Cash flow key to contractors’ success
- August 5, 2009
Cash flow is as important to contractors as gasoline is to cars. Both are needed to keep things moving forward. And when the gauge is on empty — or, in the case of business, cash flow dries up — things grind to a halt.
In fact, when you consider how important cash flow is to the business, it is surprising how many good contractors do good work, but struggle when it comes to taking care of their business.
Without a doubt, the last two years have been among the worst for the construction industry in decades. As a result, contracting businesses have failed. Perhaps just as startling as the number of business failures is the number of contractors who have managed to keep their companies in the black throughout this turbulent period. Their secret? In most cases, continued viability has been fueled by successful cash flow management.
Contractors often focus on cash flow only at the end of the fiscal year, and then only for financial reporting purposes. For a construction business to be truly viable, cash flow must be the prime consideration each and every day of the year.
Cash flow for contractors generally comes from four sources: profitable jobs; equity contributions from the owner, which are typically made in tough times to meet cash demands and provide equity by increasing the company’s overall bond rating; loans from the owner, which inject cash into the company but with no impact on bonding; and outside financing, which usually involves a line of credit, equipment financing, or lease versus buy decisions on equipment.
To manage cash flow, a contractor must begin by properly budgeting company overhead. Estimating general and administrative expenses for the coming year allows a contractor to determine not only what is needed to break even, but also how to structure each bid in order to provide a sufficient profit margin.
Contractors also need to regard each job as its own profit center. There is simply no room to make up losses on one job with profits from another. As a result, cash projections should be reviewed in the early stages of each job.
To accurately project cash flow, contractors must take into account their current workload and whether their labor force is already being fully utilized. If so, costs for added labor must be factored into the equation. Contractors also must have some sense of the financial stability of their customers and past-payment practices. They must consider any penalty or incentive provision, billing specifications, or payment terms that are included in the contract. And finally, they must recognize that the location of the work can have an impact on their cash flow projections due to variable wage rates in effect in some locations and the role weather may play in completing the job on time.
Assuming the job is still viable after considering all of these factors, the contractor must then analyze cash receipts (billings, retentions, and claims/change orders) against cash disbursements (bid costs, preconstruction costs, labor, materials, subcontractors, and overhead) in order to arrive at the net cash flow for the project.
Analyzing cash flow will not necessarily prevent cash flow problems. It will provide a contractor with a much better sense of the relative worth of each project, though, and when combined with an analysis of other projects underway, better information about the direction of the company as a whole. While analyzing cash flow will not prevent bad times from occurring, it will give contractors a better idea if tight times are ahead. As a result, contractors can be better prepared to deal with cash shortfalls.
The best way to deal with cash shortfalls, of course, is to prevent them from occurring in the first place. While that’s not always possible, improving cash flow begins with billings. Contractors should always seek contract terms that allow them to accelerate cash flow.
A contractor’s billing terms should provide for a billing schedule that corresponds to the time schedule established in the specifications for the job. Many contractors, for example, find that charging higher markups in the early stages of a job and then taking lower markups toward the end of the project allows them to earn the entire gross profit upfront. This can be dangerous, however, if the contractor falls into the trap of taking funds from one job to cover losses on another.
It is also essential to submit billings according to the terms spelled out in the contract. Rather than waiting for the entire project to be completed, smart contractors will structure a contract so that they can bill as soon as one or more components of a job have been completed. Similarly, contracts which permit billings for cost-plus jobs may allow contractors to estimate costs during a period and then make cost adjustments as necessary near the end of the project.
Billings mean nothing, though, if the contractor can’t collect. If such instances occur, the contractor must communicate immediately with the customer, the project manager, and his own management team. And if the matter cannot be resolved quickly, the contractor should have an established procedure for filing liens and should not hesitate to use it.
Beyond collections, contractors should carefully monitor under-billings and over-billings, both of which present potential problems. Over-billings are only good if that money is already in the bank or in receivables waiting to be collected, while under-billings indicate the contractor is financing the project. Finally, contractors must manage the punch list at the conclusion of the project. Not doing so slows collections and ultimately hurts cash flow.
The bottom line? Cash flow can make the difference between a contractor who keeps on going strong and one who is stalled by the side of the road.