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Financial Management and Accounting for the Construction Industry

Reproduced with permission. Originally appeared in Financial Management and Accounting for the Construction Industry. © 2015 LexisNexis Matthew Bender.

 

Cash Management

Organizational Control

Responsibility

Every contractor should have one individual responsible for organizing, planning, and controlling cash. In small construction firms, this individual may be the president or the controller. In large firms, a chief financial officer (CFO) or treasurer may have the responsibility. In some large construction companies, the treasurer may have one or more individuals in an organization separate from the accounting department working in cash management. From the standpoint of fiscal control, this arrangement is preferable, because control over corporate funds is a separate function from accounting for them, and the two processes, if properly designed, act as checks and balances for each other.

Position descriptions for the individuals who are responsible for the company’s cash management functions should be prepared. These position descriptions should clearly specify limits of authority and specific duties and responsibilities that reflect the contractor’s cash management philosophy.

Specific duties and responsibilities of the cash manager should include the following:

(1) prepare and maintain annual cash budgets, reporting budget versus actual on a monthly basis and reasons for major variations;

(2) prepare and maintain project cash budgets;

(3) forecast cash inflows and outflows at least weekly;

(4) maintain records of cash balances and investments;

(5) maintain historical information to support investment performance and bank performance;

(6) develop and maintain internal and external float information;

(7) initiate funds movements to meet the company’s forecasted cash needs and maintain audit trails of funds movements initiated;

(8) recommend changes to cash management policies and procedures based on external or internal factors; and

(9) alert management to increased borrowing needs or other significant events due to variations in planned cash flows.

Cash Management Policies and Objectives

The primary duty of the construction company’s cash manager is to establish cash management policies and an overall cash management plan with specific objectives explaining how the plan is to be implemented in daily operations. Policies must be established in several areas, including the following:

(1) check-signing and/or debit card authority and limits;

(2) internal check and cash handling for both corporate office and field personnel;

(3) risk level of investments;

(4) criteria for use of bank or other services required to mobilize or invest corporate funds;

(5) segregation of cash and establishment of minimum levels of:

(a) project-related cash,
(b) fixed operating cash,
(c) capital reserve cash, and
(d) excess or emergency cash;

(6) discounts; and

(7) billing.

Some construction companies have developed comprehensive policy manuals for cash management to distribute to all personnel involved in cash management activities.

Many construction companies have successfully implemented a “zero cash” program. In this program, cash managers strive to invest, on a daily basis, all collected balances at all banks at favorable rates and maturity schedules to maximize investment return. The objective is to maintain the company’s book balance at zero or below and, therefore, show a negative cash position on its balance sheet.

Note that each transaction at a bank, such as a wire transfer, payable through draft, purchase of a debt or equity instrument, or check cashed, has a specific cost or compensating balance requirement associated with it. Another objective of a cash management plan is to minimize the number of transactions required, which is as much of an art as it is a science and is difficult to quantify in dollar terms. For small contractors, the best method for accomplishing this objective is to be assured that each transaction performed is cost effective for the company. Techniques for evaluating one-time and ongoing costs and benefits of transactions are discussed in § 15.08, below.

The Cash Management Plan

A formal cash management plan should be established to measure results. The plan is necessary in approaching banks or other cash management service providers in order to evaluate alternatives effectively. The overall plan also serves as guidance for cash management services that are required for proposed projects and their anticipated costs for purposes of project pricing. In addition, the plan should contain a formal process for ongoing evaluation of the plan with respect to its effectiveness.

Cash management plans are developed from the company’s general or overall business plan. Elements of the cash management plan taken from the business plan include the geographical areas where projects are marketed and sold or specific product mix by geographic area.

In addition, a detailed understanding of owner, vendor, and subcontractor cash management systems is required in order to develop the plan. A profile of each owner, including banks used and historical information on each invoice submitted with respect to invoice date, date mailed (if different), check date, deposit date, and availability date should be maintained and monitored periodically for change. Profiles of each vendor, subcontractor, and major dollar payee should also be similarly maintained.

These profiles are used to develop the formal cash management plan, which should include the following:

(1) physical location of banks to be used;

(2) required accessibility to branch banks or correspondent relationships;

(3) specific services required and transaction volumes;

(4) investment requirements;

(5) size and number of credit lines; and

(6) specialized services required including:

(a) international,
(b) discount brokerage, and
(c) trust services.

