As a business owner, you know that having money coming in is the key to a successful business. But managing your cash flow: now that’s the tricky part.
There are so many moving pieces that make coming up with a strategic cash flow plan feel like a guessing game. Where do you start? How do you predict when clients will be late on their payments? Or when an important piece of machinery will break down?
Because of the uncertainty surrounding cash flow, many owners ignore it altogether. They focus instead on building a pipeline of prospective clients. But here is where you have an exciting opportunity. Because many owners fail to manage their cash flow properly, you will have a competitive edge by creating and sticking to a cash flow plan.
In this article, we dive into the strategies that successful construction business owners use to keep their cash flow in the black. We’ve combed through studies and data by top research companies to bring you this complete guide. Read on to learn all you need to know about on cash flow strategies.
What is Cash Flow?
Cash flow refers to the movement of cash into and out of your business. Positive cash flow is what happens when you spend less than you make: when more money is flowing into your accounts than what is coming out. Negative cash flow occurs when your business is spending more than it makes.
There are 3 basic types of cash flow: operating, investing, and financing.
Operating cash flow refers to the income and expenses that are related to your business services.
Investing cash flow relates to any purchases of investments or assets (think vehicles, buildings, equipment, and warehouses).
Financing cash flow refers to the cash that you spend on debt — such as vehicle loans and mortgages — or cash that you make from offering financing to clients.
Free cash flow is another term you may encounter. It refers to the cash a company has after it takes care of its expenses.
Why Is Cash Flow Important?
In a report by McKinsey & Company, it was found that the construction industry had the most major insolvencies of any industry during the majority of 2018. This does not come as a surprise. Construction companies face a great deal of risk, as they often have to front the costs for labor and materials for a project before collecting payment.
Even if you have plenty of work lined up, negative cash flow can sink your business in an instant. To stay afloat, companies must have enough free cash flow to cover their expenses and protect against insolvency.
Challenges to Cash Flow in Construction
Companies and contractors who take on large projects are the most at-risk for cash flow bottlenecks. Without proper foresight and management, you may find yourself with empty pockets right at a critical moment in the project.
There are ways to mitigate the risk of negative cash flow, and it all starts by spotting the issue before it happens. Here are a few of the most common challenges to cash flow in construction companies.
Most construction companies operate on retention, where the client holds a certain amount of money back during the project to ensure that the job gets done. This protects clients against fraudulent contractors, but the practice often has a negative impact on cash flow. If retention on a project exceeds your net profit, you will be operating on a cash deficit until you finish the project and receive the last 5-10 percent.
How to manage it: Come up with a cash flow plan before taking on a new project. Plan out your billing schedule, payments to subcontractors or vendors, when the work will be completed, and remember to factor in payment terms.
Purchasing Physical Assets
Fixed, long-term assets like vehicles, warehouses, and new equipment are crucial to construction operations. They also drain large amounts of cash at once, severely threatening your cash flow.
How to manage it: Mitigate cash flow risk by planning ahead. Schedule large purchases at the end of the fiscal year so you can deduct the expense from your taxes. Make sure the purchase will occur when you have a surplus of cash, not when you are tight on assets.
Another way to reduce risk is by renting or leasing expensive equipment instead of buying it. Consider whether the tool is one that you need on an ongoing basis, or whether a small monthly payment is a better option than purchasing it outright.
If you run the numbers and find that renting is a poor long-term decision, consider financing the purchase. This can result in paying more interest over the life of the loan, but it can be worthwhile if you secure a low-interest rate. Simply weigh the benefits and disadvantages of both options.
Issuing Late Invoices
Are you billing your customers on a regular schedule? Or are weeks going by between the contract signing and the first deposit? How quickly does your billing department send out an invoice after work is completed?
When your payment terms are too lenient or your billing process is too slow, this threatens cash flow.
How to manage it: Make sure that invoices are going out as soon as work is completed. Set up an automated invoicing system to bill on certain dates. Give the accounting department a schedule at the beginning of a new project so they know exactly when to bill the client.
Clients Who Pay Late
Even if your invoices all go out on time, you will still encounter clients who delay payment for weeks after the due date. Unpaid invoices turn your company into a bank and eat away at your profitability. Sometimes a follow-up email to a client is all it takes to get those late invoices paid. But don’t be afraid to get a collections agency involved if a client refuses to pay.
