In general, contractors’ financial statements and job schedules look very different than they did a few years ago. Few contractors came away from the initial downturn in the economy unscathed, and are now feeling the effects of the ‘new’ normal. In most cases, all components of the balance sheet have declined as contract volume has declined and margins have been squeezed.

Changes in Assets:

During the first part of a down cycle, a contractor’s cash may appear in good shape. This is because prior billings and retainages are being collected and there is less new work, and therefore less expenses incurred that use cash. While cash may look strong, this situation can actually signal a lull in new work and the beginnings of strained finances. After several months of reduced job volume, which causes a significant decline in receivables as well, the borrowing base on a line of credit can shrink, further reducing available operating cash. Additional decline in assets is possible as net equipment decreases as a result of continuing depreciation expense and the limited ability to purchase new equipment.

Changes in Liabilities:

Liabilities may be on the decline as well if related assets have been sold and there has been a reduction in new work, which in turn has reduced payables just as it reduced receivables. However, in the worst circumstances the opposite is true. If expense reductions do not happen quickly enough, liabilities may grow, usually in the form of payables and an increased line of credit. Some contractors refinanced to pull additional cash into the company prior to the downturn. Another scenario that we have seen is payables become inflated due to a lack of cash to pay down job costs from projects that have budget overruns.

Changes in the P&L:

The income statement (revenues and expenses) should shrink when the job volume decreases, but other changes occur as well for most contractors. In the current bid environment, gross margins have decreased. Additionally, if management has not implemented significant cost cutting, the ratio of general and administrative (G&A) costs to gross profit will be significantly higher as G&A expenses are largely fixed costs and will not respond the same as direct costs to a decline in revenue without additional action by management. A common indication of pending decline in finances is an increase in indirect job costs on individual contracts. Indirect costs, much like G&A expenses, do not decline at the same rate as direct costs relative to a decline in contract price. Indirect costs are allocated to jobs, which if not cut timely, results in the same dollar amount of allocation of indirect costs over fewer contracts. This can lead to a decrease in contract profit and possible contact loss if margins were tight on the contract from the start.

Changes in Backlog:

A decrease in backlog is generally the biggest red flag to contractors. This red flag may remain largely unnoticed for a long period of time if the contractor has an extended project cycle. The longer a company’s projects last, the longer the financials will remain looking strong, when in reality there is hidden danger around the corner when work levels reduce dramatically. In the current economic environment it is important for contractors to have a better understanding of their backlog. For example, a large contract on backlog due to start in the distant future may not be as much benefit to the contractor as several smaller contracts beginning in the near future depending on the contractor’s current or future financial condition. Additionally the contractor should consider the gross margin on backlog contracts. A large contract with little margin may not be in the best interest of the contractor compared to several smaller contracts with more comfortable margins and a quicker collection of retainage receivables. All scenarios and analysis of backlog information should be considered when determining jobs to bid on in the future, given current and anticipated financial health.

By being cognizant of the red flags that a reading and analysis of financial statements and job schedules can provide, contractors can prepare for financial struggles that may be imminent.

For the past couple of months we have been writing about business and leadership succession matters. This week we want to focus on how to minimize income, gift and estate taxes as part of a sale or transition process. Individual goals are always different and so the key is to tailor some of these ideas to fit your personal objectives.

If you have family members active in the business, it is worth considering whether you would want to gift some or all of your company stock to them. Through the end of 2012, gifts of up to $5.1 million ($10.2 million jointly) can be made tax free. The law could change substantially after 2012. Some owners make annual gifts of stock to their children. Annual gifts valued under $13,000 ($26,000 if given jointly) per recipient may be given without using any of your estate tax exemption. Your spouse does not need to be a shareholder in the company to take advantage of this strategy.

If you are charitably inclined, and a sale of company stock is likely, you could consider setting up a Charitable Remainder Uni-trust (CRUT) and gifting some or all of your company stock to it. The stock would be purchased from the CRUT income tax free, you would get a sizeable current year charitable contribution (based upon a formula), and you and your spouse could receive a 5-10% payout annually for life. The charities which will ultimately receive the residual balance are identified by you and can be changed by you in future years.

If, in considering use of a CRUT, you are concerned about the fact that the company value would no longer go to your children or other heirs, a wealth replacement trust in the form of an Irrevocable Life Insurance Trust could be established, which upon your death would flow to your children tax free.

