A construction company’s cash flow reflects its overall business state. In many cases, negative cash flow pushes a company not only into financial trouble but into its demise.
In a recent survey, more than 80% of companies reported that they’re experiencing cash flow issues. Of these companies, almost 20% said that combating negative cash flow is a constant issue.
- Identifying Cash Flow Issues
- Collections & Billing
- Accounts Receivable (A/R) and Accounts Payable (A/P) Timing
- The Closeout
- Tips on Construction Cash Flow Management
- Close the gap between collections and payments
- Use Cash Flow Projections to Plan
- Secure your right to file mechanics liens and bond claims on all projects
- Establish a relationship with funding sources
- Negotiate with vendors
- Process change orders STAT
- Bill consistently
- Manage your DSO and other financial metrics
- Building company-specific cash flow practices
Identifying Cash Flow Issues
Saying that a company’s cash flow issues stem from plain mismanagement is grossly simplifying the problems that can cause businesses to be in the red.
Read on to learn more about the possible reasons behind cash flow issues and how to address them.
Collections & Billing
It’s very common in construction to have issues in collecting unpaid invoices.
As an industry, these payment challenges seem almost ingrained in construction’s DNA.
Nonetheless, it’s an issue that puts many businesses in a very precarious situation.
This challenging nature can easily negatively impact a company’s ability to maintain a positive cash position, left with stacks of overdue invoices.
In contracts, the mode of collection and its schedule are usually spelled out explicitly, but that doesn’t always mean that (1) you will get paid and even that (2) on-time payment will ensure cash flow.
Making the distinction between profit and cash flow is important.
Net profit and cash flow are different things.
Some will advise that one of the first things you should look at when cash is getting harder to manage is if you’re not charging enough. Many contractors and subs do make this mistake, but since profitability is always top of mind for many people going into business, it rarely is the only reason why cash flow is tight.
Remember: You might know that your profit is based on revenue minus cost of goods and operational expenses, but the fact is that it will not impact your cash flow unless you’ve collected the cash.
Net profit is what’s printed on the report while cash flow is cold, hard cash you have on hand.
Contractors and subs can find themselves being profitable but still tight with negative cash flow — it doesn’t matter if there’s just one project underway or multiple.
There are also cases where the way a company bills explains its negative cash flow.
Successful contractors and subcontractors always have multiple projects running and not billing your clients on a timely and consistent manner can throw a wrench on cash flow.
To get a clear picture of how the way you bill is affecting your cash flow, pull up the following reports:
- Job Cost reports
- Work in Progress Schedule
- Job Profitability report
If you’re underbilling on a project or are burning too much cash before collecting on bills, you can be in the red.
The report that can help you most in getting an overview of how your cash flow is doing as a result of billing and collections is the accounts receivable aging report (A/R aging report).
Examining this report, you’ll see who hasn’t paid yet and you can compare that against your billing schedule and the job cost report. Setting up invoice terms on the contract isn’t always a guarantee that a client will stick to that schedule. If all accounts are billed out but the invoices are still outstanding for 60 to 90 days, that’s a collection problem.
Inconsistent billing and payment delays combined will likely lead to negative cash flow if not addressed the right away, which leads us to the next issue.
Accounts Receivable (A/R) and Accounts Payable (A/P) Timing
As you know, A/R refers to your collectibles while A/P refers to your payables. A cash flow crunch can be the effect of bad A/R and A/P timing. How?
Simple: If you pay your vendors before you get paid, you will burn cash, and that can result in negative cash flow.
Being able to relate with business owners, you might want to be helpful to your vendors with their liquidity by paying them right away and signing on to tighter payment terms like paying upon invoice or a net 10-15.
However, you’ll find that if you are paying your suppliers and vendors before you get paid, it will eventually turn around and hurt you.
It can be tricky to figure out a cadence that’s both not overkill in terms of stretching the terms with your vendors and also getting you to a good cash position, but looking at your Job Cost Detail report can help you with that.
Look at the way cash flows in and out throughout a job on your Job Cost Detail report. See if you’ve set up the terms with your vendors longer than the terms you’ve agreed on with your client.
You must be diligent when it comes to making sure that you get paid first and putting that in your contracts. If your collectibles are net 60s and all your payables are net 30s, timing’s definitely affecting your cash flow negatively.
Another potential source of cash flow woes is the ballooning of costs during the final days of a job.
Many construction owners are familiar with the term “the best 98% contractor,” about being really good and diligent with finishing the project in stages up until the final one: the closeout.
