Managing a day-to-day construction business using the three traditional financial statements alone leaves an important financial metric (Cash Flow) difficult to determine accurately on a real time basis. Using the percentage of completion accounting method results in only a reasonable estimate of interim profitability and likewise the cash flow derived from estimated profit.
In last week’s metaphor of flying by instruments alone there was one vital metric completely unaccounted for in the cockpit; the fuel gauge. Without a precise measurement of the amount of fuel available to complete the journey, pilots are left to estimate if they’ll have enough fuel to reach their destination. That would, of course, be a high-risk method of piloting a commercial jetliner.
Cash Flow Statement
The Cash Flow Statement is one of the three primary financial statements. (cash = fuel) It shows how much cash a company brings in and spends during a particular time frame. It can help management determine their companies’ ability to sustain both short and long-term operations. It is a construction company’s fuel gage.
Cash Flow Analysis
A cash flow analysis is the process of interpreting the data in a cash flow statement to assess a business’ liquidity, solvency, and overall financial health.
- A company can use a cash flow statement to assess liquidity, which is how well a company can meet its short-term liabilities.
- A cash flow statement can help businesses make informed decisions about expenses, financing, and investments. For instance, a construction company with a profitable income statement but insufficient cash flows may not have the necessary cash to continue operations. Using cash to invest in equipment at that point could be the kiss of death. Comparing changes in cash flow from one period to the next sheds light on the direction a company is headed in.
- A cash flow statement helps you make business decisions by showing you how much operating, investing, or financing activities are using or generating cash.
Indirect Cash Flow Method
There are two methods of calculating cash flow in a construction company’s financial statements; The Indirect and the Direct method. The following are some of the most common adjustments to net income when calculating cash flow by the indirect method:
- Depreciation is a non-cash expense on the income statement and is added back to net income for cash flow purposes.
- Increases in accounts receivable are deducted from net income, as no cash has been received for these sales. Conversely, decreases to accounts receivable are added back to net income, because they represent cash received.
- Increases in payables are a non-cash accrual and are added back to net income.
- If purchased with a cash outlay, an increase in inventory reduces net income.
The Direct Method
The indirect method is used in most instances where the calculation of monthly profit has revenues and expenses matching on a cutoff date. In the percent completion both revenues and expenses must be estimated so the cash flow derived is never entirely accurate. This is where your company CFO comes in. They can use the direct method of calculating cash flow to be accurate and up to the minute.
The direct method simply lists all receipts from the sale of goods or services; and payments to suppliers, salary, rent, and other operating expenses. This method can be more complex to prepare due to detailed data requirements but is the only method that provides an accurate statement of cash inflows and outflows.
The Direct Method Step by Step
Once you’ve established your starting balance, you’ll need to figure out your operating cash flow, which shows you how much cash your business generates from its operations.
Step One: If you’re using the direct method, you will list the actual cash transactions related to revenue and expenses. The direct method is straightforward but often takes longer than the indirect method since you need to subtract all cash disbursements from all cash generated from operating activities.
Step Two: The next step is recording cash flow from investing activities, including purchasing or selling long-term assets such as property and equipment.
Step Three: Next, you will need to identify financing cash flow from activities such as drawing down a working capital line of credit.
Step Four: Finally, you can determine your net cash flow by adding the operating, investing, financing cash inflow or outflow for the reporting period.
Summary
Although the income statement of a construction company is arrived at through work in progress estimates, the cash flow statement arrived at through this direct method is a precise real-time cash flow calculation. Keep in mind, cash flow is not the same as profit, which is the amount of money left over after paying all operating expenses. While cash flow is how cash and cash equivalents move into and out of a company.
For more information on the direct method, read more at: DIRECT
For a broader view of financial statements, read more at: STATEMENTS
To receive the free weekly Construction Messages, ask questions, or make comments contact me at research@simplarfoundation.org.
Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.
