One of the most common reasons companies go out of business is because they run out of cash. Construction businesses, which often front much of their projects’ costs before ever sending out the first invoice, are especially vulnerable to this. That’s why managing cash flow is of the utmost importance for companies in construction. Without positive cash flow, a construction company may not be able to pay its expenses, no matter how many new projects it has lined up.
What Is Cash Flow?
Cash flow is the amount of cash and cash equivalents that move into and out of a business during a specific time period. It is a key measure of a company’s financial health, liquidity and ability to pay its bills. Positive cash flow indicates that more money is coming into a business than is going out, while negative cash flow means more money is going out than coming in. A cash flow statement captures this information and helps a business analyze its future cash needs.
Net Profit vs. Cash Flow:
Net profit and cash flow are two critical measurements of a business’s financial health. Net profit, also known as net income or the “bottom line” (because it appears at the end of an income statement), shows how much profit is left after deducting all expenses from overall revenue during a specific period.
Cash flow is the amount of money moving into and out of a company during the period, reflecting its ability to collect from customers and pay its expenses. Depending on a company’s accounting method, it’s possible for it to be profitable yet have negative cash flow, and vice versa. A company that’s profitable on paper but has negative cash flow can run into problems because it can’t pay its bills on time.
Why Is Cash Flow in Construction Important?
Steady cash flow is crucial in the construction industry, where businesses need cash to fund new projects, keep current projects moving forward, pay for materials and labor and cover other costs. For some construction companies, a few late or missed payments from clients, overstock of inventory or a sudden increase in the cost of materials are all it takes to put them at risk of a cash shortfall — or worse. By monitoring its cash flow, a company can better predict its needs, flag potential problems and ultimately help grow the business. So it’s critical those in construction keep a close eye on cash flow.
How to Calculate Cash Flow in Construction
At its simplest, cash flow is calculated by subtracting cash outflows from cash inflows. Accountants think of cash inflows as “sources of cash” and cash outflows as “uses of cash.” These inflows and outflows are divided into three categories: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. In other words:
Cash flow = Cash from operating activities +/- Cash from investing activities +/- Cash from financing activities
Operating cash flow reflects payments received from customers less the amount paid to cover operating expenses, such as labor, materials and rent. Operating cash flow relates to a business’s core activities — goods sold or services performed — and excludes non-cash expenses, such as depreciation, amortization and stock-based compensation. The formula to calculate operating cash flow is:
Operating cash flow = Net income + Non-cash expenses + Change in working capital
Investing cash flow reflects money spent on long-term or capital investments, such as the purchase (or sale) of equipment and property (capital expenditures), stocks and bonds or another company via acquisition. Analyzing this activity to see whether cash movements are consistent or one-time occurrences provides management with a better view about the “quality” of cash flow. For example, a sale of old construction equipment might provide a nice inflow of cash, but is that the best way to fund payroll? The formula to calculate investing cash flow is:
Investing cash flow = Purchase/sale of capital expenditures + Purchase/sale of marketable securities + Purchase/sale of a business or division
Financing cash flow includes any funding from a company’s owners, investors and creditors relating to debt, equity and dividends. Scrutinizing financing cash outflows may reveal opportunities for better loan terms, and cash inflows from issuing debt can help alleviate temporary cash crunches. The formula to calculate financial cash flow is:
Financing cash flow = Issue/repurchase of debt + Issue/repurchase of equity + Payment of dividends
Conduct a Cash Flow Analysis
A cash flow analysis explores all the activities on a cash flow statement to determine how much money a company has available to pay its expenses. The analysis starts by generating a cash flow statement, often with the help of accounting software, that includes detailed information for each of the three categories of cash flow mentioned above: operating, investing and financing. When the results of these three categories are added to a company’s beginning cash for the period, a company can see its ending cash position, better understand the current state of the business and make operational changes for the future, as appropriate.
