Mastering Cash Flow: Essential Tips for Construction Companies – Part 1

Cash flow is the lifeblood of any construction company, yet many firms struggle to manage it effectively. Poor cash flow management can lead to severe financial difficulties, including bankruptcy—even for profitable companies. This is especially true during periods of rapid growth, when projected profits can obscure underlying poor practices and accelerate cash burn. If a company can't make payroll or pay vendors, this can quickly spiral out of control towards bankruptcy, with few firms ever recovering. This article outlines a few key strategies to help construction firms improve their cash flow and accounts receivable collections, ensuring financial stability and sustainable growth.

1. The Importance of Monitoring Key Financial Ratios

Regularly tracking financial ratios, such as the current ratio, quick ratio, and working capital, is crucial. These metrics help identify potential cash flow issues before they become critical. It's important to remember that these financial ratios are not just internal benchmarks, but are often required by bonding companies, who demand specific equity and working capital ratios to mitigate risk. Cash and working capital are often the most important elements for passing bonding company analyses.

What to Consider: Establish a routine for monitoring these ratios, ideally monthly, to ensure that your firm remains on solid financial footing. Consider creating exception reports that provide clear visibility into deviations from target benchmarks. Some key financial ratios to monitor cash flow and target results include:

Key Financial Ratios

In addition to monitoring key financial ratios, it's important to incorporate monthly cash flow forecasts that project collections as well as outflows for payroll, vendors, and subcontractors. The forecasts should extend six months to a year, particularly if cash flow is a concern, and be reviewed monthly to allow for necessary adjustments. This is another management tool that can help predict and avert potential cash flow issues.

2. Optimize the Schedule of Values

The Schedule of Values (SOV) directly impacts cash flow and should be viewed as the first line of defense. An effectively prepared SOV allows for prompt payment for overhead and profit, reducing cash flow strain during a project’s lifecycle.

What to Consider: Focus on accurate and strategic SOV preparation. Offer trainings to employees responsible for the SOV preparation on the critical role of cash flow. Foster a company-wide culture that prioritizes cash flow management. Maximizing the value of low-cost line items in the early project phases can significantly front-load cash flow in the SOV. Consider requiring that a manager or other executive review the SOV before it is sent to the owner.

3. Streamline Billings

Delayed billing and collection issues are primary causes of cash flow problems. Ensuring timely and accurate billings can significantly reduce the delay in payments.

What to Consider: Create a more reliable and efficient billing process that enhances cash flow and builds stronger relationships with project owners by implementing the following practices:

• Establish a robust process to track and monitor billing submissions, ensuring accuracy and timeliness.
• Understand the data sources for generating billings, incorporating not only direct job costs but also overhead allocations for the month.
• Provide PMs with the necessary tools and data to complete billings efficiently.
• Consider implementing a minimum billing amount, such as earned revenue plus 20% of costs to date, to achieve a cash-positive position earlier in the project. The goal is to foster trust in the process while optimizing cash flow.
• Build rapport and trust with owners/clients/representatives by aligning expectations and ensuring transparency in the billing review process.

Contractors should also be aware of the concept of 'job borrow,' a construction accounting scenario which occurs when billings exceed payments, and the difference resides in cash accounts. Monitoring this on the balance sheet helps prevent cash from one project being misallocated to another, ensuring proper alignment between AR collections and vendor/subcontractor payments.

4. Implement Strong Collection Strategies

Slow collections can severely impact cash flow. Construction companies often face delayed payments due to issues such as billing revisions or incomplete documentation.

What to Consider: To effectively improve cash flow, it's crucial to implement proactive communication, structured escalation processes, and accountability measures.

• Reach out to the project owner/client before the billing close date to confirm that all necessary documents have been provided, preventing delays in collections due to missing documentation.
• Establish a clear, formal escalation process for overdue accounts, assigning specific responsibilities to team members at different stages. A sample escalation policy might look like this:

• Incorporate Days Sales Outstanding (DSO) as a performance metric for project managers to ensure accountability.
• Fully investigate a project owner/client’s ability to pay before accepting work. Conducting due diligence up front helps reduce the risk of non-payment and ensures the financial stability of the project throughout its lifecycle.

Contractors must also be mindful of the financial strain that can arise at the end of a project, when advance billings have been consumed and final work must be completed before any retainage can be collected. This is often a vulnerable phase, particularly if cash has been redirected to other projects or withdrawn from the company. It underscores the importance of owner discipline, particularly in knowing when to withdraw funds and using financial tools to assess when cash is truly free to be withdrawn.

Conclusion

By adopting these best practices, construction companies can significantly improve their cash flow, reduce the risk of financial distress, and position themselves for long-term success. To get started on mastering your cash flow, contact our team to see how we can help.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.