The importance of cash flow for contractors cannot be understated. Understanding how cash flow works may be the most important business practice a contractor can learn. A common misunderstanding, I often see with contractors is how cash flow can affect their businesses. It is often assumed that a project with profit is always a good thing. This kind of misunderstanding can put stress on the business and even put a contractor out of business. A famous saying in the industry goes, “contractors do not run out of work or net worth, they run out of cash.” This article shows how cash flow impacts contractors and how even profitable projects can hurt a contractor’s cash flow.
To understand how cash flow impacts contractors, we must understand their cash cycle. A common cash cycle for a contractor may go something like this. Cash is used to purchase material or equipment. This equipment and material are used for construction projects along with labor and overhead costs. That construction generates income that must first go to billings, then account receivables, and finally collection which brings cash into the contractor’s bank account. The contractor can supplement cash through borrowings such as a bank line of credit.
The cycle itself is pretty simple and easy to understand. What may not be as easy is understanding how projects can affect a contractor’s overall cash.
For simplicity’s sake, we are only going to look at one project at a time. However, in reality, more projects compound the effects of each example.
The general contractor takes on a school project with a contract value of $1,200,000. The project is a public project so the school will only take 5% retainage and the contractor can hold the same amount on subcontractors. The contractor can submit billings at the end of each month and the school agrees to pay the contractor within 15 days of approved submittals. For this project, the general contractor has 5% gross profit built in. They will subcontract 95% of the work and will incur $5,000 in direct labor cost for supervision and management. The work will take six months to complete. We can assume therefore that the contractor will bill $200,000 per month.
At the end of month one, the contractor can bill $200,000 for work completed. However, the school district has 15 days to pay the contractor, minus the 5% retainage they will hold. Therefore, the contractor will not get paid in month one. The contractor will have a $5,000 cash shortfall in month one and will need to fund it with cash on hand or with bank borrowing. The project is not overall cash flow positive until month three.
This is an ideal scenario for a contractor. The owner is a public entity that is required to pay quickly and hold a small amount of retainage. Further, it’s a general contractor so they can also hold the retainage and payment on their subcontractors. Let’s look at another example that is a little more challenging.
Let’s assume the same contract amount and details above. Except in this example, it’s a private project for a private owner. The owner can hold 10% retainage and has 45 days to make payment after the submittals are received.
In this scenario, the project has positive monthly cash flows in month three, but the cumulative cash flow is not positive until month five. The longer the payment terms and larger the retainage, the more stress on the contractor’s cash flow.
Now let’s look at this from a subcontractor perspective. Subcontractors’ cash flow can be more challenging than general contractors. Subcontractors incur labor and material costs before getting paid and cash flow management becomes even more important. For these examples, we will use the same information as above. The subcontractor’s contract is $1,140,000 (95% of $1,200,000). The subcontractor has 20% Gross Profit. The subcontractor has labor costs of $360,000, material costs of $360,000 and equipment costs of $192,000.
In this example, we will again assume a public project with 5% retainage and payment with 15 days of submitting a pay application.
Even in this ideal scenario where the subcontractor gets paid quickly and there is little retention, the subcontractor’s cash flow is stressed. The project has a positive monthly cash flow in the second month. However, the project does not have a positive cumulative cash flow until the six and final month of the project. The subcontractor will need to have a large cash position or lean on borrowing to fund this long-term shortfall.
In this example, we go to a private project. The owner and general contractor will hold 10% retainage on the subcontractor and will pay within 45 days.
Notice the significant cash deficit throughout the entire project. The cumulative cash flow is not positive on this project until a full two months after it is completed. The subcontractor also had a cash deficit of more than 25% of the contract amount early in the project.
In all four examples, the contractors had negative cash flow early in the projects. General Contractors with quick payment terms were able to overcome this pretty quickly. However, subcontractors have to carry the cash burden for much longer. What would happen if there were multiple, similar projects going on at the same time? What about if the owner or general contractor did not pay in a timely manner? Cash would be really stressed, and both of the scenarios play out regularly in construction.
For these reasons, too much work is just as dangerous for contractors as not enough work. Contractors regularly fail when they have too much work because they run out of cash. Therefore, contractors need to make sure they have cash, liquidity, and borrowing ability to handle their work program before taking on new projects.
For each of our examples, we assumed that the contractor billed the same amount each month. In reality, contractors often submit unbalanced bids. These bids allow the contractor to bill more at the beginning of the project to cover mobilization, performance bond and payment bond costs, and to get ahead of the cash flow. In return, the contractor will bill less toward the end of the project. This will generally show up on the contractor’s balance sheet as an overbilling.
A key to a successful unbalanced bid is to not overdo it. A contractor does not want to get into a situation where they are significantly upside down at the end of the project either. This can cost just as many problems. Additionally, materially unbalanced bids are considered unethical by project owners and may be thrown out. The goal is only to bill enough in the beginning to pay for cash expenditures that occur early in the project.
Contractors almost never get paid upfront, yet they are often asked to pay equipment and material suppliers upfront. Contractors should try to negotiate credit with key suppliers to delay payments. This is a key strategy to improve cash flow.
Contractors are often poor at collecting money. They might worry that it will hurt them for future work. It is not uncommon to see receivables at 60, 90, or 120 days. However, these slow collection practices not only hurt cash, but can cost the contractor by increasing interest expense or even preventing future work opportunities. The best contractors manage receivables aggressively. It almost never hurts them from getting additional work.
Bank Lines of Credit are vital to contractors. They can provide a valuable lifeline when a contractor needs cash. Contractors should strive to grow their bank line of credit as their revenue grows. Too many contractors simply renew their line for the same amount each year. Remember that more projects mean additional cash needs. Grow your bank line of credit accordingly.
Because cash flow is so important to contractors, it is also vital to have a good construction accounting system in place. Without a good system, a contractor may not realize that they have a cash flow issue until after many months. This issue normally compounds and can cost the contractor significant amounts of money. Contractors often make the mistake of using cheap accounting software. Unfortunately, this can cost far more in the long run.
Understanding Cash Flow is very important to contractors. Failure to manage cash will often lead to contractor failure. Even profitable projects often take a toll on cash and contractors need to have the liquidity and borrowing ability to handle an increased workload.
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