Identifying the underlying cause of each cash flow change can help a business identify ways to improve cash flow and highlight potential drains. However, analysis is key: Negative cash flow over a sustained period of time would typically be cause for alarm, but it doesn’t mean a business lacks for cash in the short term. In fact, negative cash flow may be a sign of long-term investments meant to grow a business. It may also be expected for seasonable businesses such as construction and is offset, with proper management, by periods of high positive cash flow. Similarly, a company can have positive cash flow yet not be profitable or have significant debt.
12 Common Cash Flow Issues in Construction
Construction firms require a steady, positive cash flow in order to finance projects, pay workers and grow their businesses. A cash crunch in one project can cascade to other projects. Late paying customers are one reason for a shortfall, but ineffective accounting processes and unpredictable events, such as changes in labor and materials costs, can also set a company back. Construction companies that understand these common issues are better positioned to improve their cash flow.
Paying bills too early: It may seem prudent to pay bills the moment they arrive, but doing so can leave a construction business low on cash or even create negative cash flow if cash isn’t coming in. Keeping cash on hand until closer to the bill’s due date gives a business more money to work with, whether to invest back into the business, hire a subcontractor or move on to the next stage of a project.
Lack of any upfront payment: Construction businesses may incur many expenses before a project even begins, particularly on materials and equipment. As a result, a construction company may want to request an advance payment from the client to offset some of these procurement expenses.
Delayed invoicing: The longer it takes a company to bill for its services, the longer it takes to get paid — and that, of course, affects cash flow, especially if the project is to be paid in one lump sum at the end. Progress invoicing, in which customers are billed incrementally for portions of work completed, is a cash flow-friendly alternative. An automated billing platform can be quite helpful here, especially one that can handle the different types of construction project pricing models.
Slow-paying customers: A contractor’s cash flow will take a hit when customers are slow to pay their bills. And the further a company is from the top of the payment chain — a supplier or subcontractor, for example — the longer it will have to wait to be paid. According to one report, contractors have to wait an average 90 days to be paid (also known as days sales outstanding).
Overstock of inventory: Ordering too much inventory cuts into a company’s immediate cash on hand, as do the associated carrying costs, such as warehouse storage fees. While the company may use the inventory for another project down the road, it has to bear the entire expense, which cuts into its cash reserves. Buying only what’s needed at the time leads to more balanced cash flow.
Joint ventures: Joint ventures, in which contractors merge their expertise and resources for a particular project or longer term, are commonplace in the construction industry. Indeed, they may help all companies together land more lucrative contracts that bring in more money. However, forming a joint venture comes with risk should any partner fail to live up to its obligations or decide to pull out, both of which can jeopardize a project and, clearly, impact or halt cash flow. An operating agreement that stipulates for different scenarios is extremely important to have. Considerations should include timing of cash distributions and funding of losses.
Litigation: Many problems can derail a construction project — poor management or unreasonable client requests — but the end result is often the same: nonpayment. That in itself negatively impacts a construction company’s cash flow, and so does having to take costly legal action to get paid. Of course, there are instances where a client sues the contractor. A construction contract that spells out how to handle disputes is key to minimizing the risk of legal issues.
Timing of accounts payable and receivable: Accounts receivable (AR) are money clients owe a company and, when paid, represents inflow. On the other hand, accounts payable (AP) is the amount of money a company owes for its own expenses and represents potential cash outflows. Poor timing of inflows and outflows can result in negative cash flow if the company pays its bills before being paid by a customer. This is where capable and reliable accounting software comes in handy.
Retainage: In the construction industry, it’s common for the customer to withhold paying a certain percentage of the total contract, usually 5% to 10%, until the project is finished. This is called retainage, and it offers clients some protection should problems arise. If a company doesn’t budget accordingly, this protracted payment has the potential to cause cash flow deficits.
Floating projects: The concept of “float” in construction refers to the window of time between the earliest and latest time a project activity can start without delaying the completion of subsequent activities (“free float”) or the entire project (“total float”). While it allows for some project flexibility, it also can make cash flow harder to predict. For companies that bill based on progress, the longer it takes to start an activity, the longer it will have to wait to bill and be paid for that portion of work.
