Effective cash flow management is crucial for any construction business. This article delves into the key reasons construction companies run out of money and provides detailed strategies to maintain healthy cash flow, ensuring your business remains financially stable.
UPDATED AT: July 9, 2024
Cash flow is the number one reason why construction companies go out of business. A U.S Bank study found that 82% of small businesses fail due to poor cash flow management.
In the construction industry, delays in the payment chain can be significant, often taking 83 days or more to receive payment for completed work. This extended payment cycle disrupts cash flow, making it challenging to pay suppliers and employees on time. Contractors need to be aware of these delays and plan accordingly to mitigate the impact on their cash reserves.
Inadequate budgeting and cash flow analysis can lead to financial issues. Unexpected expenses or overlooked costs can derail project budgets and deplete cash reserves. Proper planning involves anticipating all potential costs and ensuring there is enough cash flow to cover these expenses throughout the project’s duration.
Project managers and company executives must be prepared to finance the project during these challenging periods. Graph by Project Engineers.
Overbilling occurs when the amount charged to a client or project owner exceeds the actual costs incurred for work completed so far. It becomes an issue when you reach the end of a project and have nothing left to bill with costs still coming in.
Overbilling can lead to financial misrepresentation and breach of contract. While it might temporarily boost cash flow, it can cause many headaches later on.
Without incoming revenue to cover those expenses, you’ll have to overbill another project to cover them. This creates a cycle of debt that is difficult to get out of. In construction projects, problems like unrecorded changes in plans, mistakes in measuring materials, and poor progress tracking can cause overbilling.
For instance, disagreements may occur if changes to the project aren't documented, leading to disputes over billed amounts. Errors in measuring materials can also result in invoices for more materials than were actually used.
Moreover, if project progress isn't monitored closely, invoices might be sent for work that isn't finished yet, which can mess up financial planning.
In some cases, billings can be higher than costs when savings on a project aren't planned. For example, let’s say a project plans to install 100 feet of pipe at $75 per foot, totalling $7,500. But efficient management lowers the actual cost to $65 per foot, totaling $6,500. If the contractor bills the client based on the original estimate without adjusting for these savings, overbilling happens.
This is an example of how to ensure financial accuracy and shows why it’s crucial to monitor and manage project costs to avoid unintentional overbilling.
Underbidding, especially with rising material costs, can severely impact cash flow. Bidding too low to win jobs can lower construction prices, hurting companies' competitiveness and survival. This could lead to lower worker pay, worsening labor shortages, and reduced quality.
Sometimes, contractors underbid to win a contract and then add change orders later to drive up the project's costs. This can upset clients, leading to negative reviewers or even project cancellations. It’s important, then, to bid accurately and consider the bigger picture. For instance, the National Association of Home Builders reported that material costs have increased by more than 20% over the past year.
Strategies to maintain healthy cash flow involve proactive approaches to financial management. Below are some effective methods:
If you don't plan out your cash flow for your business, you won't know how much money you'll need or how much you'll make. By looking at how much cash came in and went out in the past, and predicting what you'll need in the future, you'll have a clear idea of your cash needs. Then, you can manage your financial resources better by predicting your cash requirements beforehand and avoid unexpected shortfalls.
Send invoices as soon as a job is completed. Quick invoicing ensures that payments are received on time, maintaining a steady cash flow. Delayed invoicing can lead to delayed payments, which can disrupt cash flow and create financial strain.
One of the best ways to improve cash flow is by securing early invoice payments from your clients. This approach not only enhances your financial stability but also builds stronger business relationships. A good strategy is to offer discounts for early payment and encourage clients to settle their bills promptly, ensuring a steady flow of cash. This strategy not only improves cash flow but also builds goodwill with clients, potentially leading to more business in the future.
Using material financing can help delay payments and preserve immediate cash. Partner with financing companies to pay vendors directly, and then repay the financing company once project funds are available. This approach allows you to save existing cash reserves for payroll and overhead costs, ensuring you have the necessary funds to cover immediate expenses while waiting for project payments.
To quickly boost your cash flow, consider asking customers for a deposit before beginning work. This ensures you have the funds to start their project and order necessary materials. The deposit amount should match your cash requirements and project timeline. However, subcontractors may face reluctance from general contractors (GCs) to provide deposits due to various reasons. You can address these concerns by demonstrating your value and cultivating a stronger relationship with the GC. Ultimately, GCs benefit when all subcontractors have sufficient funds to finish their work promptly, minimizing project delay.
There are simple steps any construction business can take to speed up payment. First, send preliminary notices to inform clients you've worked and expect payment. Often, this tactic alone can accelerate payments. Additionally, streamline your billing process by setting up invoice reminders before payments are due. Many software programs offer automatic reminder features. Lastly, establish and follow your company’s mechanics lien policy (legal guarantee of payment to builders, contractors, and subcontractors). This policy allows you to know when to send notices and file a lien.
Invoice factoring allows you to sell invoices to a third party to access cash quickly. This can provide a steady influx of cash to pay suppliers and fund projects, ensuring that cash flow remains healthy even if clients delay payments. Invoice factoring can be a valuable tool for maintaining liquidity and avoiding financial strain.
When you change the terms of your debt, it frees up your cash flow and makes your monthly payments more manageable. On the other hand, by refinancing existing debt at lower interest rates, you can minimize financial burden on your part. This may be used as an additional fund for operation cost. This technique will help you in managing your cash inflow in a better way, enabling you to have enough funds to cater for continuous expenses.
Exploring various financing options in your business for operational costs is crucial. There are many options, including trade credit accounts from vendors, bank lines of credit, credit cards, invoice factoring, and equipment financing. Assess the costs and benefits of each financing option to determine the best fit for your specific project needs. Diversifying your financing options can provide the flexibility needed to best manage cash flow.
The main takeaway from this article is to maintain positive cash flow in your business. Start by tracking your monthly expenses closely and once you understand where your cash is going, project your future needs and estimate your cash requirements. Choose effective strategies to either defer expenses or boost incoming payments. By doing so, you can confidently pursue bigger projects and grow your business without worrying about cash shortages.