This information can be used in assessing banking requirements and in selecting banks.

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Cooperation Between Contractors and Banks

The Need for Cooperation

Most construction firms, even small ones, do business with many banks. Typically, the majority of lending and cash management activities take place in one or two banks.

The selection of banks requires the same diligence and criteria as the selection of any other service. The cash management plan is used as a basis for selection in conjunction with several other important factors, including the contractor’s knowledge of construction industry needs and financial stability, as well as, the banks:

(1) capability to provide financing;

(2) sophistication to meet changing needs; and

(3) pricing of services.

Banking services should be re-evaluated at least annually. The decision whether to change a primary bank, however, should be balanced against the value of the existing relationship. Banks value relationships with good customers and are more likely to help companies with whom they have long-term relationships rather than relatively unfamiliar organizations.

The primary criterion for choosing a bank is the overall package of services provided. Depending on the services needed, different selection criteria can apply. For disbursement services, the convenience of a bank to a construction site is a consideration for payroll check cashing by job site personnel, even though bank branches are generally widespread in most states and other check cashing options are available. For collection services, banks used by owners or title companies might be favored.

Bank Products

Competition among banks for business deposits has created a wide selection of products and service offerings. Most of these services fall into the following categories:

(1) cash management services,

(2) information services, and

(3) business services.

Banks and consulting firms have developed specialized staffs to evaluate internal and external cash management procedures and develop recommendations. For the cash manager, using several banks’ cash management consulting services and evaluating each approach may be an appropriate method of selecting an overall approach. An individual bank will present its services in the most favorable light thus making a comparison of multiple bank proposals difficult. In these situations, the contractor either must be very familiar with the various banking services or, in some cases, seek an unbiased third party to help in the evaluation of the various services and pricing.

Perhaps the most important category of bank services for construction companies is information services. Daily information on receipts, disbursements, investments, and loan balances is what the cash manager uses to make daily decisions regarding the movement and investment of funds. Banks and third parties provide deposit and balance reporting services, which can interface with a company’s information system. These services can include reporting information from more than one bank, thereby automatically consolidating information the cash manager would otherwise need to consolidate himself. Some banks also offer cash forecasting and automatic investment of excess funds based on company-supplied criteria.

Banks also provide a wide variety of other services, including payroll, accounts payable, accounts receivable, wholesale and retail lock boxes, controlled disbursement, zero-balance accounts, concentration accounts, sweep accounts, wire transfers, EDI (electronic data interchange), ACH (automated clearing house), and inventory services. The cash manager should evaluate the appropriateness of each service for inclusion in the contractor’s business/cash management plan.

Banks price these services on the basis of either a fee for service or an earnings credit against a compensating balance. In a fee for service arrangement, the bank charges a flat fee for each transaction. If compensating balances are required, an earnings credit rate established by negotiation with the bank is applied to average daily collected balances. Compensating balance requirements change monthly due to changing transaction volumes, service mix, and interest rates. In evaluating pricing alternatives, the cash manager should understand that some banks “double count” certain deposits for computation of compensating balances or give partial earnings credits on tax deposits.

An alternative method of fee payment to banks is the “non-interest-bearing certificate of deposit.” Under this arrangement, the contractor places sufficient funds to cover projected service fee needs into such an account. The advantage to the bank is that the reserve requirements for certificates of deposit are significantly lower than for demand deposits and, therefore, its lending base increases. Some banks will share these “savings” with contractors, by lowering the compensating balance requirement for the company.

Note that contractors exclusively using compensating balances can affect the requirements for outstanding loans and create hidden costs of capital. For example, if a contractor borrows against a line of credit with a stated interest rate and a compensating balance requirement, the effective interest rate is actually higher because of the opportunity cost of capital of funds tied up in the compensating balance. In addition, only the stated rate of interest is deductible for federal income tax purposes.

The use of fee for service in lieu of compensating balances as compensation for loan servicing or bank services potentially is preferable in some circumstances. In addition, fees are negotiable just as compensating balance rates are. These pricing issues are of prime importance in selecting a bank for the company.

