What surprised me most over the many years my consultancy finished hundreds of jobs for sureties after contractors had failed mid-project was how many contractors were surprised when they ran out of money. Most of them believed they were successful up to the day they couldn't pay the bills and the subs, suppliers and bankers pulled the plug. It seemed impossible to me that contractors didn't know they were in danger of their cash flow drying up. As I pointed out in last week's blog, the fundamental success element of every construction contractor is the capacity to complete projects successfully and to take on the next contract. Capacity is composed of multiple elements like personnel, equipment, professional relationships and, perhaps most important of all, good old fashioned adequate cash flow. 

Construction Cash Flow
In most businesses the sale transaction is accomplished in one three-phase transaction: 1) Offer the product 2) Accept payment 3) Deliver the product. The construction industry's more complex sale, however, is accomplished through multiple transactions over an extended time period often measured in years. Simply put, we are not a "cash and carry" business, therefore, our cash flows are intermittent and vary in source, flow rate, and cost. Managing the flow of cash is perhaps the most important management skill a construction firm can have. This is why, as I have preached for many years, the CFO position is so vital.

Ad Hoc Cash Flow Management = Bad Reputation = Higher Cost of Capital

• Very small residential contractors are notorious among homeowners for bidding a job, demanding a deposit, then disappearing for long periods before showing up to do the work. This is not because all small contractors are crooked but rather because they are struggling to manage their cash flow. Usually, the deposit they take from the next customer is cash needed to finish the jobs they are currently engaged in.
• Some large successful contractors are notorious for slow paying their subcontractors and material suppliers because they often manage cash flow by "borrowing" short-term from vendors, without asking.
• Banks make big money by tacitly allowing contractors to overdraw their working capital lines of credit and then charging enormous penalties for the privilege. This onerous fee and penalty income may be covertly included in the banker's business plan, but the contractor's reputation suffers anyway.
• The spotty reputation that contractors earn through ad hoc cash flow management techniques further burdens cash flow when lower credit ratings translate into higher interest rates and material prices.

Professional Cash Flow Management = Lower Cost of Capital

Our focus today is not on efficiency, profitability, or successful project completion. We are only addressing how to manage the flow of cash into and out of a construction company while keeping the cost of capital low and access to capital unimpaired. 

The first step in successful cash flow management is identifying all the potential sources of cash.

Typical Sources of Cash in Construction: 

1. Construction company owner's, or investors' cash injections.
2. Cash flow from ongoing jobs.
3. Project owner's progress payments.
4. Bank provided working capital lines of credit.
5. Vendor payment terms.

(Note: These are the usual sources of cash that flow into a construction company. Some contractors may have other extraordinary sources that should be considered, evaluated, and managed.) 

The second step is to evaluate availability, adequacy, and impact of all sources.

Evaluation of Sources

The availability and adequacy of owner's or investor’s cash injections and company ongoing cash balances are self-evident. The impact, however, can only be evaluated when the total uses of cash and the availability and timing of other sources have been factored in.

• Up front deposits, timely progress payments, funding extras, and retainage are all the responsibility of the project owner. Their attitude regarding prompt and fair payment must be evaluated in advance and managed professionally by the CFO with timely, accurate invoicing and no nonsense demands for payment. When this source of cash is not managed professionally cash flow problems always arise. (See article “Late Payment May Be Your Own Fault” in Schleifer’s Manual of Construction Practice: https://simplar.com/wp-content/uploads/2020/09/Late-Payments-May-be-Your-Own-Fault.pdf )
• The adequacy of bank provided working capital facilities depends on the quality of your company's long-term banking relationships and professional financial reporting by your CFO before the project begins and as it goes along. Do not expect your bank to make up shortfalls in the other sources of cash. Your banker does not normally consider it his or her responsibility to make up for an inadequate infusion of equity or to finance a project owner's reluctance to pay.
• Loyal relationships with material suppliers can often be a source of cash when other sources of cash get temporarily interrupted for a variety of reasons. The ability to temporarily extend payment terms beyond the standard agreement can often be a lifesaver. (key word “temporarily”.)

Overview

Cash flow management is an artform in the construction business. Every company, every project, and every season presents the CFO with new risk factors and challenges. Next week we will discuss the science of cash flow management and how it can be artfully applied in every circumstance.