Cash management in any economic environment is crucial as it’s the life-blood of any business. As the saying goes, “Cash is king”. Cash is even more important for construction companies, which have additional cash requirements and restrictions. Although the Great Recession has passed, the aftermath is that the Federal Reserve has much stringent compliance guidelines for banks. As a result of this or of what’s happening within their own lending portfolios,, many banks have reduced their lending to small businesses. As such, it is vitally important that businesses fully understand their cash needs IN ADVANCE and make adjustments to their operations to ensure that cash is available. Otherwise, your company could find itself in a liquidity crisis –unable to meet payroll, pay suppliers or pay subcontractors – which leads to bankruptcy or an operational shutdown.
Cash Is not Income – An Example
Cash is NOT income. Let’s assume you enter into a $200,000 contract to provide interior fit-out services which will take you about 30 days to complete. According to the contract, you submit invoices once per month (fairly standard in commercial construction) on the 25th, and the general contractor has 30 days to pay you. You commence work on October 1. Before you begin, you buy materials such as drywall, nails and other supplies.
Payment to Tradespeople and for Supplies (Cash Outflow)
You pay your tradespeople and foremen every 2 weeks so a check for their work is due on October 14. You buy materials and supplies for the last phase of work. You submit your invoice for $160,000 for work completed by the 25th, as per the contract. You pay your tradespeople again on Oct. 28. Assuming you have properly estimated the job and had no cost overruns, you have already spent, IN CASH,$140,000 – $160,000 on materials and supplies, equipment or equipment rental, personnel and miscellaneous.
Payment Received (Cash Inflow)
Now you must wait until November 25 to receive payment. However, you only billed for 80 percent of the project, so you will only receive $160,000 maximum. You completed the job and bill for the remaining 20 percent or $40,000 by November 25th which you will receive by December 25. That assumes there is no retainage. With government contracts or bonded contracts that retainage is typically 10 percent, or $20,000 in this example. If your contract calls for retainage, then you may have to wait several months before you receive the final $20,000.
Cash Flow Determination
So you spent $140,000 – $160,000 of your money in October: perhaps $30,000 the 1st week, $55,000 the 2nd week, $20,000 the 3rd week and $55,000 the 4th and final week. You do not receive payment until November 25. You have a cumulative negative cash flow from this job of -$30,000 the 1st week, -$85,000 the end of the 2nd week, -$105,000 the end of the 3rd week, and -$160,000 the end of the 4th week. This negative cash flow or cash flow shortfall continues for four more weeks until you receive your first check of $160,000 for the project at the end of the 8th week. Upon payment your cash shortfall goes to 0.
However, if you had a 10 percent retainage, you’d only receive a check for $144,000 and you’d still have a negative cash flow on the project of -$16,000. A little over four more weeks later you’d receive the second and last payment of $40,000 (again, assuming no retainage).
Profit vs. Cash Flow
Yes, on this job you have a 20-30 percent operating profit. This looks great on paper. However, you also have negative cash flow for as long as 12-13 weeks or as little as eight weeks, and you are likely struggling financially trying to come up with cash to pay your people and your suppliers. We have all heard of subcontractors who went bust during a job and another one had to come in and take over. This unplanned cash flow shortage is the primary reason construction companies go out of business. If you do not have overlapping jobs with payments coming in that can cover the cash flow shortage, your business is hurting. You must engage in this type of budget planning and analysis before each and every job in order to plan your cash needs accordingly.
Workarounds / Ways to Mitigate
One way to mitigate the cash outflows is to get terms from your suppliers on your materials and supplies. If you can get 30-45 day terms, you can reduce both the amount of the negative cash flow and the length of time cash flow is negative. Another way is to use subcontractors instead of trade personnel and subject them to the same payment terms you are under with the contractor. Thus, instead of paying tradespeople every two weeks, you pay the subcontractor within 30 days of the submission of the invoice. In both these instances you align your cash outflows with your cash inflows as a way of negating or minimizing negative cash flow.
(Please tune in tomorrow to read the remainder of the article, in Cash Management for Construction Companies: Part 2. http://theresourcefulceo.com/2015/12/cash-management-for-construction-companies-part-2/ )