach is that subcontractors may be more comfortable sharing financial statements and other information with a surety.

What to look for in a subcontractor

There isn’t one right way to prequalify subcontractors. The type of information you gather will depend, in part, on the nature of your business and the size and complexity of your jobs. Following is a partial list of things you should look for when vetting subcontractors:

Management team and ownership. Gather information about the owners and the current management team, how long they’ve been in place and their backgrounds. Has the company ever been terminated for nonperformance or walked off a job? Has the company or any of its owners ever filed for bankruptcy? Does it or any of its owners or management have a history of litigation, either as the defendant or plaintiff? Dig into the company’s history and practices. What is its Workers’ Comp Experience Modification Rating? Does it have a history of OSHA violations?

Consider visiting a subcontractor’s facilities and speaking to its employees to get a feel for whether its operations are well run, organized and safe.

Work quality. It’s critical to ensure that subcontractors have the skills and experience necessary to perform the type of work called for on a particular job. Ask subcontractors to provide a list of their jobs in recent years, including the nature of the work and the size of the subcontract. Request references from GCs and other customers, lenders, sureties, and suppliers. You might even ask to visit one or two of their job sites to examine the quality of their work firsthand.

Capacity. Even if a subcontractor is competent and has a quality management team, it’s risky to do business with a company whose workforce is spread too thin. So it’s important to satisfy yourself that prospective subcontractors have the capacity to handle your work. Ask for information about the size and skills of the subcontractor’s workforce, as well as a list of current and upcoming projects. This information, together with information about the volume of work the subcontractor has handled in the past, will give you an idea of the subcontractor’s capacity to take on additional projects. And consider inspecting a subcontractor’s facilities to confirm that it has the equipment it needs to handle a job.

Financial resources. Review subcontractors’ financial statements or tax returns to evaluate their financial health. Verify that financial statements conform to Generally Accepted Accounting Principles (GAAP) — preferably audited by, or prepared with the assistance of, a CPA with construction experience. Extracting key ratios from the financial statements can help you gauge a subcontractor’s financial strength. (See “Key financial ratios.”)

As you review the financial information, pay particular attention to whether a subcontractor has enough cash to keep its business going, and that its accounts receivable are appropriate to its income level. Make sure the owners are maintaining sufficient equity in the company. Finally, get input and assistance from your CPA to better analyze and interpret the subcontractor’s financial data.

Managing your risk

If your due diligence reveals that a subcontractor presents a high degree of risk, you might decide not to do business with that subcontractor. Alternatively, there may be steps you can take to manage the risk, such as imposing a contract value limit on that subcontractor, requiring performance bonds or letters of credit, or obtaining personal guarantees from the owners.

Sidebar: Key financial ratios

There are several ways you can measure a subcontractor’s financial health. Here are just a few:

Current ratio (current assets / current liabilities). Measures the subcontractor’s ability to satisfy its short-term liabilities with cash and other relatively liquid assets.

Return on equity (net earnings / total net worth). As a general rule, the higher this ratio the better. But in some cases, a high ratio may indicate that the subcontractor is undercapitalized or too highly leveraged.

Working capital turnover (revenue / working capital). Indicates the amount of revenue supported by each dollar of net working capital used. A higher ratio may signal a need for additional working capital to support future growth.

Debt-to-equity (total debt / net worth). Some degree of leverage is healthy but too much is risky.

Underbilling / overbilling. If a subcontractor is underbilled — that is, if billings aren’t keeping pace with its progress on jobs — it may signal cost overruns, lax management or sluggish billing practices. Financially healthy subcontractors typically maintain an overbilled status.

For more information contact your MarksNelson professional at 816-743-7700.

MarksNelson Angie McElhaney CPA, CCIFP

About the author

Angie McElhaney not only specializes in working with construction and auto dealership clients, she also has experience working in industries such as retail, distribution, service, and nonprofits.


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