Master the Basics: Managing Cash Flow
Just like Vince Lombardi, owners and managers can achieve a level of success in their businesses by practicing the basics – starting with cash management. One of the primary reasons businesses fail is poor cash management. That’s because cash flow is the lifeblood of all businesses. Even a profitable business can have cash flow problems and face insolvency as a result of poor cash management. This could not ring truer than in the construction industry. Managing cash flow is essential for a contractor to mitigate shrinking profit margins.
There are several techniques that a contractor can practice to improve their cash management:
Track cash flow by project
Contractors should create cash flow projections for each of their projects. Depending on the length of a project, start by scheduling out how much work will be completed and what will be billed. Next, consider how much will be paid out to subcontractors and suppliers. The ending result will either be an estimated cash surplus or deficit of the project. Determining the estimated cash flow from a project will assist the contractor to assess the impact that the individual project will have on the overall company.
One of the best ways for a company to manage its cash flow is to always have it available to pay the bills that produced the revenue that provide future cash. With this in mind, start with billing at the contract phase. When negotiating the contract, negotiate billing terms that provide for a billing schedule that matches the time schedule of job specifications. A front-loaded billing schedule will call for a greater amount of cash in a project’s early stage to cover the significant upfront project costs.
No matter how good billing practices are at a company, billings are useless if they are not collected. An individual should be assigned to oversee the collection process at a company and review the company’s accounts receivable aging regularly. This individual must communicate regularly with the customer, the project manager and management. In the event collections become delinquent, the company must decide to withdraw from the project, withhold payment to any subcontractors or suppliers, and timely file the appropriate liens.
Managing Overbillings and Underbillings
A contractor’s overbillings and underbillings must be monitored on a regular basis. Significant underbillings should be avoided. A contractor is essentially financing a project where there are significant underbillings, and it could also be an indication that unapproved change orders are not being handled timely and accurately. In terms of cash flow management, a contractor should be in a net overbilled position on their financial statements and shoot for net overbillings of approximately 5% of annual revenue.
Retainage of 5 percent or 10 percent can comprise the entire gross profit on a project for a contractor, so allowing the collection of retainage until the project’s punch list is completed can strain a contractor’s cash flow and cost the contractor in the long run. A contractor should limit retainage to certain job costs, such as labor or eliminate it through the use of letters of credit, performance bonds, or other security instruments. In addition, a contractor should negotiate a lower percentage or ask for retainage to be phased out over the term of the project. For example, a contract might provide 10 percent retainage – reduced 5 percent when a project is 50 percent complete and eliminated when 75 or 80 percent completed.
Review the terms that the contractor has with its subcontractors, suppliers and other vendors. The payment terms should coincide with the anticipated cash receipts from the project’s owner or general contractor. Retainage provisions with subcontractors should mirror those that the contractor has with the owner.
These are just a few techniques to help the contractor with its cash flow management. Whether one or more techniques are utilized by the contractor, understanding the basics of cash flow management is critical to the success of the business – it’s just as important to a contractor’s business as profitability.
If you have concerns regarding the cash flow of your operations or would like to learn more useful cash flow techniques to better your business, consult one of Withum’s Construction Industry experts.
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