The decision to pay for services with fees or balances should be periodically evaluated. The earnings credit rate is important in evaluating the decision because it represents what the bank is actually paying a customer for balances on deposit. Idle balances are unproductive, as typically they cannot be used against future charges.

Bank Reports

Although the format of reports varies widely by bank, the content of reports is essentially the same. Reports fall into two primary categories: (1) cash management reports, and (2) standard banking reports. Cash management reports are requested when cash management services are established and are usually available at a cost. The most familiar reports to the cash manager are standard banking reports, such as the monthly account statements, and monthly account analysis reports. These reports are generally available at no cost.

The account statement is simply the bank’s statement of beginning balances, detailed debits and credits, and ending balances. It is accompanied by checks cleared that month, unless the bank maintains check copies electronically, and is used primarily for internal bank reconciliation purposes by the contractor’s accounting department.

The account analysis statement is more useful to the cash manager if available from the bank. Banks generally require the customer to explicitly request account analysis statements. It shows, on a monthly basis, the basis for computing charges and amounts due for services provided by the bank. This amount is then compared against the “fee potential” for the account to determine whether the company has maintained sufficient collected balances in its account to reimburse the bank for services provided. The “fee potential” is defined as the amount of fees that would have been charged based on the transactions that the bank performs on behalf of the customer during the month. The “fee potential” is computed by rearranging the terms of the formula shown below by solving for the projected service charge (SC). A sample statement is shown in Figure 15-1.

Figure 15-1

For example, assume that projected service charges (SC) for a month are $450, the earnings credit rate (EC) is 7.5 percent, and the reserve requirement rate (RR) is 15 percent. Assume further that loan agreements call for a compensating balance of 10 percent and the projected average daily loan balance is $500,000. This requires a compensating loan balance (CLB) of $50,000. The average daily collected balance is calculated as follows:

To demonstrate the sensitivity of this computation to different variables, assume the following.

If an additional wire transfer costing $10 is performed by the company, the projected service charges would be raised to $460 and, therefore, the average daily collected balance would need to increase $156.87 to $66,039.22.

Certain computations shown in the example are based on fixed rates. The reserve requirement, not shown in Figure 15-1, is mandated by the Federal Reserve System, depending on the type of account. The transaction service costs are fixed by the bank, but may occasionally be arrived at through negotiation. The contractor can possibly negotiate required compensating balance rates to support outstanding loans and the earnings credit rate, although this practice is not as common as it was in the past.

A large portion of the cash manager’s job is to ensure that the average daily collected balance at the end of a month (net of overnight and other investments) creates a net earnings credit equal to service charges. In order to achieve this, forecasts of cash collections and disbursements for the month must be established as well as average daily loan balances. The target average daily collected balance is typically computed using the following formula:

For example, assume that projected service charges (SC) for a month are $450, the earnings credit rate (EC) is 7.5 percent, and the reserve requirement rate (RR) is 15 percent. Assume further that loan agreements call for a compensating balance of 10 percent and the projected average daily loan balance is $500,000. This requires a compensating loan balance (CLB) of $50,000. The average daily collected balance is calculated as follows:

To demonstrate the sensitivity of this computation to different variables, assume the following.

If an additional wire transfer costing $10 is performed by the company, the projected service charges would be raised to $460 and, therefore, the average daily collected balance would need to increase $156.87 to $66,039.22.

Using the original example, if the company were to negotiate an earnings credit rate of 8 percent, the average daily collected balance would need to decrease $441.17 to $65,441.18. If the average daily loan balance was $5,000 less, or $495,000, this would require a compensating loan balance of $49,500, and the average daily collected balance would decrease $588.23 to $65,294.12.

Once these projections are made, the cash manager uses daily information from the bank to:

(1) obtain the collected balance in the account the previous day;

(2) assemble a forecast of today’s collected balance given checks written and the availability of deposited funds; and

(3) make daily decisions to pay down loans and to invest excess funds.

Banks supply this information, for a fee, in cash management reports. For small banks, the cash manager may call an individual daily to obtain this information. Some banks have installed voice systems that report the same basic information and that are triggered by touch-tone telephone codes. Large banks have the capability to send this information, by tape or tape transmission, to companies in machine-readable format, including detailed information on checks cleared (including check numbers) and deposit amounts awaiting collection.

