Cash management is one of the most important aspects of effective financial control for construction contractors, yet it is often one of the most neglected. Given the heightened importance of cash flow during uncertain economic times brought about by the current health pandemic, construction industry contractors should develop or modify their cash management plans as part of their overall business risk and continuity plans. Many contractors make the mistake of assuming that working capital is a direct indication of the company’s capacity to furnish cash when needed, leaving the cash management process to chance. Furthermore, because interest rates have been so low for many years, many contractors have given little attention to fundamental cash management principles. Minimal effort is expended in planning or managing cash, which is one of the major contributing factors to the high failure rate in the industry. Identified below are some tools to evaluate the effectiveness of your company’s cash management strategies. While you may have addressed these matters in the past, ask yourself these questions:
- Is someone fully responsible for maximizing your cash flow?
- Is that person doing the job effectively?
- Do you need to make some changes in your company?
BIDDING THE JOB – ESTABLISHING EFFECTIVE CASH MANAGEMENT CONTROLS
Budgeting – The cash budgeting process can determine the timing of cash inflows and outflows, and the timing of cash transfers for investments and future use with the company. A successful cash budget implementation will take into account the cash activity of a given job, the estimated labor requirements for the job, and the anticipated overhead costs requirements. Since change is the only constant in the construction industry, contractors should develop their cash budgets to be flexible, dynamic, and responsive to any variances experienced during the job cycle. Cash budgeting developed as part of a contractor’s overall budgeting plan can provide the following benefits:
- Eliminate and reduce negative cash flow periods.
- Minimize frequency of cost overruns.
- Provide for the availability of funds for vendor discounts.
- Increase liquidity for corporate growth.
- Determine short- and long-term borrowing requirements.
Forecasting – A cash flow forecast enables contractors to predict future cash needs by examining past and future project billings, costs, and overhead expenses. Cash forecasts should be prepared on a project-by-project basis. Additionally, cash forecasts will help identify periods when surplus cash will be available, or when shortfalls may occur.
Negotiating – Contractors should develop a foundation that supports positive cash flow results during contract negotiations. This is achieved by making sure certain parameters affecting subsequent cash collections and disbursements are adequately defined in the bid proposal to the general contractor or owner.
In general, subcontractors should strive to avoid complying to terms with bid solicitations that request the general contractor’s standard subcontractor templates be used. Such templates commonly incorporate inequitable payment terms that favor the general contractor or owner, and are detrimental to the subcontractor’s cash flow objectives. Ideally, subcontractors should construct their bid proposal using their own terms. In the event that the general contractor demands their standard subcontractor letter be used, subcontractors, at the very least, should insist on reaching a consensus with the general contractor or owner for the key payment terms so that both parties are fairly treated and equally protected. The minimum provisions you should address are as follows:
- Retentions – An understanding should be reached between the subcontractor and general contractor in regards to retention agreements. Subcontractors should adopt a policy of capping the contract retention rate on any given job at 10% of the agreed upon contract price. More importantly, under no circumstances should the subcontractor retainage rate be higher than the percentage amount being withheld from the general contractor by the owner.
Standard industry practices dictate that a portion of the retainage should be released once the project has reached 50% satisfactory completion of the job. Additional timing parameters should also be established under the contract agreement to determine release of remaining retention.
- Payment Clauses – General contractors may be inclined to include certain payment clauses in the job contract that benefit their cash flow cycle at the expense of the subcontractor’s cash flow. Such clauses include the “pay when paid” clause, and the “pay if paid” clause.
Under “pay when paid”, the contractor’s obligation to remit payment to the subcontractor for materials/services rendered does not arise until the contractor has received payment from the owner for such services. Unforeseeable circumstances between the owner and general contractor,such as work stoppages or delays brought about by COVID-19, can wreak havoc on the subcontractor’s cash collection cycle. Subcontractors can mitigate the negative effects on cash flow caused by “pay when paid” clauses by incorporating strict payment schedules for all services rendered. In the absence of a payment schedule provision, the majority of states require subcontractors to be paid within a reasonable period of time, which may be subject to interpretation.
Subcontractors should avoid “pay if paid” clauses entirely. The “pay if paid” clause stipulates that the general contractor’s obligation to pay the subcontractor for work performed is contingent upon whether or not the contractor receives payment from the project owner. Whereas the “pay when paid” clause delays the timing of a subcontractors’ cash collection, the “pay if paid clause” has the potential to relinquish all of the general contractor’s liabilities relating to work performed by the subcontractor.
- Progress Billings – Subcontractors should explicitly state the monthly progress billing arrangements in the contract language, explaining their billing process and when payment for work performed will be due. Such provisions help to prevent general contractors from delaying payment for an indefinite period of time.
EXECUTING THE JOB – ACTIVE CASH MANAGEMENT
The goals of cash management in any organization are to maximize the cash balances and the related return on the investment cash balances, and to minimize the period of time that the cash is not invested. Obtaining these goals requires continuous attention to the two fundamental concepts vital during the job process that will have a direct impact on a company’s accounts receivable and accounts payable: the acceleration of cash receipts and the deceleration of cash disbursements. See below for a list of controls that will yield positive results for each objective.
