Cash Flow: Long Live the King!

Cash is King. Every profit-minded business should take this saying to heart. But the capital-intensive nature of most construction businesses makes it that much more important to manage cash flow effectively. Failure to do so can undermine a seemingly healthy business or worsen problems during lean times. By taking some well-planned steps, you can ensure that enough cash will be available when you need it.

1. Cash flow management starts with knowing the customer. Before accepting any work, find out if any liens have been placed on past jobs or if the owner or general contractor has a history of litigation. Local chapters of the Better Business Bureau and trade associations can provide such information.
2. Billing and payment terms are another essential factor in cash flow management. Establish payment parameters in the contract, and consider negotiating for accelerated billing terms. Keep in mind that if work was completed early in the month, end-of-month billing can result in a billing cycle that is closer to 60 days than 30 days.
3. Cash flow projections can reveal looming shortages that would otherwise catch you by surprise. Estimate when costs will be incurred and paid and when progress billings will be collected on current and expected contracts. Compile these project cash flow projections, along with anticipated indirect costs, into a company-wide cash flow projection. This timeline of cash flowing into and out of the company gives you an indication of when you'll need to draw on a line of credit and when you can start paying on overhead items.
4. Accurate job-cost allocation ensures all expenses are accounted for and recouped. While labor and overhead costs are usually factored in when determining the contract price, they are often neglected during the accounting phase. Be sure to allocate these costs properly. Otherwise, you may be understating your costs, which can lead in turn to understated progress billings.

Remember: Profitability is ideal, but your company will ultimately be measured on how much cash it has at the end of the day.

Cash Demand Period

Key financial performance indicators (KFIs) help provide company focus, align organizational action and serve as financial benchmarks to guide performance. Periodically, ProfitClue will focus on one of the KFIs that construction companies should monitor.

By monitoring Cash Demand Period (CDP), contractors can anticipate and take steps to prevent cash flow problems. CDP is essentially the difference between the length of time it takes to receive payment for inventory and work-in-place and the length of time you have to pay creditors.

The formula to calculate this KFI is:

(Days in Accounts Receivable + Average Days' Underbillings) -
(Days in Accounts Payable + Average Day's Overbillings)

To reduce the cash demand period and minimize the amount of cash needed to fund operations, pay attention to the following critical factors:

1. Minimize underbilling. If a project is persistently or significantly underbilled, there may be quality or performance issues at fault. Dig deeper to reveal and respond to such problems quickly and ensure those receivables turn into cash.
2. Maximize overbilling. Negotiate progress payments based on a schedule of values, and discourage payment based on invoice, which requires excessive accounting support and can result in project costs missing the billing cycle.
3. Reduce the amount of time it takes to collect receivables. A formal and rigorously followed collection policy is your best bet here. Hold project management accountable for receipt of payment and get senior management involved with aged receivables.
4. Use – but don’t overuse – credit. Bad things happen even to good companies. Prepare for that possibility by establishing a line of credit well before it’s needed.

Contact our firm to learn more about key financial indicators for construction companies or to request a copy of our Key Financial Performance Indicators Best Practices Guide.

Q: What are some practical steps I can take to improve cash management?

A: Consider the following cash-flow boosters:

1. Negotiate for early release of retainage billings, or total exclusion from retainage. Expedite the punch list closeout phase to free up retainage billings more quickly.
2. Take advantage of purchase discounts by paying early. And if payment terms don't allow for discounts, pay on time, but not before. On the flip side, consider offering early payment discounts as an incentive to your customers.
3. Use all cash equivalents before borrowing for working capital needs, and do not use short term financing to pay for purchases of long-term assets, such as heavy equipment.
4. Perform year-end tax planning before the end of your fiscal year to take full advantage of all income tax deductions and deferrals.
5. Compare actual job costs to estimated job costs regularly in order to highlight any problems before it is too late.

Porter Keadle Moore, LLP is a founding member of ProfitCrew, an association of accountants and business advisors dedicated to helping homebuilders and real estate developers build profitable businesses. For information, contact Adam Polakov at apolakov@pkm.com or Arvil Stanford at astanford@pkm.com or visit www.pkm.com.