The most common method of receiving account information today is through the personal computer. The same technology that supports PC-based account information provides a way for the contractor to initiate wire transfers, clearinghouse transactions, or investment orders.

Each specialized service that banks and third parties provide has a unique set of reports, so the contractor should be not only be aware of the types of data and reports available from each bank under consideration, but should also understand the application of this information. A cost/benefit analysis should be performed to ensure that the information received justifies the cost. Each contractor should define its service requirements in a cash management plan and select the bank based on service needs.

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Cash Management Information Systems

The Need for Systems Integration

Daily information from the construction company’s bank and from internal company information systems can provide most of the information that the cash manager requires. In addition to the pressure from high interest rates, part of the reason for the increasing sophistication of cash management is the evolution of data processing systems. These systems allow companies to pool information from a variety of sources and use this information to make more timely and better decisions. This process of pooling information from or combining other automated data processing systems is called systems integration.

It is useful to understand the input, processing, and output requirements of a cash management system. In terms of processing requirements, a cash manager must perform the following five processes:

(1) Cash forecasting—creating forecasts of near-term (daily and weekly) cash inflows and outflows.

(2) Cash budgeting—creating and monitoring annual and individual project cash budgets.(3) Information maintenance—assessing internal and external performance against objectives.

(4) Funds movements—maintaining audit trails of all funds movements, including securities purchases and sales.

(5) Updating company information (optional)—performing daily updates to company databases and check reconciliation processes if systems are properly integrated.

Information inputs to these processes come from several sources. Banks provide ledger and collected balances on accounts as well as detailed check clearing and deposit availability information. Other construction company systems provide information on billings, checks-written, budgets, purchase order commitments, and master project scheduling information. The cash management system, in turn, can provide information outputs to the bank or other external financial entities. The system can also provide information outputs back to corporate data processing systems for check reconciliation, budget comparison, and update purposes. The conceptual framework for such a system is shown in Figure 15-2.

Several commercially available custodial accounting systems for construction companies contain some of the capabilities discussed. These systems are oriented around “backing into” cash flows from financial results. For example, cash inflows from individual projects are typically calculated by adjusting project billings to date by owner retention and accounts receivable. Cash outflows are estimated in a similar manner, using project cost to date adjusted by accounts payable and subcontractor retention withheld. Many systems also provide cash requirement reports based on purchase order commitments and sophisticated budgeting tools for the preparation of company-wide and individual project budgets.

Banks can provide electronic access to their information through time-sharing terminals or other PC-based systems. Banks typically purchase these systems and make them available to their corporate customers free of charge or for a monthly fee depending on competitive conditions.

The opportunity for many companies is to pool electronically or integrate all of the information required to facilitate the cash management process. For a relatively small investment, contractors can eliminate much of the manual data collection effort required by the cash management function and provide tangible operational benefits.

Microcomputer Applications

Advances in microcomputer technology and reductions in the cost of microcomputer hardware and software make the development of integrated cash management systems a cost-effective alternative. The ability of microcomputers not only to communicate with minicomputers or mainframe computers, but also to pass and store information, makes them powerful tools for the collection and storage of information from diverse sources for later processing.

Cash managers use microcomputers in various ways. Although worthwhile for some tasks, using micro-computer automated spreadsheets for complex applications is not generally cost effective, because information must be keyed in manually. However, there are combinations of hardware and communications software available to allow “downloading” information to a microcomputer from a minicomputer or a mainframe computer. In addition, some communications software can automatically convert incoming information to formats that allow the information to be processed by several popular electronic spreadsheets. Many of the same software packages can “up-load” information from the microcomputer to the company’s mini- or mainframe computer in different formats for later processing.

There are also several “fourth generation” or user-oriented computer application development tools available for mainframe computers, minicomputers, and microcomputers that can facilitate the development of cash management applications. These application development computer languages are structured so that users not familiar with programming languages can create files, screens for data input or inquiry, and report formats quickly, efficiently, and without the need for sophisticated programming services. A drawback in using these application development tools is that, in many instances, individuals without experience in data processing systems design can make conceptual design errors that cause inaccurate data or that fail to provide adequate audit trails.

