Published September 12, 2023
It doesn’t take many months of running a business before one learns that cash flow is often more important than profitability.
And when it comes to cash flow, few industries have bigger challenges than the construction business.
The engineering-construction sector is the slowest of 17 global industries to get paid, with median Days Sales Outstanding (DSO: the time between commencing work and receiving payment) of 83 days, according to international consulting firm PWC.
By comparison, the retail and hospitality sectors have a median DSO of just 17 days.
Construction doesn’t fare much better in other key metrics. Its median Days Inventory Outstanding (DIO: the time it takes to get paid for inventory or raw materials) ranks in the middle of the pack, at 59 days—compared to just seven days for the transportation-logistics sector.
The median Days Payables Outstanding (DPO: the time a company takes to pay its bills) is 70 days—14th out of 17 sectors. Transportation-logistics and hospitality lead the category with median DPO of 38 days.
There are systemic reasons for the industry’s chronic cash-flow challenges, according to Plooto, which provides payables and receivables services to small and medium businesses.
Addressing these takes courage; it requires resisting industry norms.
Larger companies and those with exceptional reputations have more leverage to do so than smaller and newer contracting businesses. But any construction business would do well to recognize these industry-specific hurdles and work to minimize their impact on cash flow.
1. Bidding process
Whether it’s due to unclear specifications, rushing the estimate on material and labor costs, underestimating overhead expenses or simply trimming the bottom line in order to win the job, any sacrifice of profit margin in the bidding process almost always leads to negative cash flow during construction.
Keys to navigating the treacherous waters of the bidding process are:
- A clear understanding of specifications;
- Confidence in calculating project costs, and layering in a fair share on every bid to cover overhead and unexpected expenses;
- On bids with multiple line items, increasing the value of work that will be done early in the job to bring in cash sooner—when it’s needed most to pay for materials;
- Willingness to walk away from jobs that won’t cover expenses as they go.
2. Change orders
Change orders are unavoidable, and managing them can have a huge impact on cash flow.
The longer a change order goes unprocessed, the more likely it is to involve expenses that have already been incurred, or cut into revenue late in the project that you expected to cover early expenses.
Keys to managing change orders include:
- Immediate analysis of each change, and a timely response to assure all incremental costs are covered;
- Written agreement with the client on the cost of each change order;
- Clear communication with project managers and subcontractors to quickly implement any changes, thus avoiding unnecessary payroll and material costs;
- Prompt invoicing for any additional time and material costs.
3. Payroll
Payroll requires a regular cash outlay—whether or not you’ve been paid first. The higher the payroll, the bigger the outlay, and the larger the cash flow crunch when anticipated revenue doesn’t arrive on schedule.
The smaller the business, the harder it is to manage payroll. Small contractors want to avoid laying off their best talent, lest they find themselves short-handed when the next job comes in. They’re also more likely to see the human impact of each layoff.
Keys to managing payroll include:
- Hiring slowly and cutting quickly;
- Emphasizing the use of contractors over employees;
- Working to increase the regularity of incoming revenue through improved contract terms;
- Maintaining access to a business line of credit to cover cash shortages when they do occur.
4. Retainage
Retention agreements that hold back a percentage of revenue until specific goals are met are almost universal in the industry; it’s not unusual that the amount of money to be retained will exceed a contractor’s anticipated profit—assuring cash-flow issues for the duration of a project and beyond.
If retainage is a normal part of the jobs you take, there’s no way to avoid it. Keys to mitigating its impact include:
- Clear understanding of the retention rules for each job;
- Advance planning to cover material and payroll costs while waiting for final payment to arrive;
- Excellent record-keeping and written communication to support your case in the event of a dispute;
- Clear knowledge of your state’s lien laws, and aggressive filing of preliminary notices where needed to assure the right to file a mechanics lien is preserved if retention payments are delayed or not met.
In addition to these systemic issues, there are other cash-flow barriers that can be addressed through disciplined management of day-to-day activities, according to HBK, an accounting firm with offices across the Eastern United States.
Here are suggestions for everyday improvements in cash flow:
- Forecasting cash flow across all your business activities identifies potential cash crunches early—allowing you to plan for them or, better still, revise your bids to cover them.
- Sending out clear invoices at the first appropriate moment sends the message you expect to be paid on time.
- Knowing the client’s billing preferences assures your invoices have the right information and formatting to be handled routinely.
- Learning the client’s payables routine lets you know when to expect payment—so you can act promptly if it doesn’t arrive on schedule.
- Itemizing invoices using the same language in the original bid, and making sure the invoice covers all work done to date can speed processing time.
- Marking all invoices as “Due on Receipt” can help place them at the top of a pile of payables. Offering small discounts for fast payment may have a similar effect.
- Scheduling payment reminders to go out at regular intervals can help keep your invoice at the top of the payables pile.
- Don’t do work or purchase materials for any change orders that haven’t yet been approved in writing by the client. Otherwise, you’re handing negotiating leverage to the client while you’re left to defend outlays after-the-fact.
- Keeping close track of operating liabilities like payroll taxes, union dues, insurance fees, etc. assures you’re charging enough on every bid to cover these costs, and that you’re not caught by surprise when they increase.
- Using digital invoicing and payment solutions makes it easier for clients to pay, expedites the movement of money through the banking system and streamlines internal bookkeeping processes.
- Training your back-office team members on the importance of cash flow, and how their work can impact it, sounds obvious, but it’s often overlooked. People who handle administrative functions don’t always realize their own role in improving cash flow, and they need you to make it their priority.
- Spreading out costs by using a line of credit or credit card to purchase materials adds interest expense, but it preserves your cash-on-hand for payroll and other immediate needs.
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