Stricter credit standards demand disciplined cash flow management practices
Cash flow — managing the collection of contract revenues and payments of the costs of contracted work — is a leading indicator of bankruptcy for construction contractors. Of the 400 contractors that went bankrupt last year, according to the “2007 Construction Industry Annual Financial Survey,” conducted by the Construction Financial Management Association (CFMA), Princeton, N.J., half resulted from mismanaged cash flow. Too often, companies that may have been considered profitable have had to close their doors because of lack of cash.
Compounding this problem is the current economic climate in which banks and other financial lending institutions have tightened their standards and cut back on lending for an industry that relies on external credit as a necessary component to positive cash flow in a construction contract. “External financing is almost a necessity,” says Sam Thacker, partner in Business Finance Solutions, Austin, Texas. “In a perfect world, you wouldn't rely on it, but in the real world there are only two places to get that cash flow — and that's external financing and trade credit.
In 2007, the CFMA survey found that the availability of bank credit for construction companies improved for the fourth consecutive year. Of the 756 respondents to its survey, 42% indicated that the availability of bank credit was better than the previous year, and 57% indicated it was about the same. Similarly, 33% of respondents experienced an increase in their working capital line of credit. Yet, despite this upward trend, many industry economists are forecasting an impending end to the availability of bank credit.
“The banks are just being a lot tougher and much more careful,” says James Sudbury, an Austin, Texas-based financial consultant for the construction and manufacturing industries. “The market's changed dramatically in the last three months. There used to be plenty of money all over the street. You'd be hard-pressed not to be able to get a deal done. Now, it's difficult to get it done with any major banks.”
With most bank lines of credit negotiated on an annual basis, firms probably won't be faced with a major crisis until their lines come up for review. “Nine months ago, we weren't in the credit crisis we're in now, and my company had no difficulty at all renewing and expanding the line of credit,” says Steve Lords, former president of CFMA and current CFO for Martin Harris, Las Vegas. “Will we experience a little more difficulty in June or July when we do that again? Probably.”
Tighter credit standards may affect smaller businesses first. “The small business contractor is not going to have access to as much external capital as a large contractor will,” Thacker says. “Right now, a small contractor is going to have to close its doors if it can't get some external financing during tough times. That's how bad it really is. Banks are just not loaning money to small subcontractors.”
There are a few sources, other than banks, such as commercial finance companies, that will finance working capital in the construction industry. “They mostly cater to the small contractor,” Thacker says. “The big contractor is likely to still get bank credit.”
In addition, firms that work in the residential market will also have a more difficult time finding external financing. “The single-family housing market — even condominiums — has really tightened to the point that some existing projects have ended up being slow to pay,” Lords says. “Along the way, lenders tightened up and are requiring more equity involvement.”
The impact in the housing market has spilled over to commercial as well. “One drives the other to some degree,” Lords continues. “Just in this year, some of our commercial projects have been delayed and some even canceled because owners are a little bit nervous.”
Currently, there is the least amount of risk in government, education, and health-care markets. “There's a hierarchy of risk, which wasn't there a year ago,” Thacker says. “Then, as long as the geography could support the residential construction, there weren't problems, but the downturn in the economy has created this hierarchy. In my marketplace — and I suspect this is true nationwide — it is going to be easier for contractors working on commercial projects to get financing from banks or commercial finance companies than it is if they're doing residential work.”
Thacker also surmises that, likewise, if contractors are working on government-, medical-, or education-related projects, they are going to be more likely to get financing than if they're working on straight commercial projects. However, no matter what size the firm or type of project, cash flow in construction is always a challenge. “Whether you're small or large, you're always in demand for sending out your cash,” says Jeff Gould, CFO for Victor, N.Y.-based O'Connell Electric Co. “Balancing your cash inflows and outflows is always critical in any economic environment.”
Other than diversifying their portfolios, there are a few strategies electrical contractors can follow to improve cash flow. “In a tough market like there is now, doing what you should be doing anyway becomes way more important,” Lords says. “You keep doing the same things you should always be doing — just more intensively.”
Maintaining the partnership between your company's finance department and project management is crucial to improving cash flow. “Everybody needs to understand what you're trying to accomplish with cash flow,” Lords says. “That becomes more important now when the market is tight.”