Fourth generation and user-oriented computer application development tools are important, because most cash management applications for a construction company should be custom-developed. Many systems provide the basic information required, but the form and content of data within these systems are radically different and operate on different data processing hardware. In addition, banks provide information in radically different forms. Technology and application development tools are readily available that can be effectively used by contractors to develop integrated cash management software applications with tangible benefits.

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The Cash Flow Formula: How to Forecast Cash

The following article first appeared as a series in CFMA Building Profits, in the January/February and March/April 2006 editions. Copyright © 2006 Construction Financial Management Association.

Cash is the lifeblood of any organization. Certainly, cash is the basis of the world’s economic systems, the common denominator we use to measure the success and stability of business entities. However, I am convinced that “cash” has become a somewhat generic term. Too often we assume that we know what “cash” means, no matter what the context or venue. But, just as the complexity of the world’s economic systems has grown exponentially, so, too, have the dimensions, or definitions, of “cash.”

Definitions

What do I mean by “cash?” In college, I learned that the definition of “cash” for financial statement purposes was “cash and other marketable securities with maturities of less than one year.” This definition served me well while I was in public accounting; however, it has been of much less value to me during my years in the construction industry.

In the context of managing and forecasting cash, I’m not interested in the “freeze-frame” approach that tells how much cash is physically sitting in bank accounts and short-term investments at any particular point in time. (After all, that cash is already beyond managing!) Instead, I’m looking for a more practical, all-encompassing definition.

Other People’s Money

Most construction financial managers know how to legally use more cash than is actually sitting in the bank. For example, buying on account doesn’t use cash as defined above—at least not today. The terms negotiated with vendors allow the use of their cash for an agreed-upon period of time. Similarly, arranging credit terms at the bank allows use of the bank’s cash to purchase equipment and materials; to pay employees, vendors, and subcontractors; or to pay other routine operating expenses.

And, then, there’s float. The checks you send to vendors today will take several days to travel through the mail to their offices, then to their banks, and finally to your bank where your account is charged. On your ledger, the cash is gone when the checks are written; in reality, it isn’t really gone until the checks clear the bank.

A New Definition for Cash

Combining these examples, I would like to propose a non-accounting definition of cash within the context of cash management and forecasting:

Cash may be defined as spending power
a measure of an entity’s ability to
consummate transactions for goods and services.

Obviously, this is a much broader definition than just considering the hard coin or paper currency on hand, or even totaling the balance in bank and short-term investment accounts. When defined as spending power, cash is subject to expansions and contractions resulting from such things as market and economic conditions, vendor trust as represented by credit terms, changes in the extension of banking credit, and even current developments in the technologies utilized in conducting business.

New Dimensions for Cash Management

Similarly, cash management now takes on new dimensions. It is no longer just a matter of understanding and utilizing the tools of banking and electronic commerce to more effectively manage the flow of cash through your company. It now includes the development of better internal business practices and the cultivation of better relationships with your business partners (customers, vendors, subcontractors, suppliers, banks, bonding companies, etc.) in order to maximize the cash, or spending power, at your company’s disposal.

Cash management, then, is the management of resources—
tangible and intangible, internal and external—
to enhance cash (or spending power).

There are several concepts that underlie this expanded definition of cash management:

• Accelerate receipts;

• Decelerate payments;

• Minimize current assets; and

• Maximize current liabilities.

Although these concepts seem obvious, they are often not well understood or followed, especially by the operations side of our businesses. Before we discuss the application of each of these concepts, I want to add that one of the most important lessons I have learned over the past twenty-five plus years in the construction industry is that the operations, or project management, side of the business has far more impact on our ability to manage cash than anything that the accounting department can do. By the time cash is collected on a billing it essentially is what it is. Accounting is at the end of the food chain, so to speak. It is the practices upstream from accounting that make the real difference in a company’s effective cash management.

This means that the construction financial manager, or cash manager, must also be a good trainer. He or she must be good at developing the relationships with project management, good at understanding the big picture of how construction projects are managed on a day-to-day basis, and good at building consensus and working with project management to implement policies and practices that are conducive to good cash management. The cash manager needs to get out of the office more often and get onto job sites to observe, learn, and train and develop sound cash management practices from the field perspective. This amounts to negotiation with our internal customers, project management.

Now let’s look at each of the cash management concepts.