Let’s assume you have no children involved in the business, but you have a great employee group and a good business. You might want to investigate setting up an ESOP (Employee Stock Ownership Plan). There is no tax on the sale of your stock to an ESOP as long as the funds are invested in qualified securities. An ESOP can own some (must be at least 30%) or all of the company stock.

The sale of a company involves a lot of negotiation between buyer and seller because what’s best tax wise for one is usually less favorable for the other. If your company is an S-corporation, you will want to retain that status if a sale is likely to occur, in order to avoid double taxation. We can help you structure a sale to minimize the total taxes that would be payable.

There are many other ways to transition a business and receive funds from the company. The exact formula depends upon your goals and situation. Please don’t hesitate to contact us to discuss your questions and ideas.

A few reminders, the current capital gains rate is 15% and this rate expires January 1, 2013. The current gift tax exemption is $5.1 million, and this will revert to $1 million on January 1, 2013, as will the estate tax exemption.

Financial statements regularly slide over your desk and pass through board members’ hands, providing a wealth of financial data on your nonprofit’s most recent month, quarter or year. But do you and the board rely on this valuable information to make business decisions and plan for the organization’s future?

Looking for insights

Think of the audited financial statements as a family album, providing a history of your nonprofit’s financial past. Examining that past can help you better manage your organization now and in the months and years ahead.

To glean meaningful insights from these documents, you need to understand what each statement represents. Take it a step further, and you (or the board members) can use the data to create a trend analysis, an industry comparison or a projection of upcoming challenges. Such tools can springboard your organization to making better-informed decisions.

Using financials to investigate

It’s critical that your nonprofit perform monthly comparisons of the organization’s financial results to its corresponding budget. Most financial software programs allow the budget to be entered by month and produce statements that compare actual results to what was budgeted.

Make it a policy to investigate any variances greater than a certain dollar amount or percentage. A smaller organization might, for instance, base the dollar amount on the amount used in its check-signing policy. A percentage of 5% to 10% variance is often used as the rule of thumb. This allows you to properly oversee and assess operations in a timely way, and evaluate the performance of individual programs and departments.

Using figures to forecast

Planning for the near future is critical in today’s lean economy. You can compare actual monthly results through the most recent month, and add future budgeted monthly amounts to prepare a forecast of the full-year results. This “best guess” of what will happen to the organization in financial terms over a given period of time may indicate the need to find more revenue and support and cut back spending. Or you may find just enough resources to buy those new computers. Basically, the comparison will indicate whether you’re on track with your original budget or if it should be revised.

Finding other uses

Financial information should be used to evaluate the organization’s effectiveness in meeting its mission. Monitoring program information from detailed financial records can help determine whether you’re accomplishing specific goals. You may also find it useful to share this information with donors to help them visualize how their donation would be used.

If your current year’s objective is to increase membership from 1,500 to 1,800, for example, examine the total membership fees collected and monitor the progress toward your goal. If $2 million are needed to build your new facility, use the monthly statement of activities to monitor pledges and develop a detailed listing of pledges receivable to monitor donor payments.

Using stats to improve

Comparing your annual results with other nonprofits in your industry — or benchmarking against industry statistics — can help identify your organization’s strengths or weaknesses. And this can lead to spotting growth opportunities or reallocating resources. Apply these same ratios over several years and you’ll have the basis for long-range strategic planning and better use of money and resources.

For example, you might notice that another nonprofit in the same industry spends significantly less on its facilities than you do while providing comparable services. Or perhaps it raises twice the dollars that your organization does each year. Use these revelations to target areas for improvement and to create discussion amongst your Board of Directors or other volunteer committees.

In my April 19, 2012 article, I discussed the personal financial planning needed to get yourself and your family ready for a business transition or sale. In my March 22, 2012 article, I discussed the importance of preparing key employees for transition. This week I want to focus on preparing the company’s financial statements for a transition or sale, in order to maximize the value and provide you peace of mind.

Your company is most likely your single largest asset, or at least a significant part of your financial estate. In a transition to key employees or family members, you most likely will be looking for cash flow payments from them, or the company, for years to come. But what condition will the vehicle (company) be in when you turn loose of the steering wheel? Will it be in good mechanical shape able to carry a heavy load, or will it appear old and needing a lot of repair? I know which one I would want.