If there are any breaches of information between finance and project management, it's the job of the firm's president or CEO to close it. “This is the moment to intercede and say that regardless of their differences in attitude and approach, here they will work together and will share information,” says Matt Stevens, president, Stevens Construction Institute, Winter Park, Fla. “In fact, you'll want them to over-share information. If they don't, you'll want to have a serious conversation — you can't allow that.”
From a project manager's standpoint, says Stevens, the two things that determine a job's success are completing the project on time and making a profit. If the project manager is not receiving the financial information in a timely fashion, there's no way to gauge the success of the project. “He can't adjust to take advantage of windfalls for the good or shortfalls for the bad,” he says.
With several office locations, it's imperative that all employees at O'Connell Electric receive the same reports, especially the project managers. “They know where they stand with their customers, they know where they stand with their billing, and we talk about it,” Gould says. “We have various internal metrics to measure how well we're doing.”
The quest for information doesn't stop at your own firm, either. Many construction finance experts recommend turning the tables on the general contractor (GC) and owner/developer by scrutinizing their credit worthiness. “In today's economy, electrical contractors need to know their customers and know that they have the ability to finance the job to completion,” Thacker says. “From a fundamental standpoint, the most critical thing that all contractors need to be wary of is credit and collections. As they are out bidding jobs and taking on new customers, they need to be vigilant — they also need to do good credit work before they decide to take on a project.”
For electrical contractors bidding on a new project, this means making sure it will go to completion. Some customers will be better able to weather the economic downturn than others, even if it means smaller profit margins. “There might not be a huge margin in the business, but for those payers that are in health-care, government, and education, their budgets are going to be the same next year as they were last year,” Thacker says. “They're not susceptible to the same kinds of pressures in the downturn that a developer that's building high-rise condos is.”
A good test of a new client is to bill as early as possible so you can gauge their turnaround time. “If you get a chance of billing somebody a very small amount because you've done two days of work on a job, do it,” Stevens says. “If they pay you that small amount in 60 days, it's good to know so when you bill a large number later you know exactly how they're going to pay.”
According to Stevens, it's best to learn the billing cycle on a $10,000 payment versus a $300,000 payment. “I think it's much smarter to always bill what you can as quickly as you can, and as early as you can,” he says.
This will also help you weed out deadbeat clients. “You have to get rid of or fire clients who have poor cash flow and poor payment practices,” Stevens says. “But most people want to pay. It's just a matter of making sure you're billing what they want and know how to go about it.”
It's a policy at O'Connell to always know who the customer is. “The customers that are paying on time end up being a very short conversation,” Gould says. “The ones where we have other issues tend to be longer conversations. If we need to continue to make phone calls, then that works. If it means we need to get somebody else involved, we will. If it means we need to protect our rights when time runs out, then we do that.”
One of the fastest ways to limit cash flow, according to Stevens, is to be slow at billing from the start of the job. “Collecting accounts receivables is easy to do,” he says. “We just have to be better about doing it.”
Often, contractors confuse billing with revenue, says Dr. Perry Daneshgari, president of MCA, the Flint, Mich.-based consulting firm that provides supply chain consulting services to national and international companies in the automotive, medical, insurance, banking, and construction industries. “They don't understand the difference,” Daneshgari says. “They think if they bill, that is what their sales are.”
Daneshgari cites a study by CFMA that found 90% of contractors bill based on cost, not on percent completion, despite a federal bill passed in 1986 that allows contractors to bill based on percent completion or cost — whichever is higher.
Another common mistake, according to Daneshgari, is that many subcontractors aren't careful to follow their clients' billing cycles. For example, if a company pays the second day of the following month after it receives the invoice, then sending the invoice on the first of the month automatically adds 30 days to receivables. “If you moved it just one day, you're going to get paid in about 40 days,” Daneshgari says. “If you move it to the first of the month, automatically it adds 30 days.”
In addition, Daneshgari warns that in a downturn, payment schedules could take even longer. “Even though construction is still going to be okay, the pay schedule is going to be dragging,” he says.
The longer bills go past the due date, the stronger the collections tactics will have to be, so it's best to keep up to date. Especially for smaller firms, outsourcing collections is cost-prohibitive and inefficient. “You have to know the billing intimately, what's billable, and what's a change order that's pending,” Stevens says. “You have to know the details of that change order to get paid, and it costs you.”
Usually, by selling receivables to a collections agency, the firm is giving up 5% to 10% on a final bill. “If you're owed a hundred grand and sell it, you're either getting $90,000 or $95,000 for that receivable to get the money now,” Stevens says.
