Work lights strung in a construction site | Cash Flow Problems in Construction

Managing cash flow is difficult for any company, but construction cash flow problems are some of the worst. Slow, late, and partial payments can cause serious cash flow issues for construction businesses. It’s no wonder that, according to the 2021 Construction Cash Flow and Payments Report, 71% of construction businesses say they’ve had to file a mechanics lien to get paid. And 4 in 10 filed more than 2 liens in just the past year.

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. Let’s look more closely at what cash flow management is, problems in the construction industry – and possible solutions.

What is cash flow?

Cash flow is a measurement of the cash coming into and leaving a business during a given period of time. Unlike an income statement, which may include revenue that has been recognized but not received, a cash flow statement is a record of all cash (or cash-like assets) that has been received or spent by a construction company. Many construction businesses produce cash flow statements on a monthly, quarterly, and annual basis in order to get a sense of their current cash flow situation.

Cash flow can either be positive or negative. Positive cash flow means that a business has more money coming in than going on, while negative cash flow signals that a business is spending more than it’s earning. Many different financial metrics can evaluate the health of a business, but companies with negative cash flow may have problems with liquidity, meaning that they may not have enough cash on hand for immediate obligations, like payroll, insurance, materials, or other project costs. 

Notably, some construction businesses can be profitable but still have negative cash flow. This happens when a company has recognized revenues higher than its expenses—but it hasn’t yet received all of its earned income. In construction, this can happen due to retainage, slow payment, long-term capital expenditures, or poor invoicing procedures. A construction company can also have positive cash flow but be unprofitable, which is why it’s important for businesses to look at several measures of financial health.

Finally, businesses generally look at both cash flow statements and cash flow projections. While a cash flow statement gives a good sense of how cash has been flowing in the past, cash flow projections provide an estimate of how cash flow will be in the future. By evaluating known (and expected) expenses and known (and expected) revenues, companies can determine where they may have upcoming cash flow shortfalls. In response, companies may choose to use debt financing or adjust project timelines to ensure they have enough cash on hand to fulfill their obligations.

The problem: Mistakes that drain cash flow

1. 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.

2. 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).

3. 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.

4. 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 equipment and other large purchases frees up your cash to cover other necessary costs such as payroll or supplies. Yes, you’ll pay interest, but it is often a small price to pay for the cash that interest buys you today.

5. 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.

6. 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. And just because you sent an invoice doesn’t mean your work is done, either. Having a process to send reminders is an important part of the invoicing process that can help you get paid faster.

7. 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.

Learn more: How to Avoid Running Out of Cash on a Construction Project

The solution: Cash flow management

Cash flow management is the process of analyzing expenses and revenue to control the flow of money into and out of the business. It 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.

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.

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.

1. Forecasting with a construction cash flow statement

A contractor’s cash flow statement or report 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.

Learn more: 4 financial statements every construction business needs

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!

Cash flow management refers to analyzing your construction company’s cash flow statements, and making decisions that speed up cash inflow while reducing or delaying cash outflow.

2. 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.

3. 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 are paid on time, every time.

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 to protect your payments 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.

4. 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 to use 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.

5. Negotiate better payment terms

Even before you join a project, you have the responsibility to negotiate the best contract terms for your company. This may include striking out pay-if-paid clauses, or adding terms that allow you to collect retainage faster.

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.

6. Finance materials to keep more cash on hand 

By financing materials for a construction job, you can keep more cash on hand for payroll, take on other projects, or make necessary capital expenditures. Programs like Levelset’s Materials Financing offer long payment terms and low financing charges that make it possible for contractors to pay for materials when they get paid—and stay cash flow positive. 

7. 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 your customer received your invoice(s), 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.

8. Be visible on the job by filing preliminary notices

Contractors and suppliers who file preliminary notices are generally the first ones to collect payment. The owners want to prevent liens! 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.

Discover how sending notices helped a restoration company shorten their payment cycle to 17 days.

9. Offer payment options 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.

10. 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.

11. Process change orders as quickly as possible

Get approval for additional costs and other change orders as fast as possible so you can bill for them and collect 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 as they occur.

12. 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.

13. 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.

Managing cash flow is 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 to protect your payment rights.

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