What do we mean by good mechanical shape? Here are some examples:

1. A high current ratio (current assets divided by current liabilities) of at least 2:1 (higher is even better).
2. A low debt to equity ratio (total liabilities divided by total shareholder equity) of no more than 3.5:1 (lower would be better)
3. Continuous reinvestment in the business by keeping equipment and systems up to date (looking at the cash flow statements, over a period of 5-7 years, property additions should approximate the amount of depreciation taken over that same period of time).
4. Good profitability trends. There are a number of different profitability ratios, and some vary by industry. A common one used by banks is the debt service coverage ratio (Earnings before interest expense, taxes, depreciation and amortization [EBITDA] divided by the total of interest expense plus next year’s required principal payments) which should be at least 1.1 to 1.0, or higher. Banks will frequently reduce the numerator by dividend distributions and property additions not funded with long term debt.

Interestingly, if you are planning to sell your business, sellers are looking at the same factors, with perhaps even more emphasis on the last five years of earnings. In fact a multiple of earnings (EBITDA actually) is often the formula seller’s use in determining what they will pay for a business. If you are planning a future sale, it would be wise to eliminate unnecessary perks, excessive compensation and discretionary expenditures that don’t add value to a business. Focus on having a strong bottom line, but continue to make investments in people, training and maintenance.

Whether you sell your company to outsiders or transition to your family or employees, you can leave a strong legacy to those that follow you. You’ll also achieve greater peace of mind for yourself knowing that you left a strong company, in good mechanical shape, which can generate the cash needed to pay you when you leave.

In our next article, I want to cover some ideas on how to minimize taxes as you transition or sell the business.

by Anita Sherman, CPA | Managing Partner

In the last couple of weeks, I have been focusing on several of the important elements that are essential in order to successfully transfer your business to the next generation of leaders. In our March 22, 2012 enewsletter, I discussed the importance of having a process to assist in developing all the skills that will be needed by the Next Generation Leader in order to not only carry on, but to take the business to the next level. I also identified four reasons why it is in your best interest to make the additional effort to ensure success.

In our April 6, 2012 enewsletter, I reviewed the startling statistics that only one-third of businesses are successfully transitioned to the next generation, and when it comes to transitioning the business to the third generation, the success rate drops to 13%.

Regardless of which generation you represent, another issue that often creates an unwillingness or concern to begin a transition process, is the fear of not having enough money to retire. This is, in fact, a problem of epidemic proportion among the baby boomer generation and is a concern that cannot easily be fixed in the short term.

We all would like to have the comfort of knowing that we will have the financial wherewithal to begin our next phase of life, whatever that is. In this situation it is best that we sit down one on one to discuss your goals and plans, and examine your financial resources and needs, and develop together a plan to implement changes where needed. It is our goal to deliver peace of mind.

The reality is, whether you own a business or not, you should have a well-diversified balance sheet. Areas that should be evaluated include:

1. Your personal and retirement plans and goals
2. Maximizing retirement account savings and any company match
3. Regularly adding to your diversified investment portfolio
4. Knowledge of what your Company and other assets are worth
5. Effective use of College Savings (529) Plans, where appropriate
6. Life insurance – too much, too little, outdated policies?
7. Long term care needs
8. Comprehensive estate plan (I will cover this more in a subsequent article)

Peace of mind can only come through being properly prepared. Please give us a call to let us help you make sure you are on the right path.

In our next issue I will review how to prepare your Company’s financial position to maximize the value for a sale or transition.

Employer contributions for each eligible employee must be:

• Based only on the first $250,000 of compensation
• The same percentage of compensation for every employee
• Limited annually to the smaller of $50,000 or 25% of compensation
• Paid to the employee’s SEP-IRA

An eligible employee (including a self-employed individual who received earned income) is an individual who meets all the following requirements:

• Has reached age 21
• Has worked for the employer in at least 3 of the last 5 years
• Received at least $550 in compensation from the employer during the year (for 2010 and 2011)
• An employer can use less restrictive participation requirements than those listed, but not more restrictive ones.