Accelerate Receipts

Here are some questions you should ask about your company’s contract terms:

• Are contracts negotiated so that your company is contractually able to bill earlier and for higher amounts?

• Have you provided the owner with a front-loaded billing schedule that provides for stronger billings in the early stages of the project?• Are the contract payment terms reasonable and do they provide for payment by wire transfer or other accelerated payment methods?

• Does the contract allow for the billing of stored materials, either on-site or at a bonded warehouse?

These are just a few examples of how contract terms can directly affect the ability to bill reasonably—but aggressively—and to collect money promptly.

Retainage

In terms of accelerating receipts, retainage is a relevant subject in and of itself. There are two things construction financial managers need to know to effectively manage retainage:

(1) Its purpose, and

(2) The relationship between the retainage held by the owner against the general contractor and the retainage held by the general contractor against the subcontractor.

To address the first point, retainage is held to assure performance of the contracted party. This may be retainage held on the general contractor by the project owner, or retainage held on the subcontractors by the general contractor. That is simple enough and generally well understood in the industry.

The second point, however, is where the rub occurs. Unless we allow a contractual link to be created between the retainage held by the owner on the general contractor and the retainage held by the general contractor on the subcontractors, there is no relationship. Assuring performance through the withholding of retainage is a specific obligation between contracting parties. There is no contractual tie related to retainage between the project owner and the subcontractors on a project, unless the subcontracts written by the general contractor create such a link. When subcontractors have satisfactorily performed on a contract, they deserve to be paid their retainage, whether or not the owner of the project has paid the general contractor. It should be noted that making the receipt of retainage from the owner of the project a condition precedent to the general contractor paying the subcontractors is almost solely for cash flow purposes.

I recognize that it is common practice in the industry for general contractors to withhold the retainage payable to subcontractors until retainage has been received from the owner. But, common practice does not mean that it makes sense—or that subcontractors cannot negotiate better terms. This is simply another example of negotiating terms that accelerate receipts.

Even if contracts contain ideal terms, problems and inefficiencies in billing practices often slow down the receipt of payments. For example, if a pay application is submitted late, not on the proper forms, or lacks required backup documents (such as certified payrolls or lien releases), there will be a delay in getting paid. The objective of an efficient billing process should be to provide all documents and information that are required by the contract and/or needed for prompt processing of payments. Do not give the owner, or general contractor, an excuse for late payment.

Project management also plays an important role in the prompt collection of contract billings. First, they have the closest working relationship with the owner or general contractor. Second, it is project management who must satisfy the customer in terms of contract performance. The majority of disputed or uncollected receivables relates to some performance issue—the customer is not satisfied with some aspect of the contract performance. Only project management can remedy these conditions so that an outstanding receivable can be collected.

Decelerate Payments

Slowing down payments is primarily a function of how accounts payable with trade vendors and subcontractors is managed—since slowing down scheduled payments to the bank will have a negative effect on your company’s credit rating. Start by viewing your vendors and subcontractors as business partners. Treating them fairly will make them want to continue doing business with your company. Treating them unfairly will result in a contraction or termination of credit. Within those bounds are plenty of opportunities for negotiating accelerated payment terms.

Although most vendors would like to have all of their accounts on 30-day terms, most will live with something more than that, especially if the volume of business your company does with them is significant, and payment schedules are consistent and reliable. I recommend that contractors set their own vendor payment terms, rather than simply accepting the terms offered. However, be aware that extended payment terms may result in pricing increases to offset the vendor’s cost of capital. There are no hard rules here. The terms you negotiate depend on four factors:

• The trust you have developed with the vendor;

• Your skills as a negotiator;

• The amount of business your company conducts with each individual vendor; and

• The vendor’s size.

As a rule of thumb, you should be able to achieve 45–60 day terms with most vendors.

Trade Payables

The schedule for paying trade payables is related to payment terms. When I first started out in the industry, it was common practice for companies to pay discount invoices on the 10th of the month (to get the 2/10 discount) and all other trade payables on the 15th.

Consider, however, the extra cash flow achieved by paying the other trade payables on the 20th or even the 25th of the month. This could play a part in achieving 45–60 day terms. Simply changing and communicating your stated terms of payment, then changing your internal practices to follow this schedule, will effect the change.