Fronting projects: There are no two ways about it — getting a big project off the ground requires a lot of money. While it’s not unusual for a contractor to front-load expenses that an initial deposit doesn’t cover, such as materials and labor, it might not see that money back anytime soon. This can pose cash flow issues if not properly budgeted for and may be exacerbated if a client is slow to pay.
Lack of change order management: Anything that alters a project’s original contracted scope of work, costs or project timeline requires a signed change order that captures these modifications. Without proper management, including the necessary documentation and billing for change orders, a company runs the risk of not getting paid everything it’s owed. Similarly, the longer it takes to process a change order, the longer it takes to be paid, which also interrupts cash flow and likely impacts the entire project’s progress. A documented change order process is a part of every good contract.
15 Strategies to Improve Cash Flow in Construction
Positive cash flow is important for every construction business. It enables a company to cover its expenses in the here and now, begin new projects — which come with significant associated costs — and grow the business. Effective cash flow management is critical. Here are some strategies that can help improve cash flow.
Use cash flow forecasts: A cash flow forecast can identify cash shortfalls and surpluses. This helps a business anticipate and manage its cash flow accordingly, holding onto extra money for when business is slow, say, during the winter. A cash flow forecast also helps a company see the impact of a potential investment — perhaps the purchase of a new truck — on cash flow and how much additional cash it needs to generate to to make the payments.
Include payment terms in contracts: All construction contracts should specify payment terms. Payment terms dictate how long a customer has to pay an invoice, such as 30, 60 or 90 days. A billing agreement should also specify required documents, such as subcontractor invoices; details about the approval process, such as how long the client has to dispute an invoice; and terms of final payment, such as the provision of a final certificate of project completion, so as not to hold up payment.
Incent early payment: While paying bills early can cause a cash crunch, receiving early payments can result in positive cash flow. One way to encourage customers to pay soon after receiving their invoices is to offer a discount for early payment incentivize them with a discount. The industry standard is a discount of about 2% to 5%. The trade-off, of course, is a reduction in a company’s profits, so whether this is a viable option will vary from one business to another.
Schedule payments by due date: Establishing and adhering to a regular payment schedule for invoices due — operating expenses, cost of materials, etc. — is essential to effective cash flow management. It also helps a company avoid late payments, interest penalties and damaged relationships with business partners who expect to be paid on time. Leading accounting and finance software can help manage this process.
Provide multiple payment methods: Make it easy for customers to pay their invoices by providing a host of payment options, from credit cards to payment apps like PayPal and Venmo, to old-school checks and cash. Clients will appreciate the ability to choose their payment method, while businesses can potentially collect payments faster.
Negotiate with vendors: Vendors may be willing to negotiate their prices and payment terms (typically in the 1.5% to 5% range) for large projects that involve volume purchasing or cash payments. Bringing them in as a partner can also be advantageous. By offering some kind of value to a vendor, a construction company can save money and therefore improve cash flow.
Bill consistently: An efficient billing process can keep cash flowing into the business. Best practices for construction invoicing include sending out invoices quickly and adhering to a schedule, which will vary depending on the type of contract in use. An accounting system that issues invoices and reminders automatically can help keep a business on track.
Obtain a credit line with bank: A business line of credit can help alleviate negative cash flow, providing access to working capital to weather cash shortfalls. The application process is the same as with any business loan, with the lender approving a certain credit amount.
Long-term financing: Long-term financing, with payback periods of more than one year and possibly up to 20 or 30 years, is a common source of capital for construction companies and is often linked to a firm’s growth. Long-term financing is used to pay for major assets such as buildings and equipment, and those assets serve as collateral on the loan.
Leasing vs. financing fixed assets: Leasing versus financing fixed assets comes down to a company’s business requirements, goals and how much cash it needs at its disposal. Financing assets like equipment entails borrowing funds from a bank or lender and paying the loan back with interest. Once the loan is paid in full, the company owns the equipment and may be able to resell it once it no longer has a use for it. With leasing, there’s no ownership at the end of several months or years of monthly payments. From a purely cash perspective, it’s usually less expensive to lease than to finance.
