Construction Cash Flow Management: The Blue Print to Scaling

1 Introduction
2 Cash flow and working capital
3 Planning and pricing for cash flow
4 Managing income and expenditure
5 Client and supply-chain management
6 Financial management during project delivery
7 External finance
8 Managing growth
9 Conclusion
10 Related articles on Designing Buildings

[edit] Introduction

Cash flow is a critical consideration in the management and financial stability of construction businesses. Construction projects commonly require contractors to incur expenditure on labour, materials, plant, subcontractors and overheads before corresponding payments are received from clients. A business can therefore report a profit while experiencing a shortage of available cash. Effective cash flow management involves forecasting the timing of income and expenditure, controlling costs, managing payment processes and maintaining sufficient working capital or access to finance.

As a construction business grows, the value and number of projects undertaken can increase the amount of working capital required. Higher turnover does not necessarily produce greater available cash, particularly where projects involve substantial upfront expenditure, long payment periods, retentions or delayed certification and payment. Cash flow management is therefore an important part of construction business planning and project management.

[edit] Cash flow and working capital

Cash flow is the movement of income into and expenditure out of a business over time. In construction, it is also used to describe the analysis and forecasting of when project costs will be incurred and when payments are expected to be received. A cash flow forecast can be used to identify periods when additional funding may be required and to assess whether available resources are sufficient to meet financial commitments.

Working capital is the operating liquidity available to a business and is generally calculated as current assets less current liabilities. For a construction contractor, working capital can include cash, trade debtors, stocks and other current assets, offset by trade creditors and other current liabilities. Effective management of debtors, creditors, stocks and cash can reduce the amount of external funding required for day-to-day operations.

A contractor can experience a working capital requirement even where individual projects are profitable. For example, expenditure on labour and materials may occur several weeks before the associated work is valued, certified and paid. Multiple projects operating simultaneously can increase this requirement because expenditure is incurred across several projects before payments from earlier work have been received.

[edit] Planning and pricing for cash flow

Cash flow should be considered during tendering and project planning rather than only after work has commenced. A contractor can assess the anticipated timing of expenditure against the contractual payment mechanism and identify periods when significant funding may be required. The cost of financing this working capital requirement may form part of the contractor's overall business costs and, where appropriate, the tender price.

Payment provisions are particularly important. Construction contracts may provide for interim, periodic or stage payments, with the relevant dates and procedures established by the contract. A payment schedule can help identify when applications, payment notices, pay less notices and payments are due. The precise requirements vary according to the contract and applicable legislation, so contractors need to understand the particular payment mechanism applying to each project.

Where appropriate, payment structures can be arranged around measurable stages or regular valuations rather than relying solely on payment at completion. This can reduce the period for which a contractor has to finance completed work. However, the payment mechanism must comply with the contract and applicable statutory requirements.

The Housing Grants, Construction and Regeneration Act 1996, commonly known as the Construction Act, contains provisions concerning payment in construction contracts in Great Britain. These include rights relating to interim, periodic or stage payments, payment notices, suspension for non-payment and adjudication. The Act does not create a single standard payment period for all construction contracts; the applicable payment mechanism depends on the contract and the statutory framework.

[edit] Managing income and expenditure

Effective cash flow management requires contractors to raise applications for payment or invoices in accordance with the contractual requirements and to provide the information needed to support them. Delays can occur where applications are incomplete, submitted late or do not comply with the contract. Maintaining accurate records of valuations, variations, supporting documentation and payment dates can help reduce administrative delays and disputes.

Payment should be monitored against the contractual due date and final date for payment. Where payment is delayed, the contractor should establish the reason and follow the contractual procedures for dealing with non-payment or disputed sums. Simply delaying the submission of an application or relying on informal arrangements can adversely affect cash flow.

Cash flow forecasting should be updated throughout a project. Forecasts can incorporate anticipated applications and payments alongside expected expenditure on labour, materials, subcontractors, plant, taxation, finance and overheads. Comparing forecast and actual cash flow can identify emerging funding requirements and changes in project performance.

Cost control is closely connected to cash flow. Regular monitoring of actual expenditure against budgets can identify excessive labour costs, material waste, rework, subcontractor costs and other departures from the project budget. Cost information should be sufficiently current to allow corrective action before cost overruns become significant.