As a result, it's vital to get billings out on time, as well as making sure to document change orders correctly. If billed on time, change orders can be a solid source of cash flow for subcontractors. “A specialty contractor typically likes change orders because they're not charging the same rate,” Stevens says. “They can charge a higher rate, and they can bill more cost in those change orders.”
Typically, subcontractors can bill for the project manager's time, superintendent's time, and cost of the work, labor, and equipment. However, the extra time and money for the change orders must be approved with written acknowledgement. “All changes to budget and schedule have to be recognized,” Steven says. “You not only ask for dollars for what it costs you, but you also ask for days. Both are important. Always ask for dollars and days.”
Often, one aspect of a job that can't be billed until completion is retainage, which is money held to assure performance between the contracted parties. In typical construction contracts that include retainage, subcontractors are required to leave 10% of each of their billings in the project until it has been completed and delivered to the final party. “In a lot of cases, that 10% represents all of the profit that a subcontractor may have in the job, and it may take that subcontractor 180 days or longer to get paid that 10%,” Thacker says. “So accounts receivable is the biggest thing that is affecting cash flow, and it grows when firms take on more work.”
Smaller firms should be especially wary of retainage. “Smaller contractors should be very cautious about taking on jobs with retention if they don't have the retained earnings or a way to fund it,” says Stevens, explaining that the funding in this case does not mean borrowing on a credit line. “If they're borrowing money to fund shortfall retention, that's a warning sign that the firm is upside down and backward with cash flow.”
The best way to avoid this situation is to be choosy about projects. Many smaller jobs do not include retainage in the contract. Unless general contractors set up a contractual link between the retainage held by the owner and the retainage held by the GC, there is no relationship. Without that contractual link, there is no tie between the owner and subcontractors on a project. In that case, when the subcontractors have successfully performed on a contract, they can expect to be paid their retainage by the GC, whether or not the owner of the project has paid the GC. Subcontractors are allowed to negotiate the terms of their retainage to accelerate receipts. “Once performance is complete, then retainage ought to be due,” Lords says. “GCs often make exceptions for their better subs — the ones they really like to work with. We'll pay them all or part of the retainage as soon as we've signed off on their work.”
For best results, it's advisable to enter into negotiations about retainage at the beginning of the job. “Don't wait until the end,” says Daneshgari, who advises contractors to try and gauge return of retainage by the progression of the completion of the project. “At 50%, you should be able to reduce your retainage to half. If you're labor productive and putting more work in the ground, you should be able to bill based on what you have completed, not just on your costs. You bill based on percent completed.”
Another negotiation point could be to agree to a lower gross margin in exchange for better cash flow. “In some cases, you can actually get a job with 1% or 2% lower gross margin if you can get the GC to guarantee reduction of retainage and payment under 30 days,” Daneshgari says. “That 1% doesn't go anywhere versus if you have to pay them in 30 days and you have to borrow against your line of credit. Even at prime, you're still paying 5%.”
Sometimes, negotiations won't always go the way of the subcontractor. In that case, they should be prepared to walk away from the job, says Lords. “If you don't ever say ‘no,’ then you'll always be subject to those kinds of terms.”
According to Gould, O'Connell tries to get retainage reduced when prudent, and in cases where it's required, it bills and collects as soon as possible. “It is something that you can't overlook,” Gould says.
The best way to avoid overdue bills for inventory is to work lean. “We pretty much don't carry inventory,” Gould says. “We order our materials for the job just for what that job needs, and in most cases it's shipped directly out to the job site.”
When you must stock inventory, try to forge a better relationship with your distributors and vendors. In good economic times, a special relationship with a distributor can help growth. During a downturn, it can prevent bankruptcy. “It's important to be able to ride trade credit or reduce or lengthen the time for the outlay of cash for materials,” Thacker says.
Although pricing is important, it's not the only factor in choosing distributors. The timing of deliveries and billing cycles can also play an important part. “The majority of the cash flow is impacted by how contractors deal with inventory,” Daneshgari says.
One of the main reasons jobs don't become cash flow positive until the last 5% of the project is completed is because electrical contractors lean too heavily on the discount they receive from distributors for buying supplies and products up-front. “The cash conversion cycle works against them,” he says. “The rule of thumb is that the number of revenue days should be less than 45. Anything higher means your guys in the field are buying too much on the job site. Ideally, it should be 30 days.”