How to manage it: Collect a deposit upfront for a large project. Make your invoices due on receipt. Charge along the way at project milestones. Follow up right away on late invoices by sending a reminder email. If this doesn’t work, make a phone call. Next, alert the client that you will be sending the invoice to collections.
Offer incentives to clients for paying early and upfront, and charge interest for late payments.
Don’t be the source of a zero-interest loan!
Last-minute Change Orders
A last-minute change from a client can derail the profitability of a project and eat away at your free cash flow. Studies have shown that around 35 percent of all construction projects undergo a significant change order. These change orders tend to occur when project estimates are too vague or leave out important line items.
How to manage it: Reduce the number of change orders you receive by drawing up detailed, complete estimates. Many companies use BIM or CAD software to provide the client with a more accurate picture of the project, which allows them to voice their concerns earlier in the process.
When change orders do occur (because they will — it’s inevitable) process and bill for them as soon as they are submitted. It’s important that your teams are communicating efficiently, otherwise you risk a slowdown. Make sure your billing department follows up on unpaid invoices right away.
Improve Your Cash Flow with a Plan
It’s true that many factors affecting cash flow are out of your control. Clients pay late, materials go missing, laborers fail to show up on a critical day of work. But don’t fall into the trap of thinking that the process is 100 percent out of your hands.
Business owners who work to understand and control their cash flow are far more likely to succeed than those who don’t. Here are the steps to improving your cash flow with a clearly defined cash flow plan.
Know Your Numbers
As the owner of a construction company, you must get to know your numbers intimately. Sit down with your accounting department on a regular basis to acquaint yourself with the particulars of when and where your cash flows in and out.
Tracking your numbers will allow you to make wiser decisions on when to make big purchases. It will give you the upper hand on strategic decision-making for your business.
A good cash flow or project management software will allow you to gather and view data, and it will help you get a handle on how your money flows. Choose software that tracks and highlights your income and expenses, and helps forecast your spending based on past patterns.
If you’re already using construction software, take some time to learn it. Most technology will allow you to track expenditures and know when they are coming out of your accounts, monitor your progress on current projects, and see the numbers for your estimating and bidding processes.
Get a Handle on Scheduling
There’s a reason we say time is money. When it comes to cash flow in construction, tracking and planning for cash flow is directly related to scheduling. You must know when certain expenditures will leave your account, and what resources you have access to at that particular point.
Make sure your managers are aware of important billing dates. Schedule or coordinate large, costly purchases to be made right before these dates, so that you don’t act as a bank for your clients for 30 or more days.
Get a Handle on Billing
Overbilling and underbilling are two common problems that result in cash flow issues. When you underbill, your cash flow in the short term is stopped up. When you overbill, you receive a surplus of cash right away, but you risk spending this cash on other projects and having problems at the end of the project, when money is no longer flowing in.
Avoid these issues by billing on a regular schedule that is aligned with the real work being completed. Invoice promptly at these milestones, and set up automated invoices using a payment scheduling software.
Are you requiring clients to pay by cash or check? Set up electronic payments to get paid faster. Avoid clauses that require you to pay subcontractors, vendors, or suppliers before clients pay you, and ask for up-front deposits before beginning a large project.
Negotiate Better Contracts
Now that you have a solid understanding of your business’s cash flow, you can leverage this knowledge to create a better cash flow situation for future projects. Create a billing schedule that allows you to pay your vendors and cover costs in real-time during the project.
Pay close attention to the payment terms and retention release provisions when you bid on a new contract. Instead of only focusing on net profit, you can negotiate these terms for better cash flow.
Have a Chat With Your Tax Planner
No, you don’t need to understand the nitty-gritty of every line item on your tax return. But it’s important for business owners to understand the tax impact of their purchasing activities. Sit down with your tax professional and ask for advice on deductions, depreciation of assets, and other strategies that can reduce your burden come tax time.
Finance Large Expenses
Sometimes, the cash flow benefits of spreading out a large payment are greater than whatever small discount you might get for paying upfront. If you’re unsure, run the numbers. Ask your tax preparer if you can write off the interest or any other financing fees.
Proper cash flow management is a company-wide responsibility. Your project managers should have a thorough understanding of the impact of cash flow on everyday operations, and they should be empowered to make cash-flow-positive decisions in their jurisdiction. Make your cash flow expectations clear to supervisors and employees alike. You might even offer incentives for workers who prioritize cash flow.
By recognizing common pitfalls and creating a cash flow plan, you’re well on your way to avoiding insolvencies and keeping your construction company in the black.