The Science of Cash Flow Management

All competent builders should succeed. There is no reason for the contractor failure rate to be the second-highest among all American businesses right behind restaurants. However, because of the complex nature of cash flow in the construction business, without careful management, contractors often suddenly run out of cash and are forced to closeup shop. As I indicated last week, “We are not a “cash and carry” business, therefore, our cash flows are intermittent and vary in source, flow rate, and cost. Managing the flow of cash is perhaps the most important management skill a contractor can have. Last week we discussed the art of cash flow management. This week we’ll look at the science of cash flow management.

Sources and Uses of Funds

A Sources and Uses of Funds statement is a summary of a firm’s changes in financial position from one period to another. It was also called a flow of funds statement or a statement of changes in financial position. These reports were designed to distinguish cash flow management from profit and loss performance. (In 1989 the accounting profession finally settled on the Cash Flow Statement that we use today.) 

From an accounting perspective, this report was a clever and useful innovation, especially for the construction industry. It focuses on liquidity and reveals where cash comes from and where it’s being used on an ongoing basis. As I have said in these last few messages, this information is critical to contractors who, because of the unique nature of cash flows in construction, can find themselves illiquid and out of business even when they are profitable. 

Cash Flow Statement

Along with an income statement and balance sheet, construction accountants routinely produce a cash flow statement that is often little understood by construction top management and largely ignored. Because this part of routine financial statements is produced after the fact, (and in many cases only quarterly or annually) many hands-on construction CEOs see little use for this report. However, monitoring a company’s cash position is essential in any business, but critical in the construction business. The income statement reflects profit but does not give any indication of the cash components. The important information about what the business has been doing with its cash is provided by the cash flow statement. The cash flow statement shows a business’s cash inflows and outflows over a given accounting period. It provides information about the changes in cash and cash equivalents of a business by classifying cash flows into operating, investing, and financing activities. Most construction CEOs I have worked with over the years did not properly utilize cash flow statements to reduce their risk of running out of cash. (Use your CFO. Rely on the information)

Creating The Cash Flow Statement

The cash flow statement is created by listing the changes that have occurred in all of the balance sheet items between any two balance sheet dates. The cash flow statement shows how changes in balance sheet accounts can affect the cash which is available to a business. It is noteworthy that the cash flow statement covers the flows of cash over a period of time (unlike the balance sheet that provides a snapshot of the business at a particular date). Here’s how this report is generated:

The SOURCES of funds originate from:

  • A decrease in liabilities or an increase in assets
  • Net income after tax
  • The disposal of fixed assets
  • Proceeds of loans obtained
  • Proceeds of shares issued
  • Repayments received on loans previously granted by the company
  • Any increase in net working capital

The APPLICATION of funds includes:

  • Losses to be met by the company
  • The purchase of fixed assets/investments
  • The full or partial payment of loans
  • Granting of loans
  • Dividends paid
  • Any decrease in net working capital

(Examples of construction industry cash flow statements can be found on construction accounting websites across the web.)

A Management Tool

When the cash flow statement is utilized as an integral part of a contractor’s projections and budgets, it goes from being an interesting report to a critical management tool. Starting with your company’s opening balance sheet, your accounting department can predict for every project the timing of deposits, progress payments, working capital utilizations, necessary capital expenditures, necessary increases in debt, and even increases in equity contributions as each project progresses. By integrating a cash flow statement into the budgeting process, the accounting department can track the company’s liquidity status and future cash needs and utilization accurately. No longer relying on financial reports that are compiled from field “estimates” of how far along each project is, contractors can manage the liquidity of their company by relying on the cash flow statement as an accurate picture of the company’s current cash position and future needs. (Again: Use Your CFO. Rely on the information.)

Next week I’ll talk about how to integrate the cash flow statement into your company’s budgeting process. Check this space.

Details on these issues in my latest book The Secretes To Construction Business Success, published by Routledge

For a deeper look into construction accounting, read more here:  CONSTRUCTION ACCOUNTING

For a broader view into financial management, read more here:  FINANCIAL MANAGEMENT 

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