Instead of an up-front discount, contractors should concentrate on delaying payment, even if it costs a little extra. “They need to watch the inventory and regulate the money that's tied up in it,” says Daneshgari, who recommends offering a 1% or 2% bonus for a longer payment term. “The distributors will work with them if they have some kind of incentive. That is much cheaper for everybody.”
Another strategy for reducing inventory costs is to cut down on the number of purchase orders (P.O.s) issued by your firm. A blanket agreement with your distributors can be arranged, with summary billing on a regular basis, such as monthly. “On average, every time a contractor writes a P.O., it costs $42 to process internally,” Daneshgari says. “You want a reduced number of P.O.s, and you want to get your distributors to give you summary billing, broken down by job, once a month.” The objective is to have one bill each month, and a longer term to pay for it.
Lords agrees that distributors and other vendors are often amenable to such agreements, but only when you've established a reputation as a good customer. “If they can rely on me paying on schedule, they really don't care that much,” he says. “I've been demanding and getting 60-day terms in the construction industry for more than 20 years, even with much smaller companies than I work for now.”
However, don't let loyalty stop you from shopping around. It's advantageous for contractors to have the best of both worlds. “We have a handful of vendors that we primarily work with,” Gould says. “But in certain situations — something very specific or unique that we can only get from someplace else or really competitive pricing with it — we'll turn around and try to take advantage of those opportunities too.”
According to Matt Stevens, president, Stevens Construction Institute, Winter Park, Fla., and author of the 2007 McGraw-Hill book, “Managing a Construction Firm on Just 24 Hours a Day,” there are several common scenarios that will cause projects to have a negative cash flow. Here are the top reasons, followed by ways to avoid them:
Early in the project, create a schedule of values that accurately reflects costs for work early in the project.
Keep the budget up-to-date by comparing the field projections with financial figures. This will show you where there is a disparity that can provide numbers that place you upside down.
Avoid agreements with contractors and distributors that cause the project to be in a negative cash position.
Walk away from these projects before they begin.
Collect your rightful costs, including your change orders.
Source: The Contractor's Business Digest
Cash includes currency, the reconciled amount of money in the company's bank accounts, and items negotiable for cash, such as checks and bank drafts. Cash may also include certain temporary short-term investments that can be quickly converted into cash, such as government-issued treasury bills.
An asset by definition has future economic value to the business. Current assets are expected to be converted into cash or used within an operating cycle of the business. For most businesses, an operating cycle is one year. Current assets typically include customer and other accounts receivable, inventory for resale, and prepaid assets, as well as cash.
A liability represents an obligation by the business to pay. Current liabilities are expected to be paid within a business operating cycle. Trade accounts payable, employee wages, short-term loans, and taxes are some examples of current liabilities.
These are other assets and liabilities that are not expected to be converted into cash, consumed, or paid within a business operating cycle. Examples of long-term assets are plants, equipment, and buildings. Long-term liabilities include long-term loans, such as a mortgage that is due in five years.
Net working capital is current assets less current liabilities. For most financially healthy businesses, this should be a positive number.
The current ratio is current assets divided by current liabilities. It should be at least one (1.0), preferably higher.
The quick ratio is current assets, less inventory, divided by current liabilities. Because inventories can sometimes be difficult to liquidate, the quick ratio is considered by some to be a better measurement of a business' ability to pay its bills than the current ratio. The quick ratio is sometimes called the “acid test” ratio.
Account receivable represents money owed to you by your customers.
Aging is accounts receivable analyzed by due date. Typically, the due dates are grouped by monthly periods, such as 30-, 60-, 90- and 120-plus days past due. If your 120-plus aging is usually under 1% of total receivables, but has recently jumped to 5%, that indicates you are developing a collections problem.
Days sales outstanding is the accounts receivable divided by the average daily sales. It's a measurement of how quickly a business collects its account receivables, so the lower the number the better.
Inventory is usually the cost of the products a company holds for resale to customers. It includes not only finished goods, but also raw materials and goods in production.
These are products in inventory that are selling at lower-than-expected rates. If a business expects to keep a product in inventory for an average of no more than 60 days before selling it, then a product with 6 months worth of sales in stock would be slow moving.
A stock-out happens when a customer order cannot be filled because there is no product available. A “stock-out rate” is the number of times this happens for every 100 product orders. A high stock-out rate may create a risk of losing sales to customers who are not willing to wait for the business to replenish its stock of inventory.
Source: AllBusiness.com Buyer's Guide, “Jargon Watch: Cash Flow Terms”