When the economy is booming, the construction industry typically follows. Unfortunately, the opposite is often true as well. The nature of the industry itself also means that when contractors have significant volumes of working capital tied up in individual projects, when a problem occurs, it can have a drastic effect on the contractor’s available cash and, at worst, ability to continue operations.
Construction companies need to maintain significant working capital balances. The following top 10 tips will help maintain effective cash flow management practices.
Establish a Line of Credit
A line of credit should be put in place by Management, even if it is not expected to be required for the foreseeable future, in order to give a safety margin for times when cash reserves become depleted. Having a line of credit already in place will avoid the need to request one when it is required imminently. If it is left too late, the terms offered by the bank may not be favorable.
Maintain a Cash Flow Forecast
Cash should be managed using a cash flow forecast at the corporate level, which incorporates individual project cash flows. By identifying future financing needs early, Management will be able to proactively seek additional funding or take corrective action before it is too late.
Perform Credit Checks on the Owner
The resources of the project owner should be investigated to ensure the owner has adequate cash resources available to fund the construction.
Such a credit check could include: reviewing the owner’s loan agreement or the commitment letter they have with their bank, reviewing the owner’s audited financial statements and assessing the commercial viability of the completed project. In addition, the terms of the draft contract should entitle the contractor to periodically receive information relevant to the owner’s financial ability to complete the project.
Understand the Billing and Payment Schedule
A detailed understanding of the contract terms for progress billings and payment terms should be obtained prior to bidding for the work to ensure you are not financing the owner’s project. This information should then be incorporated into a cash flow forecast for the project to assess the amount of working capital that will be tied up by the project and ensure you have the resources required before committing to the work.
Review the Whole Contract
Certain contractual terms, other than the billing and payment schedule referred to above, can have significant implications on the project’s cash flows, and it is important that these effects are understood. Such terms include: project milestones, change orders and concealed or unknown site conditions. If these terms in the proposed contract differ from those typically used, the contractor should
carefully weigh their effects before submitting a bid.
Follow Billing Procedures Closely
Any deviation from the billing procedures requested in the contract documents may give rise to delays in payment being received. Contractors should ensure that owners also follow the contractual payment terms; when progress bills are not paid on time contractors should follow up immediately by either phone or in writing to enquire when payment will be received. If progress payments are consistently being delayed, the contractor should immediately consult with their legal counsel to determine a suitable remedy and avoid any adverse outcome.
Disputes can be avoided by following the contract specifications and by performing quality work. If disputes do arise, the deficiencies should be corrected promptly to avoid delays in the payment of progress billings. Where this is not feasible or cannot be done, you should agree with the customer or their consultant to treat the bills for any disputed work separately so that payments for other
work are not also delayed.
Control the Company’s Growth
A strategy often seen in the construction industry is to maximize the level of sales; this can mean that low margin work is undertaken which can easily erode the company’s overall profit margin and therefore working capital. The strategy should be to maximize net earnings and that can be achieved, in part, by:
• only taking on projects that have sufficient gross profit margin to make them worthwhile;
• making steady incremental increases in the size of individual projects undertaken; and
• closely managing the expenses below the gross profit line.
Obtain Payment Security
Or, if payment security cannot be obtained and the contractor has doubts about the creditworthiness of the customer, the contract should not be entered into.
Advance the Collection of Holdback
This may be achieved by breaking up a long term contract into several shorter distinct contracts, so the holdback will become payable earlier due to the earlier date of substantial completion. By following these steps, you should be well positioned to avoid the consequences of unexpectedly running out of cash and on your way to operating a successful and profitable business.
Cash flow management is described in greater detail in CCA 28 A Guide to Improving Cash Flow in the Construction Industry and in CCA 50 A Prime Contractor’s Guide to Project Financing and Payment Security which are available from your local construction association or from the Canadian Construction Association (CCA).
This article has been prepared for general information. Specific professional advice should be obtained prior to the implementation of any suggestion contained.