Construction companies often face cash flow challenges due to their position in the payment chain. Subcontractors rely on timely payments from general contractors (GCs), who, in turn, depend on funds from project owners. This can lead to significant financial strain as subcontractors must cover operational costs upfront, such as labor, materials and rental fees, often waiting 60-90 days for invoices to be paid. This paper explores the consequences of cash flow issues, mitigation strategies and best practices for planning adequate cash flow in construction.
The Risks of Insufficient Cash Flow and Undercapitalization
Undercapitalization can be a serious risk for construction companies, especially given the industry’s typical profit margins of around 5%. Insufficient cash reserves lead companies into a cycle where future project payments are used to fund past projects—an internal “pyramid scheme” that creates instability and financial risk. Preventing this cash flow cycle requires proactive strategies, clear visibility into cash flow status and careful financial planning.
Understanding the Construction Cash Cycle
Unlike many industries, construction has unique payment cycles that involve substantial upfront costs with delayed payments. Subcontractors need sufficient cash reserves to cover ongoing costs, such as payroll and supplier payments, between billing periods. A typical payment delay of 60 to 90 days can cause serious liquidity issues if cash reserves are not adequate. Without cash on hand, subcontractors risk their ability to meet financial obligations, which could jeopardize project timelines and relationships with vendors and clients.
Example: A subcontractor completes a phase of work and submits an invoice. While awaiting payment for 60+ days, they must continue paying for labor, equipment rental and materials. Without sufficient reserves or a line of credit, they may struggle to meet these expenses, potentially stalling work on the current project or impacting others.
Forecasting and Cash Flow Management
Effective cash flow forecasting is essential for avoiding cash shortfalls. Subcontractors should monitor cash flow on a rolling basis, ideally bi-weekly, to identify potential shortfalls before they become critical. Key elements of a robust cash flow forecast include:
- Work-in-Progress (WIP) Projections: Estimate revenue and costs associated with ongoing work. Is the project on-time and within budget? What is the deviation of the project plus or minus number of days?
- Stress Testing: Assess how potential delays or unexpected costs may affect cash needs. What does the revenue stream look like in relationship to the accounts payable stream?
- Periodic Reviews: Review cash flow status at regular intervals to make timely adjustments. Weekly reviews with the construction management team is one viable option to establishing a review of the cash flow and project statuses.
This approach allows subcontractors to anticipate tight cash flow periods and plan accordingly, especially when GCs impose additional documentation requirements or conditions that delay payments.
Contract Terms and Payment Conditions
A thorough understanding of contract terms, especially “pay-when-paid” and “pay-if-paid” clauses, is essential for cash flow stability. These terms can significantly delay payment, affecting subcontractors’ ability to plan and allocate funds effectively. Clear communication with GCs about contract expectations and payment terms can help mitigate delays. Additionally, maintaining transparency with vendors about any delays can foster trust and prevent strained relationships.
Example: Suppose a GC has a “pay-when-paid” clause and adds a new requirement for progress documentation before releasing payment. The subcontractor, by understanding these clauses and staying in communication, can anticipate potential delays and plan cash flow accordingly, preventing a last-minute scramble for funds.
Strategies for Cash Flow Stability
Construction companies can stabilize cash flow by establishing sound financial practices, including the following:
- Establish Retained Earnings:
- Retained earnings create a cash reserve that acts as a financial buffer between projects, ensuring funds are available for operations. Rather than investing all earnings in equipment or real estate, construction companies should build a retained earnings account. This account provides essential working capital, especially as the company grows. Establish a minimum of 90 day working capital fund.
- Example: “Financial professionals may view retained earnings as idle cash, but it’s crucial for financing growth without relying on external loans.” (Source: Step-by-Step Cash Flow Management – Simpler Foundation)
- Set Up a Line of Credit:
- A line of credit with a preferred financial institution provides liquidity to cover temporary shortfalls, particularly when vendor accounts extend beyond 45 days. Though it may require collateral, a line of credit can be invaluable for navigating cash flow challenges without disrupting operations.
- Implement Key Performance Indicators (KPIs):
- KPIs help monitor financial health and provide early warnings when cash flow is at risk. Both leading and lagging KPIs offer valuable insights. Leading KPIs are particularly useful as proactive indicators that allow the management team to adjust before cash flow issues arise.
Key Performance Indicators (KPIs) for Construction Cash Flow
A balanced approach to KPIs—incorporating both leading and lagging indicators—helps construction companies not only assess past performance but also anticipate future needs and constraints.
Leading KPIs
Leading KPIs are forward-looking, proactive indicators that allow companies to make adjustments to steer future outcomes. In construction, some key leading KPIs include:
- Bid Win Ratio (Hit Rate): Reflects the effectiveness of the bidding process. A high win rate signals competitiveness and a healthy project pipeline, directly influencing future cash flow. However, do not over extend the pipeline. Considerations of cash flow, resource allocations and business process bandwidth need to be evaluated before signing the next job. It is not uncommon for companies with a high hit rate to be insolvent when multiple jobs are in process.
- Labor Productivity (Revenue per Labor Hour): High productivity suggests efficient labor use and minimizes cost overruns. Lower productivity may indicate potential project delays or resource inefficiencies. Watch over allocation of labor on jobs. Bidding for eight workers and then having 16 workers on the job and extending the job by 30 days is problematic.
- Backlog Growth Rate: A growing backlog indicates future revenue potential and the need to plan resources and finances accordingly.
Lagging KPIs
Lagging KPIs provide feedback on past performance, helping assess how effectively a company managed cash flow and resources. Key lagging KPIs include:
- Project Gross Margin: Measures profitability, showing whether projects met financial expectations.
- Days Sales Outstanding (DSO): Reflects the time taken to collect payments. A high DSO signals collection issues, while a lower DSO indicates a healthy cash flow.
- Project Schedule Variance (PSV): Tracks adherence to schedules, with delays potentially leading to increased costs and reduced cash flow.
Summary of Leading vs. Lagging KPIs:
| Aspect | Leading KPIs | Lagging KPIs |
| Purpose | Predict future performance | Assess past performance |
| Timing | Forward-looking | Backward-looking |
| Focus | Process, behavior, inputs | Outcomes, results |
| Proactivity | Enables corrective actions | Used for performance evaluation |
| Examples | Bid Win Ratio, Labor Productivity | Project Gross Margin, DSO, Schedule Variance |
In essence, leading KPIs provide proactive guidance, allowing companies to steer financial health in real time, while lagging KPIs offer insights into the effectiveness of past strategies.
Final Thoughts on Cash Flow Management for Construction
Construction companies must navigate complex cash flow challenges due to the nature of their payment cycles, high upfront costs and reliance on delayed payments. By focusing on clear forecasting, understanding contract terms, building retained earnings and using KPIs, companies can stabilize cash flow and mitigate risks. These strategies allow construction companies to maintain financial health, support growth and improve project outcomes by proactively managing cash flow constraints.
REFERENCES
How to Manage Your Accounts Payable as a Construction Contractor – Atlas CFO
Tips for Managing Your Accounts Receivable as a Construction Contractor – Atlas CFO