In Construction, Cash is King
A few days ago I met a fellow after doing laps in the pool, ala Michael Phelps! (I’d like to think we know as much about construction as Michael knows about swimming.) We began talking and sure enough he was the proud owner of a thriving construction company… but it wasn’t always that way. In fact, he shared with me the trials and tribulations he had experienced in the construction business. We laughed about the scrutiny his work received when doing custom mansions for the very wealthy. And then we talked more seriously about a dramatic change in his career. You see, this strong willed Irishman was a victim of a key risk factor: Mismanagement of cash flow.
He shared with me how cash flow had put him out of the construction business. His claim to fame was the installation of high end custom wood work in plush offices and homes. As he became bigger, he just was not prepared for the cash flow crunch that he would experience. He shared with me his frustrations at getting paid from General Contractors who always had an excuse for not paying, and he used a few choice words. It was obvious that he had experienced what has put so many companies out of business, a cash shortage. He indicated he was making good money, and I believe that because custom millwork brings a good margin and there is not a lot of competition for highly specialized woodwork. He had different types of wood shipped in from all over the world and he shared with me how even though he was profitable, when he pursued the bigger work, cash flow became too much of an issue and he was forced to reinvent himself. This certainly is a familiar story.
There is a basic collection tenet that states “the longer the bill is outstanding, the less the chance of collection.” Although this particular construction company was able to collect its money, the bill was outstanding just too long, often up to 90 days according to his description. This brings us to the importance of conducting cash flow projections. You see, if he had been able to project the cash demands for his company, he may have found the cash resources in advance to continue it. That is why it is imperative to continually assess the timeliness and the probability of collecting open accounts receivable. This is particularly important in the construction industry because of the sizable dollar amounts that can be withheld. It is also important to recognize that the longer the bill remains outstanding the more likely you could be talking about a bad debt, and that possibility needs to be taken into account in cash flow projections as well.
Particularly in tough economic times as we are now experiencing, each owner, developer, and general contractor has to be scrutinized before doing business with them and finding out that they themselves have run out of cash. Since it is difficult to accurately predict when down cycles will come and go, a continuous aggressive collection effort will assist in increasing cash flow and lowering doubtful accounts. Therefore, accounts receivable personnel and/or project management must regularly meet with senior managers to discuss potential collection issues that might arise. If a contractor does not regularly perform this task, it will usually fail to react fast enough to manage potential cash shortages. Failing to do this exercise over a long period of time can result in overstated receivables and a misrepresentation of the financial strength of a company, potentially misleading management, banks and bonding companies. Since bad debt expense directly impacts the bottom line of the financial statement, a bank or surety may believe it was misled in its credit decisions by the contractor’s failure to reveal the bad debt in advance. When a bad debt expense suddenly arises after being uncollectible for a long period of time, key bank and bonding relationships may be damaged.
The summary of all this is that cash is king, and failing to perform cash flow projections is a major risk factor in industries that experience fast moving cash like construction. To lessen the risk of potential harm, a contractor must project speed of receipts, have meetings to identify potential collection problems, try to recognize bad debt in advance and aggressively collect open accounts receivable. Only by doing cash flow projections can you take all these factors into account and avoid a surprise cash flow shortage. In the case of my new contractor acquaintance, every story has a silver lining. He decided to go into high end millwork as a manufacturer only. Now he gets paid up front for the expensive woods he uses and gets paid within 30 days as a vendor having a much needed product that is not easily found elsewhere. Hurray for him, he avoided being another one of the many construction companies that have simply failed by running out of cash, even while making a profit.