The timing of expenditure can also be managed through effective procurement and supply-chain planning. Negotiated credit terms may reduce the period between expenditure and receipt of project income, although payment obligations to suppliers and subcontractors must continue to be met in accordance with their contracts. The objective should be to manage the timing of legitimate liabilities rather than to delay payment improperly.

[edit] Client and supply-chain management

The financial standing and payment performance of clients can affect a contractor's cash flow. Appropriate commercial due diligence before entering into a contract can help identify risks associated with client solvency, funding arrangements, payment history and contractual terms. The level of due diligence should reflect the size and risk of the proposed project.

Subcontractors and suppliers also have an important role in project cash flow. Delays in procurement, delivery or subcontracted work can affect the construction programme and consequently the timing of valuations and payments. Conversely, contractors need to ensure that their own payment practices do not create unnecessary financial pressure within the supply chain. Cash flow problems affecting subcontractors or suppliers can result in disruption, reduced productivity and, in severe cases, insolvency.

The payment chain can be particularly significant on large projects involving several tiers of contractors and suppliers. The Construction Act includes provisions intended to support regular and prompt payment through the construction supply chain and prevents certain forms of 'pay when paid' arrangement.

Retention can also affect cash flow. A retention is an amount deducted from sums otherwise due under a construction contract and held until specified contractual conditions are met. Where retentions are used, the timing of their release should be incorporated into cash flow forecasts. Retentions can represent significant sums for contractors and other parties in the supply chain.

[edit] Financial management during project delivery

Cash flow management should form part of routine project and business management rather than being treated as an annual financial exercise. The frequency of monitoring required depends on the size and complexity of the business and its projects, but larger contractors may require frequent or continuous monitoring of project costs, applications, receipts and expenditure.

Project managers and commercial teams should understand the relationship between programme progress, expenditure, valuations and payment. Delays to construction activities can result in expenditure being incurred for longer than anticipated, while delays to information, approvals or certification can affect the timing of income. Effective coordination between commercial, financial and site teams can therefore contribute to more predictable cash flow.

Labour productivity, procurement, material availability and subcontractor performance can also influence cash requirements. Poor coordination may result in idle labour, additional plant costs, material wastage, rework or programme extensions. These costs can reduce project margins while also increasing the amount of cash required to complete the work.

[edit] External finance

External finance can be used to manage temporary differences between expenditure and income. Possible facilities include overdrafts, revolving credit facilities and forms of invoice or receivables finance. The suitability of a particular facility depends on the contractor's financial position, the nature of its projects, the terms of the facility and the cost of borrowing.

Invoice finance may allow a business to obtain funding against eligible outstanding invoices or other receivables before the client makes payment. The proportion advanced, fees, interest, security requirements and eligibility criteria vary between facilities. It should therefore be assessed as a financing cost rather than treated as a substitute for effective payment and cost management.

External finance is generally most effective when it is used to manage predictable working capital requirements rather than persistent operating losses. Contractors should consider the total cost of borrowing, repayment requirements, security and the effect of interest and fees on project profitability before entering into a facility.

[edit] Managing growth

Rapid growth can increase a construction company's working capital requirement. Taking on additional projects may require increased expenditure on labour, materials, subcontractors, plant and overheads before additional project income is received. A business therefore needs to consider cash requirements as well as turnover and projected profit when assessing its capacity for growth.

A contractor considering expansion can use cash flow forecasts to model different levels of project activity and payment performance. This can identify the maximum funding requirement and the potential effect of delayed payments, cost overruns or programme changes.

Growth should also be supported by appropriate management systems, commercial controls and personnel. Reliable project information, accurate cost forecasting, effective procurement and disciplined payment administration become increasingly important as the number and value of projects increase.

[edit] Conclusion

Cash flow management is an integral part of construction business and project management. Profitability alone does not guarantee that a contractor will have sufficient cash to meet its obligations because expenditure and income occur at different times. Effective management therefore requires realistic forecasting, appropriate contractual payment mechanisms, prompt and compliant applications for payment, active cost control, supply-chain management and sufficient working capital.

The objective is not simply to maximise turnover, but to ensure that the timing of expenditure and income remains manageable as the business undertakes more and larger projects. Appropriate financial controls can reduce the risk that otherwise viable construction businesses experience financial difficulties as a consequence of inadequate liquidity.