The last few days of a job truly impact not only the overall success of a project but also your profitability. A contractor’s work is remembered not really by how a project is started but how it’s finished.
Some last-minute hitches can easily turn a model project into a full-blown catastrophe — and this happens more often than many contractors would like to admit.
Imagine: Everything working well and everyone looking like they’re in the zone until a couple of things don’t go as planned, derailing the whole project and taking it down in the process. It really does happen.
The nightmare can be anything from issues in employee scheduling or suppliers not doing their end of the bargain and being flakey toward the end of a job.
It’s also not unusual for clients to show up on the final days being critical about everything on the job site — questioning why equipment is still there or why it’s so disorganized. It doesn’t matter if their complaints are valid or not. What they see and how they act upon it can quickly derail a project. A minor change order can become a full-blown claim because of slight miscommunication.
Even when everything seems to be going right, closeouts can suck up a lot of money, especially when projects are slowing down and sitting at 98% completed. These delays can extend the need for laborers and other resources.
The adage that time is money is definitely true in construction — especially when you consider retention. Delayed closeouts mean you won’t have access to that retainage that you’ll only get when you finish the job 100%.
It’s common practice in construction to have 5 to 10% of the contract price to remain withheld by the client and can only be released when the job is done.
While this may seem like “gravy” on paper, the reality is that the retainage is often what contractors and subcontractors are counting on to reinforce positive cash flow or recover from negative cash flow throughout a job.
Consider this: According to the CFMA, the net profit margin for subcontractors hovers only around 6 percent.
What does this mean?
It’s typical that a contractor is operating at cost throughout the project and can only get their net profit when the retainage is released.
Generally, many if not most contractors are not making enough profit throughout the job to cover retention.
In cases where the retention is more than the net profit (a 10% retainage on a 6% net profit project), being pushed to a cash deficit is just a fact until retainage is released.
For larger and longer projects, not having access to that last 10% can be a heavy financial burden to the contractor. Coming up with other sources of cash to roll over to finish the project can push a contractor to pursue means that will slash their profits.
Given the issues we’ve discussed earlier in this article, like collection problems, billing inconsistencies, delayed closeouts, and other problems that can stretch a contractor’s cash flow thin, retainage can really hurt a contractor’s cash position.
Of course, we’re not saying that retention in itself is something that needs to be removed as a practice. It’s there for a reason: it protects the client from dishonest contractors and subs who are out to make a quick buck.
However, construction companies that have positive cash flow always make sure to manage retention strategically.
Looking at the A/R Aging report, you can do a quick computation that reflects the state of your cash flow.
Calculate what percentage of your A/R is retention. If it’s more than 30%, your cash is moving at a snail’s pace, tight and stuck. In a perfect world for a contractor, retention is zero, and in some cases, that’s possible. But that’s more the exception rather than the rule.
Growth is a great “problem” to have, but it burns a lot of cash!
When revenue is snowballing — more new clients signing on and project totals are increasing — additional costs will be incurred and will need to be floated.
The reality is that getting a project off the ground requires a lot of cash. Front-loaded expenses and costs are the norm. You’ll have spent a significant amount of money at the beginning of a project when things start rolling.
We’re talking paying for deposits, supplies, labor, and other things that are either absolutely needed for the project to begin or are most cost-effective when bought ahead, in volume.
Floating these costs are typical for items that the contractual deposit can’t cover in the immediate but are necessary for the project; and, of course, the return on the spending will not be made until some time later on the project, or at the end of the whole thing.
On a more strategic view, a construction company in growth mode is expected to burn 30% in cash, meaning expect to spend 30% of the growth in cash to support and maintain it.
If you’re currently in growth mode, chances are you feel that cash crunch. To get a clearer picture of this, look at your revenue and costs records for the period where you’re growing. You’ll see how growth tightens up your cash position.
Again, this is a good problem to have, but later we will talk about how to not put you in the red even in growth periods.
Tips on Construction Cash Flow Management
Close the gap between collections and payments
Review the terms on your contracts, for both clients and vendors.
The key is to make sure you get paid first before you pay so you won’t be dipping into your cash on hand (buffer). Sure, vendors want to get paid, and you understand their situation, but it’s never a good thing to have longer terms for your clients than you have from your vendors.
What happens here is that you either go in the red, or you finance vendor payments.
Of course, financing vendor payments and taking out small business loans is not always a bad option but don’t make it the norm. Only consider this if on-hand cash is really slim.
