Accounting, banking, insurance and real estate are highly regulated industries that are forced to follow strict guidelines. For the most part, we rarely see these industries fail or mislead the public. Generally, these four industries have had record profits for nearly a decade and overall the public places a high degree of trust in them.
BANKINGContractors borrow money from banks on a regular basis to “float” their businesses until paid by the client. Once paid, contractors pay off their loan or pay it down in hopes of limiting interest expense. Banks, on the other hand, prefer that contractors, at some point, generate enough profits to create their own working capital.
Profit is free money! Businesses can use their profit dollars to pay for material and labor rather than use borrowed money from a bank. For example, banks have what they call the “cost of money,” which is the average of what they pay for the money they lend out. Since very few banks pay interest to people who have checking accounts, the money in non-interest bearing checking accounts is “free money” for the bank. This “free money” allows banks to loan money at virtually no cost to the bank.
Smart contractors realize the importance of using free money rather than borrowed money. Smart contractors also know that investing their free money along with borrowed money allows them a lower “average cost of money,” just like a bank.
WHAT IS GROWTH?How does a small subcontractor grow his business? Why do some businesses grow from nothing to hundreds of millions of dollars in relatively short periods of time? Do you bid more work and borrow more money to do the work? Or, do you build working capital (free dollars) as well as borrow more money to do more work?
Artificial growth (fake growth) is when you do a lot of work and have a lot of money running through your checking account but the money never seems to stick. Doing a lot of work and keeping all of your employees busy for the year may feel and look like growth but it may be artificial unless you’re earning profits that stick.
The next difficult issue to deal with is paying taxes on profits, which become retained earnings in the company. You can look at retained earnings before tax if you want, but in truth your true retained earnings are after tax.
So, how do you truly grow your business? Banks grow their business by leveraging. Banks borrow money for as little as possible and they lend it out for as much as possible. A bank must loan out a certain amount of money at a certain rate of interest in order to break even.
A contractor has to do a certain amount of work at a certain margin to break even. Every day, banks monitor their deposits to determine how much they are paying in interest to their depositors and lenders. Most contractors use a job cost system that tracks all costs related to a specific job, but in most cases a job cost doesn’t show how much the contractor paid for borrowing money to do the job.
BORROWING MONEYBefore a contractor borrows money from a bank the contractor and bank will agree on collateral, loan fees and interest rate. Collateral is simply giving the bank something of value it can sell in the event you go broke. Some banks will use the money you are owed as collateral, but most start up companies need some sort of solid security like money or real estate.
After the collateral issue is resolved the bank would then offer to make you a loan based on a fee they charge to put the loan together which is known as a loan fee. A typical loan fee is around 2 percent of the total loan amount. If you were borrowing $100,000.00 you would have to pay a $2,000.00 loan fee. Then you would agree on the term or length of the loan and an interest rate. A one-year loan of $100,000.00 at 2 points above the Federal Prime Rate would be about a 7.25 percent interest rate.
If you borrowed $100,000.00 for one year at a 7.25 percent interest rate and a 2 percent loan fee your cost to borrow this money for a year is roughly $9,250.00. In construction talk; if you did a $100,000.00 job and your total cost to do the job was $83,338.00 your gross profit would be $16,662.00 or roughly 20 percent. You would then subtract $9,250.00 from your gross profit for the cost of money you borrowed which leaves you with $7,588.00 or roughly 7.5 percent.
Of course the goal is to do a lot more then a $100,000.00 worth of work with the $100,000.00 of borrowed money, but I want you to see how expensive it is to borrow money. People in general talk about borrowing money as if the banks give it away and I don’t understand that.
LEVERAGING BORROW MONEYIn order for a highly leveraged company to survive it has to leverage borrowed funds by doing as much work as it can with the money it has. That is what being highly leveraged is all about.
If you were able to do a million dollars worth of work at a 20 percent profit margin your cost of money would much lower. If you manage the money you receive from your clients as well as use the borrowed money you would be surprised how much lower your average cost of money would be.
As the housing market declines there will be housing contractors who will enter the commercial market. In most cases they will start with smaller light commercial jobs they feel they can finance. Often times when the residential market slows down commercial general contractors who are in trouble will find a residential contractor who is slow and invite them to bid a commercial or large multifamily project in hopes they can take advantage of a low price.
When you are highly leveraged and you take on a project that you don’t normally do or is much bigger than you normally do you stand the risk of loosing it all. You have to remember that most general contractors in the commercial or multi-family business have only one goal. That goal is to keep their job within budget no matter the cost to the subcontractor.
BUSINESS 101For many years I built my business plan backwards. I established what I wanted the company’s net profit for the year to be. If my plan showed a $200,000 net profit that is what I worked towards. I did this because I was interested in doing the least amount of work at the highest possible profit margin. I looked at what it would cost me to make $200,000 net profit and decided if I wanted to risk what it would take to make $200,000.
Again, my goal was to do the least amount of work but still hit my goal. Although I followed this practice for a long time I found the system to be far too conservative and didn’t allow me to leverage. In the case of my own company we had slow, steady growth as opposed to a somewhat leveraged growth where more risk was involved.
I’ve learned there should be a balance between being highly leveraged and leveraging to maximize profit.
Most contractors set their goals based on total sales for the year rather than profit for the year. It’s true you have to do a certain amount of work to break even and its also true you have to do enough work to make a profit. The key is in knowing you have a profitable job.
Many contractors are willing to sell their products for very close to what it cost them in hopes of making money on shear volume like some of the big retail stores. The problem with doing this is that contractors don’t have a huge variety of products they sell. In most cases it’s just a few products and if those few products are priced very low the risk skyrockets.
Risk is directly related to reward. The higher the risk the higher you should be rewarded. If your going to highly leverage yourself or company make sure your product is priced so you will receive a respectable reward.
Remember: Teamwork begins with a fair contract.