Managing cash flow is difficult for any company, but construction cash flow problems are some of the worst. Construction payment takes 83 days on average, according to PWC. (That’s among the longest of any industry in the world.) The rise of COVID-19 has increased risk even more, delaying projects and interrupting project funding. Slow, late, and partial payments can cause serious cash flow issues for construction businesses. It’s critical that companies in the industry address the practices that drain their cash, and build good cash flow management practices to prevent future problems.
On a construction project, cash trickles down from the property owner or lender to the lowest tier subcontractors and suppliers. With each step away from the top of the payment chain, the later payments get. Contracts generally push the risk for late payments down, rather than up the payment chain. So contractors end up struggling to pay their employees and suppliers, and, oh, make a profit.
It’s no wonder that, according to the 2019 National Construction Payments Report, 98% of contractors said they have threatened to file a mechanics lien to get paid. And 58% actually had to file a lien to get paid.
Discovering where your cash comes from and where it goes can be an eye-opening experience. Most owners focus only on the operational activities of a company. They may not see how decisions like financing purchases and selling assets can also make a difference in how much cash is available on a daily basis.
Let’s look more closely at what cash flow management is, problems in the construction industry – and possible solutions.
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What is cash flow management?
Cash flow is your business’s wallet. When you are looking at your company’s cash flow, you are mapping when cash comes in, and how much, and when cash goes out, and how much. The timing of these transactions can greatly affect the financial standing of your company at any given time.
A cash flow report will show how much money you actually have on hand at a certain point in time. You can send invoices to customers and receive invoices from suppliers and subs, and these will show on your financial statements as income and expenses. But until you actually deposit a payment from a customer or until a supplier deposits yours, those activities do not reflect in your cash flow. You can’t pay your electric bill with Accounts Receivable!
A contractor’s cash flow statement is an analysis of all the cash that came in and went out for a given period (usually one month). The period can be in the past or a projection for the future. Past reports are good to have around because they can help you spot trends and predict future report amounts. After all, the best predictor of future activity is past activity.
Cash flow management involves looking at current cash flow reports for your construction business, your predictions for cash flow in the future, and making business decisions based on that information. For example, if you know that you will be receiving a $100,000 payment next week, you can make decisions about what bills to pay today, knowing that the money will be there next week. If you didn’t know you had $100,000 coming in, you would make a different set of decisions.
This analysis is cash flow management.
The Problems: Construction mistakes that drain cash flow
High payroll burden
If your company does work that is labor-intensive, the financial stress of having to pay your employees every week or two can make cash flow difficult. The Construction Payment Report I mentioned earlier found that employee paychecks are the biggest casualty of poor cash flow caused by late payments. You can’t tell your employees that you’ll have to delay their paychecks until your customers pay their bills.
Companies who use a lot of subcontractors may not have as much of a problem. Their payments come only once a month and they can pass any payment delays down to their vendors. Many subcontracts contain a paid-if-paid or paid-when-paid clause, meaning that payment is not due to the subcontractor until, or unless, the owner pays the GC for the sub’s scope of work. These clauses push the burden of late payments on to the subcontractor and provide protection for the GC.
Paying bills early
If you always pay your bills as soon as they come in, this can leave you cash strapped. Waiting until more cash is available, or until the end of the payment terms, gives you more money to work with during the days in between.
While it is good to pay your bills promptly, if you continue to spend money you don’t have yet, you will end up in a negative cash flow situation (which is not good).
Failing to budget for retainage
Retainage – also called retention – is money withheld until the end of a project to ensure that the project is completed to the job specifications. A practice common in the commercial construction industry, retainage is typically 5-10% of the total contract.
If you are not used to having a portion of each progress payment held until the end of a job, and don’t budget accordingly, your construction company will run into cash flow issues. With average profit margins of only 5%, a 10% retention holdback means there isn’t any room to pay overhead or other expenses once payments come in.
Paying cash for assets
Creating positive cash flow in a construction business is all about managing working capital – the liquid cash you have in your bank account available to pay bills, wages, and expenses. If you are buying equipment or vehicles with cash, you are stealing money from yourself.
Financing large purchases frees up your cash to cover other necessary costs such as payroll or supplies. Yes, you’ll pay interest, but it’s a small price to pay for the cash that interest buys you today.
Slow paying customers
The longer you must wait for payment from a customer, the longer you are without the cash you need to run your business. They don’t just affect your future cash flow. Late or slow payments can also cost you more, as late fees and finance charges add up fast.
Being slow to invoice customers
Customers aren’t going to pay you until you invoice them. If your invoicing is slow or inconsistent, it is costing you money.
Using cash for other investments
It is a good idea to invest excess cash so you can earn more through interest and investment gains. However, if a sudden cash emergency comes up, you are often left with no quick way to recoup that money.
The Solutions: 12 ways construction businesses can manage cash flow better
Now let’s look at some ways that construction business owners, credit managers, and office managers can improve their company’s cash flow. The good thing about this list is that all these ideas are things you can do yourself, and they don’t require changing your customers’ payment habits.
