Richard E. Gavin, CPA, CCIFP is a partner at Grassi & Co., CPAs where he heads up the Construction Niche Practice Group. Gavin can be reached by calling 516.336.2440.
Where's the cash? This question is all too common in the construction industry, and even profitable construction companies can have cash flow problems. For years, lack of control over cash flow has been a major contributing factor to the high rate of insolvencies in the industry; therefore, it is a subject that should be taken seriously by all contractors. Simply stated, contractors go out of business because they run out of money, not because they run out of work.
Contractors that are about to start a significant project or a significant amount of new work are especially at risk. What is the cash flow impact of this new work? How much of an investment will the company need to make before the project(s) produce positive cash flow?
In simple terms, cash flow planning is the charting of cash movement into the production process, then into accounts receivable, and back into cash. By compressing this cycle into the shortest period possible, a company can create more leverage for every dollar of working capital in the company. Preparing a cash flow plan is merely an attempt to predict the flow of cash during a future span of time. In our experience, companies with the most control over this process are the ones most likely to be in business ten years from now.
Cash flow problems can be caused by a number of factors, many of which are unrelated to job profits. Examples include:
- Labor-intensive work
- Payments made to suppliers or subcontractors before receiving cash payment from the related project
- Cash purchases of fixed assets
- Time lags between billing and collection of receivables (slow payers)
- Internal time lags between end of period date and submittal of requisition
- Investments in joint ventures
- Cash used for outside investments
- Cash advances or loans to officers or employees
- Overstock of inventory
- Unfavorable legal settlements
Today, construction companies are using many of the time tested cash management techniques that have been used for years in other industries. Cash flow problems can be controlled if they are identified and addressed early. If ignored, they can result in increased interest expense, increased investment of owners' capital, diminished credit ratings, inability to take advantage of new opportunities and ultimately, failure of the business. Many companies hesitate to engage in cash flow planning under the popular misconception that meaningful cash flow forecasts aren't possible. Although it's not an exact science, proper cash flow planning can help a business make intelligent decisions regarding budgeting, capital expenditures, financing, compensation and growth. It can help make the company more efficient and inspire the confidence of bankers, sureties, customers and other business partners.
In order to maximize cash flow and income, the data required to implement and monitor cash flow should be integrated with the contractor's procedures for estimating and bidding projects and for scheduling and monitoring performance on contracts in process. With today's advanced computer systems and lower prices for sophisticated construction software programs, such as Timberline, there is little reason for contractors to be unable to accomplish this integration.
Project planning is fundamental to the task of preparing a cash flow analysis. In order to analyze cash received and cash disbursed, the contractor must have a good understanding of when it is going to perform various segments or activities that comprise the project. It cannot be calculated simply as a function of time. It is imperative that companies determine when activities are to be performed and have a thorough understanding of the constraints of the technical relationships between activities and the availability of a company's resources.
For example, we recently began working with a new client who was experiencing cash flow difficulties. As we examined a number of their contracts, we noticed how activities triggered billing and identified numerous lost opportunities to improve cash flow. When we met with their project management personnel, we were able to show them these lost opportunities. In one particular contract, they installed a very costly piece of equipment two days after the requisition cut-off date. We advised them to review their contracts and share important dates with their team. They needed to focus on completing certain tasks before critical billing dates. Our new client learned a very costly, but valuable, lesson in planning. Not having a clear understanding of situations like this costs companies thousands of dollars and slows down the receipt of cash for at least thirty days.
Common Deficiencies that Drain Cash Flow
Some common deficiencies that drain a contractors' cash flow include:
- Not closing out completed projects-This can result in final change orders not being resolved and holds up payment of final requisition and retainage.
- Not having standard procedures to issue payment requisitions on a timely basis-Some public agencies pay within forty-five days, yet the contractors' average days of accounts receivable is more than seventy-five days. This means that thirty days of the cycle are within the company's control.
- Assuming there is nothing a company can do to speed up collections and ignoring the aging of receivables-Customers need to be reminded that they owe you money and that you haven't forgotten about them. Consistent (and persistent) phone calls are a must.
Cash Flow Strategies
While planning and monitoring are extremely important, there are also many simple action steps construction companies can take to improve cash flow, boost cash reserves and strengthen borrowing capacity. You can schedule payments by due date, considering the relative costs and benefits of any available discounts for early payment-mail checks as late as possible, but avoid late payments. When bidding a job, evaluate the cash flow impact of payment terms and retention release provisions. You can negotiate any appropriate changes before the contract is signed. You must plan the way a job will be billed before it starts: Although overbilling can improve cash flow, too much overbilling may mean that a contractor is borrowing from one job to pay for another. To avoid job borrowing, match payments to subcontractors and suppliers with collections from related projects. You must always avoid underbilling on projects.
An important strategy for general contractors is to apply retention to subcontractor payments that correspond to the retention applied by the owner. When dealing with public contracts, inquire about substituting municipal bonds for retainage. This technique generates interest income, which will boost cash flow and net profits. You must be sure that change orders and claims are billed and collected as soon as possible after they are approved. Other important strategies for contractors:
- Establish an adequate credit line with a bank
- Secure long-term financing for fixed asset purchases
- Consider leasing rather than purchasing fixed assets
- Make sure that delayed payments (e.g., claims and delinquent change orders) include increases for the cost of cash
- Consider depreciation methods for tax purposes that accelerate deductions and decrease tax liabilities
- Get involved in the tax planning process-understanding the tax impact of various activities and strategies is key to your business
Cash flow is just as important to a contractor's business as profitability. Cash flow planning is challenging and inexact, but it is critical to be aware of potential problems in order to minimize their impact on the business.
Construction Business Owner, June 2010