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FMI Quarterly/September 2013/September 1, 2013

Managing Cash Before Earnings

money_image“All sins are forgivable except one, and that is running out of cash!” Hank Harris, FMI’s president and CEO, has often said when teaching Financial Management for Nonfinancial Managers to construction industry leaders. The quote is even more appropriate as we recover from the Great Recession.

More companies will fail in an expansionary economy than in a recession. Why is this so? The answer is that growth and expansion take cash to fund growing payrolls and materials while projects are beginning. Building permits are currently at record levels and the construction industry is poised to be a significant contributor to United States GDP growth through 2013 and 2014.

Project teams have many difficult and challenging assignments in the building environment today. Ask, “How many of you are willing to work without a paycheck?” and you resoundingly get a one-word answer (or potentially a multiple-word response, with inclusion of colorful adjectives): “NO!” Fortunately, there are some tools and techniques to ensure everyone gets a paycheck and you have sufficient cash to run your company.

One of the best methods to manage cash is to ensure all finance personnel and project teams understand the concept of the “liquidity indicator.” In its simplest definition, the liquidity indicator uses income statement and balance sheet accounts to determine if your work-in-process is providing or using cash. The project liquidity is calculable at both the project and company/business unit levels.

The liquidity indicator for the company tells contractors how much cash operations generates from or is used by Work-In-Process (WIP). The liquidity indicator calculates cash demand using six key balance sheet accounts controlled by project management. These six accounts consist of three current asset accounts: receivables, retention receivable, and cost and earnings in excess of billings; and three current liability accounts: payables, retention payable and billings in excess of costs and earnings on contracts.

The net summation of the current asset accounts less the current liability accounts has three possible outcomes:

  • Zero, indicating that the funding and asset accumulation are in balance.
  • A positive number, indicating that project execution is consuming cash. That is, the contractor is financing the WIP.
  • A negative number, indicating that project execution is generating cash. That is, the owner, combined with other subcontractors and/or vendors, is financing the WIP.

Clearly, a better financial position for contractors is to have the owner and others financing the WIP.

Dividing the account balances of each asset and liability account by the average daily revenue produces the equivalency of a number of days’ revenue outstanding for each current asset and current liability account. Average daily revenue is computed by taking the annualized firm revenue and dividing it by 365. The quotient of the current asset or liability account balance divided by annualized revenue returns the average number of days of liquidity either applied to or provided by WIP for each respective account. A contractor can also identify the amount of cash that can be generated with an improvement to the ratio of current assets to current liabilities as well as which accounts offer the greatest opportunity for improvement.

The number of days outstanding can be compared to industry averages for all contractors, which are compiled by the Construction Financial Management Association (CFMA) or Risk Management Associates (RMA), to determine positive and negative comparisons to similar subcontractors. The ranges of days outstanding of accounts receivable and accounts payable for subcontractors within a certain volume range vary significantly within the industry. The goal for your firm should be to rank in the top quartile of firms in this comparison survey. These firms have best-of-class financial management practices.

Exhibit 1 shows a subcontractor with annual revenue of $22,120,246, which converts to an average daily revenue of $60,603. If this contractor is able to accelerate overbillings and improve collection of accounts receivable, a net improvement of five average revenue days or, equivalently, $303,015 (five days x $60,603) in generated liquidity would result.

2013q3_managing_cash_ex1

This same subcontractor is generating $1,324,882 from WIP, or 22 average revenue days. The use of trade credit and overbillings has allowed the contractor to reach a position whereby other people’s money (i.e., owners, vendors and subsubcontractors) is financing the WIP.

2013q3_managing_cash_ex2This same calculation applies to an individual project (see Exhibit 2). The days are not necessary to this analysis. The individual project accounts receivable, retention receivable and underbilling are totaled. This represents the “Cash Demand” from the project. The accounts payable, retention payable and the over billing for the project are totaled and deducted from the cash demand for the project. If the sum is negative, then the project is generating that amount of cash. If the sum is zero or positive, then the project is using cash. In Exhibit 2, cash in the amount of $55,500 is being provided from this project.

TEN TECHNIQUES TO ACCELERATE CASH GENERATION

1. Negotiate aggressive payments through an aggressive schedule of values up front in your contract. You are not in business to fund projects. The risk return relationships in your company are unfavorable enough without including the financial risk and cost of funding the owner’s project. For some reason, everyone likes to argue with this premise. The successful contractors are negotiating aggressive schedules of values and not making excuses. If you are not doing the same, then you might consider changing your thinking around this practice.

2. Bill and collect. Your job is to see that project billings are timely, accurate and consistent with the terms of the contract. A delayed, inaccurate or inconsistent invoice will cause most of the problems with a contractor’s cash flow.

3. Go ugly early. This is a phrase regarding how collecting money never gets easier, and the lack of noise on your part trains the people paying how to treat you. Aggressive collection efforts at the inception of the project show the owners you are watching payments and that they matter on the project.

4. Do your due diligence on projects and clients. Many large financial investments are made without any checks of creditworthiness or proper funding of projects. If you have failed here, you do not have an excuse when the cash runs out. It is an easy and necessary step as well as a good practice to follow.

5. Do great work. Many collection issues are camouflaged performance issues. A contractor that performs excellent work provides great service and has discipline around billing and collecting is quickly paid. Settle change orders quickly. By following the terms of the contract and proactively managing the change order process, you can avoid significant adjustments at the end of the project.

6. Communicate, communicate and communicate with your owners. Most owners and parties to contracts are reasonable. Construction is about a constantly dynamic and changing environment and experienced people understand the process. Being candid and early in options and benefits provides those with vested interests opportunities to participate in the decision process. You are more likely to have successful outcomes by overcommunicating than  undercommunicating. Take advantage of every opportunity to demonstrate your knowledge of the process and options along the way.

7. Know how to negotiate. My son-in-law has been a project manager for a general contractor for the past eight years and has never received any training on negotiating skills. Negotiating change orders, schedule dates, cost adjustments and numerous other aspects of the construction process involves constant trade-offs. Project managers are constantly negotiating.

8. Submit to arbitration in the contract. This process is far better and more cost-effective than legal action. Appointing an arbitrator and submitting to arbitration in advance are preferable to litigation. You will be further ahead using this method of resolving differences.

9. Retain a construction attorney to collect. This is your last resort. Very few contractors leave the courtroom saying, “Man, I am glad I did that!” Avoid the legal route since the process is extremely slow and expensive. No one wins here.

Project management is a difficult job. All aspects are challenging in today’s construction environment, but tools like the Liquidity Indicator facilitate understanding and application of sound financial management for project managers. The three key roles for successful project management include building the project correctly, managing the cost to earn a profit and ensuring the cash flow is positive from the building process. The tools and ideas in this lesson will help with your final role in the project execution process.


Ken Roper is a principal with FMI Corporation. He can be reached at 303.398.7218 or via email at kroper@fminet.com.

 

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