Poor Cash Management Can be Kiss of Death in Construction Industry

By Jim Jordan

Construction companies can avoid such a destiny and enhance their bottom line by enacting thorough cash-flow forecasting procedures.

For any business, mismanagement of cash flow usually proves fatal. Yet many companies continue to relegate day-to-day cash flow to their list of secondary concerns, assuming cash will continue to flow while they focus instead on net profit, market share and other chief features of their business plan..

Unfortunately, poor cash management and forecasting is epidemic in the construction industry, making it difficult for companies to secure lines of credit and properly fund operations. Even worse, it's a major reason why 80,000 American construction companies failed between 1990 and 1997, with 10,867 failing in 1997 alone. Most of the failures were due, among other reasons, to ineffective financial management systems, according to industry studies. Most of these firms, it should be pointed out, were small- and mid-size operations with small administrative staffs and weak controls.

Given the rather unique nature of the industry's bidding and billing processes, construction companies both large and small can greatly enhance their bottom line by enacting thorough cash-flow forecasting procedures. Many companies fail to do so, however. In fact, one industry study shows that only 25 percent of companies with revenues of $10 million or less even try to forecast cash. Although laziness is a major reason, lack of understanding is the main problem.

Too many managers continue to fool themselves about cash-flow management. Cash flow is not depreciation added to the bottom line of an income statement. Managers cannot learn what they need to know about cash flow by merely looking at their income statements and balance sheets. They need timely information about collection of receivables and their organization's ability to repay debt and purchase equipment.

Cash flow from operations is the cash a company generates from receipts from customers and disbursements for job costs and overhead -- but before asset purchases and debt repayment. Over five or more years, cash flows from operations should approximate net income before depreciation. Financially sound companies tend to have a ratio of net income (excluding depreciation) to cash flows from operations that are close to one-to-one over a five-year period. Companies that aren't faring well tend to have a high ratio of net income to cash flows from operations.

Cash management is critical to a company's success for many reasons, perhaps none more important than bank financing. In considering whether to extend credit or grant loans, bankers look closely at cash flow. Strong cash flow reflects strong viability, which is what all bankers require before determining how a loan may be collateralized. Bankers want to be repaid with cash, not the collateral.

To successfully manage cash flow, there are several steps company executives can initiate. They include:

• Establishing systems that calculate actual cash flow on a regular, dependable basis. The best of these systems delineate cash flows month by month.
• Investing excess cash: When companies find themselves with excess cash, they should begin a dialogue with their financial consultants or bankers about ways the cash can be invested.
• Identifying areas of operation where cash flow can be increased: The process should begin with accounts receivable. At the most successful companies, receivables average fewer than 40 days old. Contractors should not become complacent about collecting money and should look carefully at how often they under-bill.
• Talking with bankers about cash management services.

Among its many benefits, forecasting can shed an entirely different light on a company's operations. Only through extended forecasting do many companies learn they need to maximize cash flow by negotiating better payment terms with project owners before contracts are signed.

Regular forecasting can also reveal much about the financial viability of clients. The process often pushes construction companies to do a better job of determining the creditworthiness of owners and the adequacy of their project loans.

After two years of hard market conditions, it appears the construction industry is poised for growth. For those who want to reap the benefits, it's time to adopt accounting fundamentals, and perhaps none is more important than cash-flow forecasting. Always remember: Cash is king.