Cash Flow: Keep Water Out of Your Ship

A cash flow problem is a drag on the performance of a construction firm. Just as a foot of water in the bottom of a ship would cause it to ride lower, move slower and be a foot closer to sinking, it is problematic. Cash flow is a primary economic factor whether a contractor does well or not. Understanding this issue can keep your company profitable and thus, make your job of management easier.

How important is understanding cash flow? It is very important, in fact, we believe it is a top five issue. Why? Negative cash flow is the leading predictor of construction contractor bankruptcy.

As a company grows, it will become even more important for each project manager to manage the cash flow on all projects. Think of each project as its own separate business. It has its own profit and loss statement. Typically, that is equivalent to the job cost summary that you get regularly to update the status of the job. First it’s important to understand the difference between the concept of profit and cash flow.

•           Profit is the contract revenue less the cost of the contracted work.

•           Cash flow is the timing of those revenues and the payments of those costs.

Let’s start by stating that there exist some bills which are nonnegotiable. In other words, they have to be paid. What are these? Payroll is one. If you cannot pay your employees then, you have crippled or killed your construction firm. Construction is half people. Having or not having the money to pay wages and salaries is the reason that cash flow is such an important concept.

Additionally, there are cash and non-cash items. On an accrual basis of accounting, there are items we don't actually write a check for, but they do tell us whether we make a profit. As an example, depreciation is not a negative on cash flow. However, most contractors do book it yearly; they are not poorer in cash for doing so.

On the revenue side, the promise of future work is also a non-cash item. It is nice to hear however, you cannot pay expenses with it unless you can bill it and collect it.

Construction firms have been stung by this type of promise. They have paid for certain design or estimating costs only to have the contract go to someone else.

The difference between cash and non-cash is a clear concept to anyone who has managed through any of the recessions in the last 30 years. The danger is that there are items that will give you less cash to pay your nonnegotiable demand payments.

The basic cash flow problem is that clients tend to pay us in 45 days from billing (cash in). While, vendors want to be paid in 30 days and employees quicker than that (cash out).

To further complicate matters, no contractor has unlimited working capital. That is, no construction firm can be continuously cash negative and stay in business.

This difference in timing of cash in and cash out is not a problem while we are small and static. Once we take on more and/or bigger contracts, the gross dollars needed to fill that difference in timing can be huge. Unless, we have substantial cash reserves or a credit line, someone will go unpaid. Therefore, we stand the chance they will enforce their right to payment through the court system. At a minimum, vendors will charge your firm higher prices while limiting your purchases.

Recently, a young man approached me for counsel on starting a construction firm. After going through a checklist of necessary business and legal requirements, we turned to his cash needs. He is an underground contractor and felt he would need to buy a backhoe. We discussed this for a while and we concluded since he didn't have contracts in hand, he couldn't predict the utilization and therefore the billing for this piece of equipment. He is going to do some work for his former employer. Again, some work but, past that there are not locks on other business. In his first year he has chosen to rent. Then, as he does have a predicable revenue stream, he can cut his cost by buying instead of renting. He will only fail, if the demand for cash exceeds the inflow of cash plus his cash reserve.

By renting in his first year, he additionally benefits by not having pressure to "get a job". There is no onus to cut price to get the next job. This allows him to ask for and receive a fair price. He can be patient.

Project cash flow in the construction industry is defined as total billings less our obligations to pay for the work performed. Sometimes projects have negative cash flow situations. Here are some scenarios that could cause this to happen:

Under-Billing the Client – This can be prevented by creating a schedule of values which accurately reflects costs to be for work early in the project.

Inaccurate Project Budget – If the budget isn’t current up to date, comparing the field projections with financial figures will show some disparity and provide numbers that can place you upside down.

Special Payment Terms – agreements made with subcontractors (if applicable) and distributors are sometimes necessary, but can cause the project to be in a negative cash position.

Project Started in a Negative Cash Position – Hopefully, this is a temporary situation and is eventually worked out as the project progresses. Otherwise, there may have been a budget bust of a large proportion.

Uncollected Change Orders – All projects have changes and hopefully all change orders are paid. The contractors who aren’t able to effectively collect their rightful costs plus overhead and profit are certainly affected in both cash flow and profitability.

Know where you stand on each project. Financial profits are derived by calculating the percentage of completion on a job multiplied times the estimated project gross profit. If projects are profitable then your firm will be profitable. The first step is to calculate percent complete. The equation is:

                            Total job costs incurred

 ___________________________________________

Total job costs incurred + Projected costs to finish project

Yes, it is very important to re-estimate the remaining costs on the project.

Profits are like oxygen to a company. They have to be collected if you are to stay in business. If those profits are never collected, our economic success is non-existent. The ability to keep financial demands satisfied (positive cash flow) allows our company to deliver profits. This funds our salary, bonuses and dividends. Thus, our personal financial independence grows.

For more information on this critical subject, purchase a copy of my McGraw-Hill book, Managing a Construction Firm on Just 24 Hours a Day. We offer a bundle with Excel templates that are featured in the book and 5 on-line courses to help teach construction business concepts.

Our workbook companion with 10 case studies for Managing a Construction Firm on Just 24 Hours a Day is now available. This text is focused as an assist for Colleges, Associations and Contractor Training Programs that teach the business of construction.

My next book, The New Business Model of Construction Contracting is planned for December 2007. It focus concerns the changing construction environment and what processes address those changes.

Matt Stevens is President of Stevens Construction Institute, Inc. A management consulting firm which works only with construction contractors. Learn more at www.stevensci.com