“The ultimate measure of performance is not what is earned, but how the earnings are used to increase a construction company’s value.” (The Business of Construction Contracting, Thomas C. Schleifer, Aaron B. Cohen, Wiley, 2025
The only way for small or start-up contractors to fill the big shoes of dominant regional contractors is to grow into them. But since contractors have been maneuvered into financing their work as well as building it, the only way to grow into the regional contractor’s shoes is to have the capital on hand to finance the increasing cash flow demands of subsequent larger jobs. Construction professionals must understand that it is extremely complex to envision how much their organizations can effectively perform and finance. Every organization has a limit. The financial limit is set by the amount of available capital on the balance sheet.
Sources of Working Capital
One of the myths that contractors share is that the cash needed for financing ongoing production is obtained by a little careful front loading of projects in the start-up phase, drawing down their working capital line of credit at the bank, and extending accounts payable beyond the traditional thirty days. When contractors are small and working few to several projects simultaneously, this home spun method of working capital financing seems to have worked well enough. However, as contracting firms grow and gradually have numerous projects in varying stages of completion, it is almost impossible to estimate companywide cash flow with any degree of accuracy. All front loading eventually comes home to roost as projects near completion. Working capital lines of credit get used up quickly, and 30 days of supplier credit becomes 60 in no time and begin to evaporate after that threshold.
Retained Earnings
For small companies to grow into larger companies they must increase in value every step of the way. That is to say, the earnings from early jobs must be retained on the company’s balance sheet to finance future growth. This strategic financing step is essential to long term success.
Many contractors seem to believe that taking larger jobs supplies cash rather than consumes cash. Nothing could be further from the truth. Although jobs in the early stages tend to supply cash through front load billing, as they wear on, they begin to use cash as the job completion percent begins to outrun the actual cost to complete. In other words, if a contractor has been overpaid by front loading a job that is 60% complete, the remaining 40% of the job will have continuous negative cash flow. The remaining expenses can only be covered by a working capital line of credit available from the bank or capital (retained earnings) residing on the company’s balance sheet. This is what is meant in the aforementioned book; “How the earnings are used to increase a construction company’s value.”
The Best Investment
Most contractors seem to believe that leaving cash in the company is both risky and inefficient. They either distribute profits to stockholders quickly or invest in fixed assets. Some investment in new technology and modern equipment is necessary to improve productivity and ultimately gross profit, but investing in non-productive assets (like fancy offices) is always questionable financial management for construction firms.
I believe that in today’s construction business environment, removing a significant amount of earnings from a contractor’s balance sheet is both risky and inefficient. The risk of running out of cash to finance ongoing operations is one of the greatest risks that contractors face. Retaining earnings in a construction company in the form of liquid working capital is one of the best investments smaller and growing contractors can make.
Next Week
It is my contention that, over the years, contractors have been badgered by lawyers into accepting the role of the weaker party to the construction financial transaction, as if contractors are always doing something wrong and need to be disciplined and watched carefully. I consider this nonsense. As long as contractors have been required to provide the financing for the owner’s asset improvement they should begin to act like lenders. Next week we’ll be discussing two more important steps in working capital management.
- Conducting a thorough credit analysis on all owners prior to signing a contract.
- Demanding prompt payment according to the terms of every contract.
See you next week.
For more information on retained earnings, read more at EARNINGS
For a broader view of cash management , read more at: CASH
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