Managing cash flow in the construction business is a complex task that takes professional financial skills, flexibility, and constant focus. The elements of cash flow are all variables that could go for you or against you at any given moment. Let’s look at the fluid nature of each component of cash flow.
Step #1. Retained Earnings
This initial component relies on the forward planning prowess of the company’s owner and the profitability of each job as the company rolls along from infancy to viability. But you can’t retain earnings if you don’t have any.
- The competitive nature of the low-bid acquisition system has caused net margins in construction to shrink dramatically over the past half century from a robust 10 to 15 percent down to the 3 or 4 percent that is typical today.
- Construction profit and loss accounting has become quite muddled by the indistinguishable financial complexity of multiple ongoing jobs. Without a five-year profit and loss history it is almost impossible to isolate the profitability of individual construction jobs and clearly identify accurate corporate earnings at any given moment in time.
- Most privately owned construction companies rarely retain the meager earnings they do generate. The tendency is to invest earnings into fixed assets like a corporate headquarters building or a yard full of expensive equipment.
- Even financial professionals see a large cash hoard on a construction company’s balance sheet as an idle, nonproductive asset that could be put to better use. It is extremely difficult to accurately calculate the working capital capacity of a growing construction company and the importance of a robust retained earnings account to finance their growth.
Step 2. Front-loading Hopscotch
Frontloading is a common way to cover the unpaid upfront costs of a construction project. However, it must always be done with integrity and with the contractor’s eyes wide open. Desperate to manage tricky cash flow needs, contractors often forget the amount they successful front loaded and fail to make allowances for the attendant shortage of capital at the end of the project. This is why they “hopscotch” the front-loaded payment of the next project back to cover the uncovered cash flow of the previous job.
Step 3. Working Capital Line of Credit
The front money requirements in the typical construction contract combined with the scarcity of retained earnings make borrowing the primary source of working capital necessary. Banks typically provide these funds to contractors. The problem is they are rarely sufficient. Bankers often consider all lending asset based and limit the amount of these loans to the value of the collateral. This, of course, would be adequate if the contractors owned the structures they were building for their clients. However, they do not, and most banks default to the tangible net worth of the construction company and its owners to determine the size of a working capital line of credit. The size of the working capital line is, therefore, disconnected from the working capital needs of a growing contractor who is often required to simultaneously finance the up-front costs of multiple projects.
Step 4. Accounts Payable Aging
Typically, construction material suppliers work with creditworthy contractors on a “net thirty days” basis. The ability to extend payment terms out to 45 days or even 60 days is often a critical source of working capital for most contractors. However, this secondary source of working capital is never a sure thing. Favorable payment terms must be negotiated with vendors in advance. It is inappropriate to wait until you need the money and simply delay payment. Suppliers consider this tactic “underhanded”, and it will lower your credit rating as a result. They will be less likely to cooperate with your cash needs in the future and charge you increased markups if they do so.
Step 5. Accurate Billing and Timely Payment
Decades of consulting with contractors of all shapes and sizes has taught me a lesson: contractors are timid when submitting invoices and let owners and their agents dispute proper invoices and pay when they’re “good and ready”. My post-mortem audits on many contractors who ran out of cash in the middle of a job and their surety had to intervein revealed that many of them had not billed the job accurately and almost never demanded timely payment. Owners and their agents admitted that they would delay payment to simply let the dust settle and keep a tight leash on the contractor who they believed was “fudging” the invoices anyway. This attitude pervaded the entire industry and does to this day. Contractors must prioritize timely, accurate billing and demand prompt payment as stated in the original construction contract. Any timidity will be seen as an admission of guilt and will delay payment even further.
Professional Skill
Managing cash flow in the construction industry is a highly complex and critical financial management task that must be handled by a professional CFO. Even if you don’t feel you need a CFO for accounting data output, hire one just to manage cash flow. Believe me when I tell you that most of the contractors that suddenly failed and had to be turned over to their surety were competent, experienced builders who never took managing cash flow seriously.
Next week we’ll discuss the magic of professional cash flow planning.
For more information cash flow, read more at: CASH FLOW
For a broader view on financial management, read more here: MANAGEMENT
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