Avoid over- or underbilling: Overbilling is invoicing for more than the work completed, putting more cash in a contractor’s pocket early on. This practice is sometimes used with late-paying customers as a way to offset the negative impact on cash flow. However, a contractor could find itself short on cash at the end of the project if the extra funds collected early aren’t managed properly. Underbilling is the opposite of overbilling, invoicing for less than what is owed and creating negative cash flow in the near term — yet with no real upside in the long term. A business’s best cash flow bet is to bill in line with its costs and based on the project’s actual progress.
Charge for delayed/late payments: Late and delayed payments impact cash flow, with the potential to jeopardize other projects and even the business itself. Delayed payments are considered carrying costs, meaning the amount of money it costs a business to carry a customer’s debt. Penalties for delayed payments, typically in the form of late fees or involving collections, should be spelled out in the construction contract so there are no surprises.
Speed up closeout: The longer it takes to complete a construction project, the longer a contractor must wait to receive final payment, including retainage — both of which impact cash flow. But closing out a project means more than finishing the physical part. It also involves significant administrative work in the form of gathering all project-related documents, such as a completed punch list, inspection certificates, lien waivers and much more. The more organized a company is throughout the project, the quicker closeout will be and the sooner it can be paid.
Retainage: For the same reasons a customer may withhold paying a percentage of the total contract until a project is complete, so, too, can a contractor retain a percentage of payments to subcontractors. But there’s a secondary reason: Retainage helps a contractor better manage cash flow by timing payments to when the contractor has been fully paid.
Tax planning: A large tax payment can negatively impact a construction company’s cash flow, especially if it hits during slow periods. Proper tax planning, plus an understanding of tax deferrals, can minimize or prevent any surprises. It’s also a year-round endeavor that, based on the tax reporting method used, can improve a company’s cash position.
Manage and Improve Cash Flow With Construction Accounting Software
A company’s cash position is subject to frequent fluctuations and is best monitored and managed by accounting software. A solution like NetSuite’s cloud financial and accounting system includes billing and invoicing management, access to real-time metrics and overall visibility into a company’s cash flow and cash position. In addition, NetSuite Project Accounting automates and manages project invoices to reduce delays and monitoring project profitability metrics, so they’re completed on time and within budget.
Construction businesses need to continually fill their cash coffers in order to fund new projects, pay their expenses, including materials, labor and operating costs, and ultimately grow. But in an industry that typically operates on thin profit margins, sometimes a single slow-paying customer is all it takes to flip a company’s cash flow from positive to negative. Understanding the issues that can hamper cash flow, employing strategies that can boost cash flow, and using software to manage and monitor cash flow and billing can keep a construction business in operation for a long time.
Construction Cash Flow FAQs
At its simplest, cash flow is calculated by subtracting expenses (outflows) from income (inflows) for a specific time period. In the construction industry, where projects are often paid incrementally as a company finishes different stages of work, staying on top of cash flow is especially important given the frequent flow of cash in and out of the business.
Positive cash flow allows construction companies to pay their expenses on time. But money going out requires money coming in, so a business must be vigilant about billing consistently and accurately, avoiding over- and underbilling. Determining the best way to fund new projects, with cash or through financing, and purchasing fixed assets like equipment also depend on the amount of cash flowing into the business.
To gauge its liquidity and solvency, a business needs to track and analyze cash flow from operating activities, investing activities and financing activities, all of which are included on a company’s cash flow statement. Cash flow from operating activities comes from a company’s normal business operations, i.e., the provision of a good or service. Cash flow from investing activities is based on the purchase or sale of fixed assets, such as equipment, and marketable securities, like stocks and bonds. Cash flow from financing activities involves capital raised, invested, used to service debt, cover operating expense, or pay dividends.
Cash flow in project management is the movement of cash related to a specific construction project. A project accountant is typically responsible for analyzing a project’s cash flow to predict cash needs and creating a payment schedule to ensure there’s enough cash for each phase of a project.