Business toolbox: Maximizing cash flow
Having cash at the ready to procure materials, pay salaries, fund new projects and finance all the other functions of a construction business is essential for the smooth operation of a company. When financial obligations outpace the influx of money, it doesn’t take long for a business to become overwhelmed by debt or, in the worst-case scenario, go under.
“Too many [contractors] fail,” said Steven Goldstein, audit partner at accounting and consulting firm Grassi & Co., “because they don’t manage cash properly. They don’t understand what’s happening until it’s too late.”
First, though, it’s important to recognize that there is a difference between being profitable and having healthy cash flow. A contractor could be killing it on margins, but if money is not making its way into the company coffers, it could feel like the firm is on its way down — and out.
Cash flow challenges
One of the primary cash flow challenges facing contractors, particularly in active building areas like New York City, Goldstein said, is that firms are doing a lot of work and possibly overshooting their cash capacity in the process. Opportunities for growth should be taken advantage of whenever possible, but those lucky breaks have to be funded, oftentimes upfront and before receiving a single payment.
In that scenario, if a large customer is late making a payment or has financial problems and fails to pay altogether, contractors could be forced to rely on profits from other projects to pay the bills. And successful projects can’t take up the slack of late or no payments forever. Subcontractors are particularly vulnerable, as they are footing the lion’s share of labor and material costs.
So, the primary cash flow mission for subcontractors and general contractors is getting paid in a timely fashion for the work they perform. General contractors typically pay subcontractors after receiving payment from the owner, so they shouldn’t be quite as stretched for cash as subcontractors.
For general contracting firm Broadway Construction, collecting on accounts receivable has not been an issue, according to its president, Everard Martin. However, Martin said he won’t dismiss the possibility that the company will face such challenges in the future. Martin said GCs should have an open conversation with owners and subcontractors at the beginning of a project to establish how and when payments will be made so that everyone is on the same page from the start.
Setting payment terms
As a subcontractor, Bill Weber, principal at Gaston Electrical, said the terms of payment can vary from project to project, and the sub should always have discussions before the projects starts about payments without the conversations becoming contentious. This is possible if the GC and sub have a good relationship, Weber said, but added that there are some general guidelines for negotiations.
“On short-duration projects, we certainly don’t want to wait 90 days for payment, in which case we could be substantially complete on a project before we see our first payment,” Weber said. “On larger and longer-duration projects, we expect our customers to establish a predictable payment cadence so that we can understand our cash flow needs and plan accordingly.”
And it’s to the GC’s benefit to have agreeable payment terms with its subcontractors. “If you pay your subs on time, you can get better leverage on price points and better participation,” Martin said. “You may [end up with] better quality, but what you get at a minimum is responsiveness.”
That could manifest itself in a few ways. The subcontractor might be willing to expedite certain tasks on short notice as a sign of appreciation or even extend invoice terms occasionally because of previously consistent on-time payments.
Material suppliers can also be partners in payment talks. Weber said Gaston’s material suppliers are typically willing to negotiate invoice terms so that they fall in line with the expected general contractor-to-subcontractor pay schedule, but subcontractors already need to have a healthy relationship with that supplier to begin with.
“If a subcontractor both provides a steady flow of business to vendors and builds trust by consistently honoring their commitments,” he said, “a supplier is almost always willing to negotiate special payment terms on projects.”
So what should contractors and subcontractors do if their customers consistently pay late or refuse to pay a legitimate bill? After all, there are certain expenses like payroll, insurance and office rent that can’t wait.
If one of Gaston’s key customers is late with a payment, Weber said, they try to be flexible. However, the company will pursue its full rights if in its best interests, and that includes the option of filing a mechanics lien. However, Weber said that’s a rare occurrence since it often creates tension between the general contractor (Gaston’s customer) and the owner.
The issue of retainage can also be an area of negotiation. Retainage of typically 10% is commonly withheld by the owner from payments to the general contractor, who passes that on to subcontractors. In theory, this temporary reduction in net payment is to ensure that contractors are motivated to take care of any end-of-project issues like punch lists.
At a certain point in the project, retainage is sometimes reduced to 5%, and the owner will sometimes even release retainage in full to early trades like the excavation contractor who would otherwise have to wait months or years, depending on the size of the job, until substantial or full completion to receive the withheld amount.
“I think it’s important for subcontractors to advocate for themselves when it comes to collecting retaining,” Weber said. “Our customers are focused on so many other things that retainage could be held far longer than needed if we don’t ask for that payment as soon as we believe we are entitled to collect those funds.”
In order to manage the collection of retainage effectively, Martin said, a contractor must first know what its release is being tied to, like the completion of a punch list or some delivery milestone. Then, he said, make sure the work is performed according to the plans and specification and address the punchiest items quickly.
Change orders are another area where contractors can lose out on cash. Without proper tracking of the extra work a customer requests, the contractor could end up bearing the cost without being able to invoice for it.
Checks and balances at Broadway, Martin said, reduce the chance of that happening, but every so often someone drops the ball. By the time the project team realizes the company paid for work and never billed for it, it could be hard to assemble the paperwork and other proof to justify submitting a bill for those services.
But once all the cash is collected for work performed under the contract, plus the aforementioned changes, there are ways contractors can save some of that money through internal policies and procedures.
Increasing cash flow
One way to ensure contractors are maximizing cash flow is to make sure the billings reflect the work performed and that they’re turned in on time, Goldstein said.
Inventory control is also important, which means it can be detrimental to tie up cash by stocking up on materials that aren’t needed for work in progress. If there is a need to warehouse a large quantity of materials, Weber said, Gaston uses pictures, inspection reports, etc. to prove to the owner that the company has taken ownership, then bills for it.
Quick payment could also increase cash in the long run. “Our vendors are also very cash-flow conscious and most are willing to provide discounts for quick payment of invoices,” Weber said. “If a subcontractor can provide positive cash flow from their projects, they can use that [money] to increase margins by taking advantage of vendor discounts.”
Looking to outside financing when cash reserves are low is another option, Goldstein said. Establishing a line of credit with a bank is a good business move, but some companies may also turn to factoring. Factoring is when a company sells its receivables to a third party at a discount. So, if a contractor is waiting on payment for $100,000 in invoices, a factoring company might provide them with 75% of the money, or whatever percentage the two agree on, and then collect the money from the customer themselves. A large chunk goes to the factoring company, but a service like this comes in handy if it’s a matter of making payroll or not.
The construction industry, Goldstein said, is a business like no other, so it’s important to engage an accountant or financial advisor with appropriate experience. Not only will they be able to give the right tax advice, but they can provide a warning about new regulations that could have costly implications, such as the recently enacted safety training requirement in New York City. Noncompliance with that rule, according to city officials, could result in a $5,000 violation issued to the employer, permit holder and owner.
There are, of course, actions contractors can take, like keeping expenditures low and not overstaffing, but for Martin, cash flow is a simple calculation. “It comes down to having substantial working capital in place and understanding how much you need in reserve to cover the inevitable,” he said.