Accelerating Cash Receipts
- Bill on Time – The cash collection process cannot begin until the subcontractor bills for work performed. Therefore, it is important to promote a culture and internal process amongst key personnel that stresses the importance of completing all steps relating to the billing process in a timely manner, such as documentation and authorization of invoices.
- Monitor Receivables – Acceleration of cash receipts begin with the billing cycle. However, timely billing is only part of the problem. Collection is often more critical. Monitoring the aged accounts receivable coupled with consistent and aggressive follow up of past due accounts can make the difference. Monitoring the collection of receivables also helps contractors monitor jobs that are falling behind.
- Deposit Controls – After successful collection of customer receivables, sound processes for converting collections to deposits ready and available for operating purposes must be in place. Mail, email, and bank accounts for electronic payments should be monitored daily for payments received from customers, and deposits should be prepared and submitted to the bank on the same day. If you have not done so already, it may be helpful to consider adopting a check truncation system. Check truncating systems convert physical checks into electronic format, reducing transportation costs and processing time.
Decelerating Cash Disbursements
- Perform Cost-Benefit Analysis for Vendor Discounts – Slowing down disbursements to the point where payment is not made until the last possible day will help provide the largest return on your available cash. However, never sacrifice a discount for early payment, such as the typical 2/10, net 30 arrangement. Failing to take this discount is equivalent to an effective annual cost of approximately 36%.
- Use Company Credit Cards – Consider ditching cash and using company credit cards instead for purchasing materials in order to provide an additional 30-day float.
- Inventory – Avoid buying excess inventory and supplies. Excess inventory ties up cash and has additional hidden costs for insurance, handling, warehousing, and security. If feasible, adopt a “just in time” inventory purchase system.
- Recruit Outside Labor – Consider hiring independent contractors to assist in completing unique projects. Using independent contractors can save money on payroll taxes and other personnel costs.
CLOSING THE JOB – CONVERTING EARNINGS INTO CASH
Upon completion of work, contractors should focus on formally closing out the job. The job closeout process is perhaps the most difficult phase for contractors since collection of outstanding retainers and final payment is contingent upon the owner or general contractor’s satisfaction of the work performed. Additionally, the closeout process is commonly prone to cost overruns caused by lack of oversight. Contractors who do not incorporate adequate controls during the job closeout process will fail to turn profits into cash.
A useful tool contractors can utilize to protect their cash flow is a close-out checklist. The close-out checklist serves as a comprehensive guide that helps contractors determine whether all stages of the job have been performed as agreed upon within the contract provisions.
CASH MANAGEMENT PRINCIPLES
- Cash Budgeting/ Forecasting
- Acceleration of Receipts
- Deceleration of Disbursements
- Investment – Maximize Earnings
AFTER JOB COMPLETION… STRATEGIES TO INCREASE CASH FLOW
- Resolve all outstanding issues and disputes.
- Challenge all reductions in billings.
- Have payments delivered instead of mailed.
- Consider adding late fees.
- Eliminate grace periods.
- Resolve punchlist items.
- Confirm all change orders have been fulfilled.
- Match payments received to payments due to subcontractors and suppliers.
GENERATING CASH OUTSIDE OF OPERATIONS – MAXIMIZING INCOME
Interest income derived from investments is another income source for contractors. In order to make an investment of excess cash needed to generate interest income, contractors must know that they will have excess cash and will not need the cash in the immediate future. The cash budget is an effective tool to help determine this. A contractor’s cash position, relative to their short-term and long-term liquidity requirements, should dictate the type of investment and the term of the investment they choose to pursue.
Short-term investments – Since contractors are constantly bidding work and can never predict with certainty when the next job will hit, most long-term investments are eliminated from consideration as an investment vehicle. For idle funds thought to be short-term, liquid, low risk investments are preferable. A description of some common, low-risk investment products are as follows:
- Certificate of Deposit – a Certificate of Deposit (CD) offers flexible terms from 7 days to over a year, with variable rates available. Some CDs have staggered maturity dates, where portions of the bond mature at different dates, providing better liquidity.
- Treasury Bill – a Treasury bill is a short-term debt obligations of the U.S. government. Treasury bill obligations require a minimum investment of $10,000, with maturities ranging from 90 days to one year. There is a large secondary market for these, making them highly liquid investments.
- Commercial Paper – Commercial Paper represents unsecured promissory notes issued by corporations for short-term financing needs. Maturity ranges from overnight to 270 days. Commercial paper is not highly marketable.
- Banker’s Acceptances – Bankers acceptances represent drafts issued by corporations and guaranteed by the bank on which they are drawn. Maturities range from 30 days to one year and can be sold before maturity.
CASH IS KING
In the construction industry, cash remains king, and an effective cash management strategy in good and bad economic times separates best-in-class contractors from those that are struggling to stay above water. Contractors should understand that the successful implementation of cash management policies requires a multifaceted approach that must be developed by owners/executives of the firm, and communicated to all employees. A sound cash management program enables contractors to remain many steps ahead in the ultra-competitive construction industry. During this time of uncertainty with COVID-19, cash management is crucial. If you would like an evaluation of the effectiveness of your cash management process or assistance with identifying strategies that will help to improve your cash flow, please contact the CREG team at 301.231.6200. We can help.