SEPs are attractive because they do not require annual discrimination testing or IRS filings. However, this lack of oversight can lead to errors. One of the most common mistakes is the employer’s failure to contribute for eligible employees. Other errors include:

• Failure to amend or update the SEP plan document
• Failure to include employees of a related business
• Errors in the calculation of the contributions due to usage of incorrect definition of compensation
• Contributions are not a uniform percentage of compensation per participant’s compensation
• Contributions exceed maximum legal limits

These problems can be corrected by using one of the various IRS correction programs.

In our last issue (Are You Developing the Next Leader / Your Successor for your Business Now?), I suggested that in order for your “successor” to be successful, a well thought out development plan should be created and implemented. But is a lack of a development plan the primary reason that the generational transfer record is so poor? Probably not, based on our experience and the research and reading that I have done on this topic.

See if this sounds familiar. Founders are typically strong controlling leaders with Type A personalities. The business is an integral part of their identity-it’s who they are. They tend to believe what is good for the business is also good for the family. Often times they retain control of most decisions and nothing can be done without their blessing. As a result the next generation may not get the experience or background to make the important decisions wisely. When the Founder does begin to retire, he/she often does not give up control easily or willingly. They know that they have a lot to continue to offer to the business, but it seems to them that there is very little acknowledgement of that fact from the next generation.

The “next” generation working in the business tends to think that future ownership is a given, as is the progression to management control. Often there is an entitlement mentality. Rarely are the issues and concerns discussed or planned. In the most difficult of situations, each of the two generations feels undervalued and underappreciated. That only makes the Founder generation feel that they must retain control longer. Succession becomes a long, tedious, and contentious process. As time passes, the next generation becomes more involved with management and the Founder(s) are semi-retired, but retirement lacks any real definition other than less work, but perhaps not less pay, or less control. Resentment grows.

Unfortunately, while ”family” has always been extremely important, the anger and hurt that often develops can destroy the family. Everyone is confused. Parents don’t understand why their children don’t accept that they have made all of this possible and that they will control the purse strings for as long as they like. Middle aged children (yes that is frequently the case) have been waiting for a chance to really take over and prove themselves without parental oversight. Employees wonder: who is the boss? It is very confusing — and still no one feels comfortable coming to the table to establish a plan.

Often it helps to have a respected third party work with the two generations to sort out what is important to each and to help the families develop a plan. We call it a Legacy Plan. As part of this process, we think it is important to develop a Vision/Mission statement to which both generations would be committed to. This would also identify the important goals and action plan for how and when the families and business will achieve that vision. This plan may need to include addressing the non-active siblings — also often a source of bitterness. To be successful and fulfilling, some Founders need to develop retirement activities outside of the business so that the business does not become the retirement activity. The next generation of decision makers must be empowered with real control and be formally evaluated against actual results.

It is not easy to let go. It can be made easier with proper planning, including a training and development plan for the next generation to help “round” them out. It is very important to have empathy for what both generations are going through because each has very valid concerns and feelings.

Interestingly, many of these same issues are in play in non family owned businesses as well. This is just the second critical area associated with business transitions. I look forward to sharing my thoughts on additional matters in our next issue.

On March 20, 2012, the Governor signed into law Senate Enrolled Act 293 that changes the exemption amounts and eventually calls for the phase-out of the Indiana Inheritance Tax. Prior to January 2012, the Indiana Inheritance Tax was calculated based on different classes of exemptions and tax rates associated with those classes. Beginning in January 2012, the amount of the exemption increases from $100,000 to $250,000 for the class that includes children, grandchildren, parents and grandparents.

Beginning in 2013, the inheritance tax will begin to be phased out. The phase-out is a credit that is applied to the inheritance tax. The credit begins at 10% in 2013 and increases 10% each year over the next 9 years. The Indiana Inheritance Tax will be completely eliminated on January 1, 2022.

The Governor also signed a bill that enhances the Automatic Taxpayer Refund that was established last year. The enhancements affect the calculation of the refund amount for taxpayers. To receive the refund, the taxpayer must have filed a resident Indiana income tax return in the previous year. If there is an Automatic Taxpayer Refund allowed, taxpayers could receive a minimal refund as early as next spring when they file their 2012 income tax returns.

