Measuring contractor’s financial sustainability
By Aaron Sinclair
The 2018 CFI Contractor Survey results measured a number of factors affecting the sustainability of harvesting contractors across Canada. Snippets 2 and 3 reported the profitability of contractors. Profit is a measure of a company’s ability to generate more revenue than it spends in expenses. The survey results demonstrate reasons to be concerned about contractors’ financial health.
By Aaron Sinclair
Approximately 50 per cent of contractors reported 3 per cent or less profit versus 38 per cent in 2016. Almost a third more contractors are generating low profit margins.
Profit, however, is not the best measure for examining the performance of capital-intensive industries because it does not properly consider the capital, and cost thereof, required to be successful. Earnings before interest expenses, taxes, depreciation expense, and amortization expense (EBITDA) is a better measure than profit to determine a contractor’s financial success and health. Remember the ITDA portion of EBITDA.
EBITDA calculates the cash flow generated by a company before the cost of capital and ownership of capital assets. How a contractor chooses to capitalize its business, pay for its capital assets, and generate a return is the business of the contractor. Benchmarking EBITDA allows for better comparisons before discretionary capital structures to focus keenly on the operating efficiency.
In 2017, PNL Consulting in Prince George, B.C., was commissioned by the B.C. Ministry of Forests, Lands, Natural Resource Operations and Rural Development to examine the financial sustainability of forest sector contractors. PNL analyzed external accountant prepared financial statements for almost 30 per cent of the harvest capacity in B.C. on both the Coast and in the Interior. After sensitizing for tax planning measures and non-operational expenditures, a clear independent picture of the financial health of contractors was evident. More importantly, the analysis predicted a sustainable range of financial performance that would lead to long term sustainable contractor performance.
On average, EBITDA needs to be between 20 per cent and 25 per cent for Interior contractors and between 17 per cent and 22 per cent for Coastal contractors to be considered sustainable. The Coastal industry experiences lower sustainable margins due to the larger handfalling component, which requires less capital investment. Comparing to profit margin, these results translate to a margin between 8 per cent and 13 per cent. The actual EBITDA results in any given year for the contractors range from a low of 11.8 per cent to a high of 16.7 per cent for the Interior and a low of 7.4 per cent to a high of 9.7 per cent for the Coast.
Remember ITDA from above? The interest, taxes, depreciation, and amortization represents a potential minimum cash flow required to purchase capital assets. It would provide no return on equity and impoverish the investors in the business. For mechanized contractors, the minimum ITDA is 14 per cent, and for all types of contractors minimum ITDA is 9.4 per cent.
Comparing the actual results, it is clear that the sustainability of contractors has challenges where there is insufficient or barely sufficient cash flow (EBITDA) to replace capital assets as they wear out, nevermind providing investors with a return.
The need for healthy contractors to provide harvesting services to sawmills is a genuine concern. PNL analyzed capital investment and repair expenditures of sawmills and contractors over a 20-year period. The analysis concluded that contractors will spend 18.1 per cent more on capital over 20 years than the sawmills they service. Contractors that do not earn sustainable EBITDA are putting the future of the sawmills they service at risk. Unsustainable contractors should be a concern for sawmill investors and the communities they call home.
The good news is that calculating your EBITDA margin is as easy as identifying your net income after tax and adding your taxes, financing interest, and depreciation and amortization. The total of this divided by your revenue indicates your EBITDA margin. Benchmarking contractor EBITDA margin against sustainable industry performance will provide significant insights into the sustainability of sawmills and the communities that depend on them.
Aaron Sinclair, MBA, is the president of Timber Tracks Inc. and principal at PNL Consulting, based in Prince George, B.C. Need help calculating, interpreting, and benchmarking your financial performance? Contact Aaron at email@example.com for assistance.