Use Cash Flow Projections to Plan
In construction, no two projects are the same, making it a bit more complicated to project cashflow than typical businesses. The variety of projects paired with how much a project can change in the middle of a job makes cash flow projections in construction requiring more sophistication.
Thankfully, the technology to assist finance departments in making these projections are well-adopted in construction. Construction management and accounting software allow contractors to get the data on their current cash position as well as a general idea on their income and payables that are still to come.
Having these at hand is very useful because they allow construction companies to plan their finances in anticipation of their upcoming project costs so they can prevent dipping into negative cash flow.
Secure your right to file mechanics liens and bond claims on all projects
When it comes to collections, there are a few things you should do at a minimum in order to be able to collect and minimize if not eliminate the chance of non-payment.
Being cautiously optimistic is important when dealing with collectibles in construction. You’re always planning ahead while anticipating payment issues to arise — not because you’re not confident you vetted your client thoroughly but because situations change and things can happen.
At the very least you want to know that you’re entitled to options when it comes to getting paid and going after delinquent accounts, not leaving your cash position in a tight spot.
The ideal scenario is to get paid as fast as possible. Aside from the payment terms on your contract with the client, one of the most powerful ways to encourage early or timely payments is by pro-actively sending Preliminary Notices for all your projects.
The primary function of a Preliminary Notice is to secure your right to file a mechanics lien in case payment issues do arise but its other positive “side effect” is that it reinforces prompt payment. They are not threats.
Sending preliminary notices are an industry standard practice, and you’ll find that the most liquid and successful construction companies send pre-liens on every single project.
Sending Preliminary Notices or Pre-Liens helps improve your cash flow by getting you paid faster while also limiting the number of invoices you write off.
Establish a relationship with funding sources
Whether it’s your bank or a factoring service, it’s important for construction companies to maintain a healthy and open relationship with funding sources. The key is to always communicate with them, update the account manager on the goings on in the financial side of things, and establish a “consultative” relationship with them.
Why? There are situations where financing costs — like what we’ve discussed about vendor payments — is better, even when there’s interest.
Being in the red is much worse than losing a small sliver of profit by financing.
Paying costs upfront only makes sense if the discount is really attractive but a contractor should strongly consider financing costs to spread out expenses. This leaves cash on hand for operations even when you’re nearly strapped.
Negotiate with vendors
Suppliers are always working on getting new customers and retaining their current ones. Make it a routine to check up on prices and shop for the best offer on materials— both specialty supplies and those that you always need. When you tell suppliers that you are shopping for the best offer, you’ll find that you’re going to get better offers and even price matching.
This is especially helpful when you’re more liquid. It’s easier to negotiate when you have cash on hand, so this tip is more pre-emptive than the others.
Process change orders STAT
Change orders are just all in a day’s work of a contractor. From rental renovations and home improvement projects to working on commercial buildings, change orders are common and to be expected. However, when they’re not addressed and processed quickly, they can take up more resources than they could have. Situations change, and you can also get a client that changes their mind at the blowing of a breeze.
Process the change order before it becomes a full-blown claim. You can bill for the change order quicker — and collect faster.
Schedule the sending of your invoices and bills regularly. You don’t need to wait for certain milestones to bill your clients. By establishing a regular cadence of billing, say every two weeks or even every week, your client will be able to take you up right away in case of issues, and they won’t forget to settle your invoices.
It’s always better to overbill than to underbill. However, the best practice is to bill often and regularly!
Manage your DSO and other financial metrics
Setting a goal and keeping it on the board for your A/R and A/P team increases the likelihood of hitting the target. Net 60s and Net 90s are typical in construction, as we’ve discussed, but shooting for shorter terms and overall better daily sales outstanding (DSO) can significantly impact your cash flow.
A few things to do to shorten pay cycles:
- Bill regularly.
- Vet your clients thoroughly. Check credit reports.
- Send Preliminary Notices/Pre-Liens for all projects.
- Spell out the payment structure on your contract.
- Establish flexible terms to offer in case of delinquent clients.
- Incentivize early payment.
- Provide multiple payment methods — the more accessible and more straightforward, the better.
Building company-specific cash flow practices
Optimizing your processes in order to serve your effort to improve cash flow management is always an ongoing process, much like personal finance. For each project you wrap up, assess what could’ve been improved and identify what lessons have been learned. From there, use the information to refine and polish your existing processes.
Make it a company-wide effort. Be open to adopting new technology or replacing old ones if it will serve a purpose in improving your company’s cash flow.
Making an investment toward building your own best cash flow practices will yield an impactful and positive ROI, keeping you away from a cash flow crisis.