In the construction industry, maintaining consistent cash flow is crucial to the success of a project. To estimate cash flow and manage construction projects profitably, you need quick access to key metrics and indicators before, during, and after a job.
What Is Cash Flow?
Cash flow is one of the most significant measurements in business. It is the amount of money and cash equivalents that flow into and out of a business at any one time. Companies with a positive cash flow have more money than liabilities.
This allows them to stay in the black and cover their bills on time each month. Those that have negative cash flows, on the other hand, do not have enough money coming in to meet their monthly obligations.
Having a negative cash flow indicates that a firm may be facing financial problems, which, if not resolved, may lead to the company’s eventual demise. This may be hard, but there are a few tactics that construction and contracting companies may use to get from being in the red to being in the black.
Cash flow in the construction industry
When dealing with cash flow, construction firms should manage incoming funds to procure materials, pay salaries, complete projects, and support other day-to-day operations.
The key is to ensure that cash flows into the business fast enough to cover the construction supply chain while keeping costs low enough that cash is not tied up in one area of the business. Funds must be available in real-time to cover expenditures as needed.
Construction cash flow problems
Cash flow can be a major obstacle for the construction supply chain. If there isn’t enough positive cash flow, a project may suffer due to a lack of consistent funds.
Common cash flow problems within construction are:
- Taking on several projects and exceeding cash capacity
- Failure to establish a payment schedule and/or an initial payment prior to starting work
- Failure to fund an entire project as a result of late or non-payment
- Mismanaging or failing to track change orders
When construction companies utilize outdated tools to manage cash flow, these issues become more common.
Line of Credit
To fund projects, many contractors will have to acquire and access a line of credit (LOC) with a financial institution. Many LOCs are accessible up to a certain limit based on a prescribed borrowing base calculation. The borrowed amount is calculated as a percentage of the contractor’s outstanding contract receivables.
LOCs are short-term borrowing facilities that must typically be paid off in full at least once a year. If the LOC is not paid off, it may suggest that the contractor is undercapitalized. An undercapitalized contractor may struggle to meet cash flow needs and may require additional long-term debt or an infusion of capital from the construction company’s owners.
Schedule of Values
The schedule of values (SOV) is a thorough list that supports the many project components. Each item is assigned a price, resulting in the total contract value.
The SOV is created by the contractor and approved by the customer at the start of a project. The contractor will requisition the customer as the project progresses. Each requisition to the customer shows the percentage completed for each project component, as well as the amount that can be requisitioned to the client.
The customer will review the schedule of values upon receipt of each requisition to ensure the contractor is requisitioning at the agreed-upon percent complete at the start of the project. If the customer disagrees with the percent complete on one or more SOV components, the customer will lower the request to the percent complete that the customer believes is appropriate for each component.
As a result, it is critical that the contractor focuses on the SOV to ensure that, as the project progresses, requisitions sufficient to cover costs and profit while delivering positive cash flows may be generated.
Front Loaded Cash Flow
Front-end loading is a common practice used by contractors to increase cash flows at the beginning of a project. This is the practice of gaining profits on items in the SOV incurred at the start of a project, such as mobilization costs.
More profit on earlier components of a project will increase cash flow in the early stages. The disadvantage of this strategy is that requisitions at later stages of the project may produce little to no profit, due to lower billables than the contractor’s cost at those stages.
It is essential to project future cash flows on a project-by-project basis in order to track the status of cash flows on a project. Otherwise, front-end loading could be catastrophic if the contractor does not have the cash to complete the project.
Cash Flow Forecasting
Cash flow forecasting is the forecast of both cash in and cash out of the construction project.
- To be able to make a workable project schedule, the resources needed for the project & their availability must be checked.
- Money is the most important resources.
- Cash flow forecasting is the forecasting of both cash in and cash-out for all construction projects.
Project engineering agreements typically provide that as the work progresses, the client will make progress payments of the contract amount to the main contractor.
Components of Cash In
Value of work: actually performed on the site. The total value of work done on-site to date is obtained in different ways, depending on the type of contract.
Material on site: but not yet incorporated into work, as well as any prefabrication or pre-assembly work that the contractor may have done at some location other than the job site.
Contract Provision that Impact Cash In
1-It’s An percentage (%) of each progress payment is usually retained by the owner in accordance with the terms of the contract.
2-The retention may be held by the client until the work receives final certification by the authorities, the client/owner accepts the project.
3-Final payment is then made to the contractor, including cumulative retention.
1-After the work has been done & all deficiencies remedied, the client makes formal written acceptance of the project & the contractor presents his application for final payment.
2-Under a lump-sum contract, the final payment is the final contract price less the total of all previous payment invoices made.
3-In all cases, final payment by the client includes all retention that has been held by him.
Components of cash out:
1-Upfront costs = initial expenses = start-up costs are costs necessary to start the project such as costs of moving in workers and equipment; erecting field offices, storage sheds, fences; job layout; installation of temporary electrical, telephone, water, sanitary, and other services; bonds; permits and project insurance.
2-Payment of direct job costs. These include costs associated with payrolls, materials, equipment and subcontractor payments
3-Payments for filed overhead expenses.
- Cash flow refers to a contractor’s cash in and cash-out.
- The net cash flow: It is the difference between cash-out and income at any point in time. A negative net flow means expense are exceeding income, a normal situation on even a highly profitable project during the greater part of its duration.
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