Managing Cash Flow

Managing Cash Flow

Thomas C Schleifer, Ph.D.

Few construction companies sell stock to the public to raise growth capital. Construction companies rely on the contractor’s invested capital, retained earnings, and various forms of borrowing to finance the front money required by the typical construction contract. Working capital is therefore limited. As construction companies grow, they take on multiple contracts each requiring front money. Cash flow management suddenly goes from an “after thought” to a primary “survival skill”.

Borrowing from Peter to Pay Paul

The first cash flow management technique that emerges as contractors grow from startups to established businesses might be called “Borrowing from Peter to pay Paul”.

  1. Most startup contractors finance their first job with their savings, a small bank loan, and money borrowed from their uncle. Their lumber supplier drops the first load on a net thirty-day basis so they get to work and invoice their client as quickly as they can for as much as they can get (front loading).Ā 
  2. The first progress payment kick starts them into business, and they bid a second job. Same game, except this time the progress payment from the first job becomes part of the cash flow necessary to finance the up-front costs of the second job. (borrowing from Peter to pay Paul).
  3. They gradually extend material supplier payment terms to forty-five days.Ā 
  4. Thay head down to their bank to arrange a “working capital line of credit”. Only to find out that the bank will only lend what their personal balance sheet and the balance sheets of partners and investors will support.
  5. The two jobs are beginning to make progress payments as they bid a third job.
  6. They try to extend their material supplier to net 60 days.Ā 
  7. While trying to expand accounts payable beyond 30 days, their clients are trying to expand their accounts receivable beyond 30 days by contesting their invoices and refusing to pay for what the contractor considers “completed”. (Hopefully, lawyers are not engaged in these negotiations because legal costs compound the slow payments, negatively impacting working capital).
  8. Time to add another job and a fresh source of cash flow. The cycle continues.

Sound familiar?

Front-loading

Although many consider “front loading” an unsavory term, it is nevertheless a common cash flow management practice in construction. Front loaded costs refer to costs that are disproportionately applied to elements of the work that take place early on during a project. The practice allows the contractor to mitigate the absence of what should have been, in any other industry, a fair and proper deposit before work begins.

A long-standing onerous business practice requires contractors to cover all the up-front costs of a construction project. Over time, contractors have tried to soften the cash flow burden by charging the client at the beginning of a project for costs that might otherwise be amortized over the entire course of the work. Costs like engineering, procurement, licensing and fees, site preparation, infrastructure installation, etc., are submitted in the first invoices and paid for at the beginning of a project. Unfortunately, cash flow suffers toward the end of the project when required to pay the final balances on all invoices.

Retainage

The practice of withholding a percentage of the total project cost until the final punch list has been approved puts more negative pressure on a contractor’s cash flow. 10% or 5% of a $10 million project is serious money. Owners and their advisors are reluctant to release retainage until every T has been crossed and every I dotted. Final payment often takes months after the project has been completed. The contractor, on the other hand, must make timely final payment to vendors and subcontractors. If a contractor has already “borrowed” from supplied by extending accounts payable they are not in a position to delay final payment until the project’s retainage has been released.

Managing Cash Flow

All the above puts negative pressure on the contractor’s cash flow and is the number one cause of contractor failure. For that reason, I believe that cash flow planning and management is a critical management skill that has been overlooked by our industry.

For the next month we will be discussing the following cash flow management steps that all contractors should be taking.

  1. Retain a percentage of earnings from your first day in business to build an adequate working capital balance as your company grows.
  2. Prepare a “go/no-go” cash flow capacity plan before every new bid is submitted.
  3. Review your accounting department’s billing and payment procedures insisting on timely accurate invoicing and no-nonsense collection standards. (If the contract states “payment in x days” then that’s what you should insist on. The timely submission of accurate invoicing and prompt (contractual) payment are powerful mitigating factors in maintaining healthy cash-flow.)
  4. Negotiate an adequate working capital line of credit at your bank before every bid. Try to convince your banker that an adequate working capital line should be based on projected usage needs not solely on collateral value.Ā 
  5. Arrange positive payment terms with suppliers before work begins. They may charge you a couple of percentage points but that will prove cheap if you find yourself in an unexpected cash flow squeeze as work progresses and owners delay payment for any number of reasons.
  6. Before signing any contract, negotiate positive progress payment and retainage terms. Do not settle for negative “boiler plateā€ terms.

Next week we’ll discuss how to create a “go/no-go” cash flow capacity plan.Ā 

For more information financial management, read more at: FINANCIAL

For a broader view on cash flow, read more here: CASH FLOW

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