“Developing” successors is an important matter that often does not get addressed until it is over ripe, because, while it is important, it is not urgent. Very few businesses have successfully transitioned in the past from one leader to another, so many CEOs don’t have a road map to follow. This process often isn’t well thought out, if it is viewed as a process at all. “Hey, nobody taught me how to be the President. I learned it all by myself”, we frequently hear. There are a number of reasons why approaching your transition early and on a proactive and deliberate basis might be a better idea than leaving the process to chance: a) the complexity of business today requires strong skill sets, b) you want to leverage your knowledge and talent, c) you want to ensure that your financial future is more secure (assuming that the value of your business, or a future income stream from it, is important to you), d) to identify the skills needed and work on development of those in your identified next leader. Even if your exit strategy is to sell to an outside buyer rather than internal one (i.e. children, other family members or existing key personnel), having a strong management team in place is a real plus. Continual assessment, promotion, and development and retention of your key performer’s are critical to a successful plan.

Some of the elements that should be considered in creating a development plan include:

Nurturing and Development of -

1. Trust
2. Shared values and vision
3. Commitment to the organization and it’s culture

Technical Competencies -

4. Relevant education and experience
5. Required critical skills (deep understanding of your Products/Services and Customer needs)
6. Track record of profitable management of operations
7. Sufficient finance and accounting knowledge to manage the organization
8. Knowledge of the trends in your specific industry
9. An understanding of how your business makes money and how entrepreneurs think (vs. an
employee mentality)

Leadership Competencies -

10. Good communication skills
11. Good connections with customers, vendors, employees, service providers
(bank, attorney, CPA) and ability to build relationships
12. Strong motivational, mentoring and accountability skills
13. Creativity to take the business to the next level.

Each business/organization is different, but if any of the above elements are lacking, a supportive development process should be created to build skills and groom the next leaders. The inclusion of younger team members in meetings with your bankers, accountants, insurance agents and attorneys, and in important internal meetings is essential. The next generation leaders learn a great deal from observing more experienced leaders in action, especially if it is followed by a debriefing session to address questions or provide additional background on the reason for the positions taken.

40% of the workforce in our country will be poised for retirement in 2020. If you, as the leader of your organization, are one of them, it’s time to get started on your plan now!

Most potential business leaders tend to come up from the operational side, and frequently their knowledge and ability to read and understand financial statements, understand the importance of key financial ratios, and how to use them to manage a profitable operation may be lacking. They may or may not have been involved in industry trade associations or know all of the key customers, etc. We would be happy to help you develop a succession strategy for your organization.
In our next newsletter, we’ll discuss reasons why it is not easy to pass a company to the next generation of leaders.

Every day people make plans that don’t go exactly as planned. For those in the construction business, adjustments to plans aren’t always as simple as making a phone call or switching a schedule. Many times, for a contractor to get paid there needs to be a change order issued. As with any adjustment in plans, there are many items to consider.

Review the Fine Print:
Some construction contracts will require multiple steps to be performed to secure additional payment/time through a change order. Failing to meet the requirements of each step could lead to the change order being waived. We suggest contractors take the time to read all requirements listed in the contract for change orders. By doing so, contractors reduce the chance of the change order being waived due to a small technicality written in the original contract.

Verbal Agreement vs. Signed Change Order:
Far too often, required procedures for a change order are not followed while in the field. Contractors instead will accept a verbal agreement with the owner or general contractor to not only do the work, but also regarding how much it will cost. Unfortunately, when it comes time to be paid for the extra work performed, disagreements may arise, non-payment may occur, and sometimes messy litigation follows. We suggest that as soon as a contractor realizes additional work is required, the project manager present to the owner or general contractor a formal listing of estimated additional charges, along with a change order. The contractor should then wait, whenever possible, until the change order has been reviewed and signed before continuing with the additional work. While this may cause slight delays, it could save the company money and spare you from expensive and time-consuming disputes or lack of payment for work performed that was not approved.

Keep Your Accountant in the Loop:
Project managers should also be sure to communicate any change orders to their accounting department, whether approved or unapproved. This allows the accountants to accurately track the additional costs and profits on the project and properly classify the additional expenses for financial statement purposes. In most cases, expected profits on change orders can not be reported on the financial statements until the signed change order is received.

By thoroughly reviewing contracts, obtaining signed change orders, and communicating these changes to your accounting department, a project is more likely to run smoothly, be accurately reflected in the financial statements, be easier to collect on, and be profitable.