Many contractors complain bitterly about their lack of cash
flow. That's no surprise, given that employees, subs, and
vendors all expect to be paid — whether or not the
customer has paid the company.
This problem would not exist if customers paid up front, but
in some states it's illegal to front-load construction
contracts. Even where doing so is allowed, not every customer
will agree to do it. The fact that most construction companies
are underfunded to begin with only makes matters worse. Once
cash-flow problems appear, they tend to multiply and lead to a
vicious cycle.
Cash Crunch
One contractor client of mine experienced nearly catastrophic
cash-flow problems because a customer who had started out
paying promptly began taking longer and longer to pay each
invoice. When the contractor asked what was going on, the
homeowner told him, "Look, I'm out of cash, but I promise to
pay you as soon as my additional financing comes through. But I
can't get financing until the project is finished, so the
quickest way for you to get paid is to finish the job
quickly."
The contractor had foolishly allowed himself to get in so deep
on this job that he felt the only way to bail himself out was
to go along with what the customer wanted. But finishing the
job meant covering his payroll and payments to subs and vendors
out of his own cash flow — which turned out to be
insufficient.
In the end, my client managed to keep his company afloat and
to collect partial payment, but he still lost money because he
had to pay significant interest and penalties on his past-due
bills.
If only he had taken a few simple steps early on that could
have helped him manage his cash flow, he would have saved
himself a lot of trouble — and money.
Bill Early, Bill Often
It takes a lot of paperwork to run a construction company,
much of it related to ordering and paying for material and
labor. Billing the customer requires substantially less
paperwork — yet many contractors seem to put this task
off. If you are going to succeed in business, you need to put
as much time and effort into asking for money as you do into
paying the bills.
Too many contractors invoice customers once a month, or when
they notice they're short on cash. I tell my clients to get
into the habit of creating invoices weekly. This doesn't mean
that everyone pays once a week — some jobs might be
invoiced every other week. The trick is to stagger the
invoices: Bill half the customers one week and the other half
the next. What's important is that you request cash from at
least one client every week.
The shorter billing cycle not only brings cash in more quickly
— it also functions as an early-warning system. If the
customer can't — or won't — pay, it's better
to find that out when he owes you for only a week or two of
construction than when he owes you for six weeks of work.
It's also more profitable in the long run to invoice
frequently. Why? Because if you collect from clients
frequently, you will be able to take all vendor and supplier
discounts and avoid having to pay penalties for accounts past
due.
Pay Attention to Billing
Methods
Cash flow from progress billings is different from cash flow
from T&M billing or milestone billing. But whatever
method you use, be sure to time your billings to match your
cash requirements.
Start by determining which bills you need to pay when. If you
have more than a few employees, the cash needed to pay them is
probably your first priority. You may want to separate the
invoicing process so that customers pay for labor weekly and
receive invoices for the subs and materials only every other
week.
Milestone billing. The problem with
milestone billing is that it is often structured so that the
contractor gets paid only upon "substantial completion" of a
particular phase of the project. Unfortunately, "substantially
complete" might mean different things to the contractor and to
the client.
For example, if payment is due upon completion of drywall, and
you can't finish one of the ceilings because the recessed light
fixture is on back order, the client may believe he doesn't
have to pay until that ceiling is done. So you'll have to
either wait until the ceiling is complete to get paid, or
convince the client that the drywall is substantially complete
in spite of that one missing ceiling.
To avoid having to haggle about when things are substantially
complete, tie payments to the start rather than the end of a
phase. For example, instead of keying the payment to the
completion of drywall, key it to the beginning of interior
trim. As soon as the doors are delivered and one of them is
installed, no one can reasonably argue that interior trim
hasn't begun.
Progress billing. Progress billing
— also called percentage-of-completion billing and AIA
billing — is preferable to milestone billing because
it more closely ties payments to expenses.
With progress billing, you break the job into smaller phases,
such as demolition, framing, and finishes. When you invoice,
you determine what percentage of each phase has been completed
since the last invoice and bill accordingly. Since phases
overlap, you will likely bill for more than one each
month.
Many small contractors shy away from percentage-completion
billings because they think it's too much work and requires
giving too much pricing information to the client. But progress
billing can significantly improve cash flow and is not that
difficult if you limit yourself to a small number of very
general phases.
Furthermore, with this kind of billing, you can front-load the
prices — that is, take money from phases that occur
late in the job and use it in earlier phases.
With progress billing, it's important to invoice for change
orders as soon as they happen; don't wait until the end of the
job to bill for them.
Use OPM
OPM stands for "other people's money." Many small contractors
end up covering their clients' expenses; then they simply hope
to get paid. This makes it hard to maintain cash flow and puts
the contractor into a position where he's one bad job away from
going out of business.
T&M (or cost-plus) invoices can be timed to your
advantage so that you can use other people's money. First, you
purchase the materials; then you invoice the client; next you
receive the money from the client; and finally you use the
client's money to pay for the job costs. If you time this
sequence right, you will be paid by the client before your
payments to vendors are due (see "Accrual vs. Cash Accounting,"
Business, 10/04).
Credit cards. Sometimes, however,
the timing is too tight or the vendor requires a deposit or
cash up front. In this case, careful use of credit cards can
help, but only if you are sure you will be able to pay the bill
when it's due. The finance charges and late fees from an
overdue credit card payment can be enough to put a struggling
contractor over the edge.
If you do choose to use credit cards, you can control your
billing cycle to improve your cash flow. For example, if your
card's cutoff date is the 20th, make your purchases on the 21st
of the month. That way, you have one month before the bill
arrives, and often two to four more weeks before it's
due.
Take All Discounts
Many vendors and suppliers offer discounts for early bill
payments. These discounts may seem small, but they can add up
to a significant amount over the course of a year. To improve
your ability to take advantage of such discounts, learn your
vendor billing cycles.
I know contractors who routinely wait until they've received
all the bills for each month before creating invoices for the
client. This means their invoices don't go out until about the
5th of the month — so even if the client pays within a
week, the contractor misses the 10-day window for taking the
vendor discount.
My recommendation? Don't wait for all the bills. Invoice
clients by the 25th of each month. That way, you'll be able to
use the client's money to take advantage of the early-payment
discounts.
Keep Track of Overbilling and
Underbilling
Front-loading a contract or invoicing a client for work that
isn't yet done is called overbilling. This can certainly boost
cash flow — but it may be illegal in some
states.
That said, overbilling is common practice for construction
companies.
If you do overbill, it's important to account for it in your
P&L statement. Overbilling can cause you to overstate
your profit, increasing the chance you'll run out of cash
before the end of the job. Contractors who routinely overbill
and do not manage the process often end up using tomorrow's
cash (overbillings) to finish today's jobs.
Underbilling — doing the work without invoicing the
client — is even worse. I was once in a contractor's
office when a client called to complain about the invoice. His
complaint? That an invoice had not been sent!
If you want to maintain good cash flow, you need to avoid
getting behind on your paperwork. That means sending out
invoices as soon as possible.
Leslie Shinerhas worked as a financial and management
consultant for more than 25 years. Her office is in Mill
Valley, Calif.