Establish good accounting & financial practices
Every construction company needs the right accounting reports and financial statements to identify where their cash flow is healthy, and where it needs support. After all, you can’t manage what you don’t measure.
Businesses need to understand more than just how much money they have in the bank. You need to be able to quickly identify how each project on your books affected your cash position overall.
For example, an accounts payable report will help you identify aging bills that are accruing interest penalties. An accounts receivable report shows which customers are delaying payment, so you can quickly identify who to follow up with, or which jobs to lien. A cash flow forecast helps predict future cash issues, so you can take action before it impacts your bottom line.
These reports don’t need to be so complicated that only a CFO can understand them. At its core, tracking cash is simply about good record-keeping.Most construction management and accounting software can quickly produce these reports automatically.
Good accounting and financial practices help business owners manage cash flow, identify strengths and weaknesses, and make more informed decisions that help the company grow.
Finance fixed asset purchases whenever possible
Giving away all your cash to avoid interest payments doesn’t make sense when it comes to cash flow. By making smaller payments over time, you free up cash each month which can be used for necessary business expenses, such as payroll.
Another benefit of financing purchases is that you are building up a good credit rating. This rating comes in handy when you need to apply for a short-term loan or need other financing to help your business.
Negotiate better payment terms
Talk to your suppliers about how to get the best offer on the materials you need. This may include buying in larger quantities or even threatening to change suppliers to get better pricing. Make sure you are getting the best prices and the best payment terms you can from all your vendors. Your terms with your suppliers should ideally be equal to or longer than the terms you give your customers.
Ask the GC or property owner to purchase materials directly from the supplier
Down payments are rare in construction. According to the Construction Payments Report, only 4% of contractors say they get an upfront deposit regularly on jobs. If the GC isn’t willing to give you a deposit, ask them to buy the materials you’ll need. After all, they’ll be paying for them either way. If you can get them to pay for it up front, you’ll keep more cash in your own pocket for later.
Invoice promptly and regularly
Make sure you have a system for sending out invoices or payment applications promptly and regularly. Avoid delays in payment by following the billing schedule closely and ensuring that you include the required documents with each invoice. Get confirmation that invoices have been received and follow up a week after sending them to see if there are any issues.
Good invoicing requires close coordination between the project manager and the office or credit manager.
Be visible on the job by filing preliminary notices
Contractors and suppliers who file preliminary notices are generally going to be the first ones paid. The owners want to prevent a lien being filed! This can significantly shorten the time from invoice to payment. More and more companies are using these documents to leverage their lien rights and improve cash flow, so sending them doesn’t have the negative connotation that it used to. Implement a payment funnel or a company credit policy to help you know when to act.
Offer payment options and/or discounts for early payment
Offering your customers multiple ways to pay your invoice could speed up payment. Many companies like the convenience of paying by credit card, even for large purchases. Your accounting software or bank can help you set up merchant services so you can accept these payments. There is a transaction fee for each charge, but it can be worth it to get your cash faster.
You can also offer discounts for early payment to encourage your customers to pay quickly. However, don’t make the discount so steep that it negatively affects you if your customers choose to use it. About 2-5% is standard for the industry.
Avoid over and under billing
If you overbill a project, you’ll have an influx of cash up front, but nothing to cover expenses at the end of the project (when hidden costs tend to pop up). Underbilling doesn’t help either. It is best to keep your billing as close to your costs as possible, so you will always bring in enough cash to cover your expenses.
Process change orders as quickly as possible
Get additional costs and other change orders approved as fast as possible so you can bill for them and get paid as the costs come in. If you wait until the end of the job to bill, you won’t have the cash to cover the extra costs while they are being incurred.
Create accurate estimates
Using your estimate and job schedule, you should be able to project cash flow needs for a job ahead of time. The more accurate your estimates are, the more accurate your cash flow projections will be.
Speed up your closeout process
Waiting months on final retainage payments, which might represent your total profit on the job, isn’t good for cash flow. You need those funds to pay business expenses and invest in your company. Speed up collection by turning in your closeout documents as promptly as possible.
Protect your company’s right to file a mechanics lien
Every construction business owner worries about the risk of non-payment. A mechanics lien is one of the most powerful tools that construction businesses have to ensure they get paid. Since every state has their own mechanics lien laws and requirements, it’s important that someone in your company is tracking the different rules and deadlines. Make sure your payments are protected on every project by sending preliminary notices when you start work, sending a notice of intent to lien when payment is late, and filing a lien claim before the deadline.
A big part of managing cash flow in construction is about collecting what you earn as quickly as possible. Companies that implement a strict mechanics lien policy are able to collect payments faster and with less effort than businesses who only protect certain jobs.
Managing cash flow is the key to survival in construction
Cash is king, as they say, and that means getting paid for the work you do. Making it easier for your customers to pay you, spreading out your payments for assets, and invoicing promptly are only a few of the things you can do to better manage your construction company’s cash flow. And always make sure your payment rights are protected.