I have also found that the definition of the 2/10, net 30 terms may also be redefined. Most creditors will allow the two-percent discount to be taken for all invoices paid on the 10th of the month. Some of the invoices, of course, will be older than 10 days. This is also a matter of negotiation.

Subcontractors

Payments to subcontractors typically do not follow the same kind of routine payment schedule as trade payables. Generally, contracts include the terms of when the subcontractor will be paid, such as a specified number of days (normally ranging from 3 to 10) after the owner has paid the general contractor. (Unfortunately, “pay when paid” and “pay if paid” clauses are outside the scope of this material).

Payment terms with subcontractors represent a point of negotiation and, as such, are affected by your company’s perceived financial strength, integrity, and reputation in the industry, in addition to the amount of business it does with each individual subcontractor. Build a strong foundation of trust with your subcontractors by consistently paying according to the agreed-upon terms.

Minimize Current Assets

The concepts of minimizing current assets and maximizing current liabilities are contrary to what most of us were taught by our parents. We were taught essentially that assets were good and that liabilities (debt) were bad. A sound understanding of how assets and liabilities affect cash forms the foundation of the cash flow formula presented later. Let’s look at assets first.

Assets absorb, or use, cash. For example, an account receivable results from expenses such as paying labor costs; purchasing equipment, materials, and inventory; and paying subcontractors. Such paying and purchasing requires using, or committing, some of your company’s spending power. These efforts turn to cash only upon collection of the account receivable.

The objective should be to minimize the amount of current assets required to conduct business effectively—in other words, to use your company’s resources more effectively. When current assets are reduced, cash (or spending power) is increased. Cash is the only asset that we want in the final analysis. All company efforts should be reasonably focused on converting other assets and liabilities to cash in the most efficient and effective manner.

Maximize Current Liabilities

The opposite is true with current liabilities. Rather than absorb cash, current liabilities are a source of cash (or spending power). This is because, under our new definition of cash, a liability means that we are using someone else’s cash.

In terms of the cash management process, there is a certain balance that can (and should) be reached between minimizing assets and maximizing liabilities. Keep in mind, too, that creditors and lenders may also impose contractual limitations on the ratio of current assets to current liabilities.

The Cash Management Process

Cash management, as previously noted, is often affected more by operational decisions and practices than by financial ones. Frequently, when a contractor is struggling with cash flow, the focus is placed on finance doing a better job of collecting A/R or of scheduling payments. Although there certainly are instances where finance needs to improve its processes, over the years I have found that poor cash flow is more often caused by poor operational practices.

Collecting A/R, or managing A/P, are processes that fall at the end of the food chain, so to speak. Focusing exclusively on the financial processes would be the same as treating only the symptoms of an illness, rather than treating its cause.

Cash Forecasting

In the early years of my career in construction accounting, my efforts at forecasting cash focused on the balance of cash in the bank. I attempted to develop reliable methods for predicting when receipts would come in and when payments would go out.

It is easier to predict, or forecast, cash payments, since we are in control of when they happen. I devised elaborate schemes to track outgoing payments by how they were sent. All of this effort resulted in less-than-satisfactory attempts to forecast cash in the bank.

What I Know Now

While I am still a proponent of developing systems and methods to track the flow of cash through our businesses, I now do it for a different reason. If we are to successfully forecast cash, we have to understand how our banking systems work, and how these systems are affected by our internal business practices.

However, rather than attempting to forecast cash in the bank to the nearest dollar, we should focus on understanding patterns and trends. If we try to be too exact, we will most likely give up eventually in frustration. With these basic concepts to lay the foundation, let’s now look at the Basic Cash Model (or Formula).

The Basic Cash Model

Cash management really “came together” for me a few years ago. My employer at that time (a division of a larger, global concern) reported its earnings, and demonstrated that a high percentage of those earnings have been turned into cash. Our internal budgets and management incentives had both an earnings component and a cash flow component in them.

Given the size of that company and the magnitude of its banking structure, it would have been sheer madness to try to manage and forecast cash based on what was in our bank accounts. In fact, the company did not have any “cash” as such, since it was swept daily for management and investment at a global corporate level. Our solution, instead, was to employ a formula that focused on the management of assets and liabilities.

The formula, with minor modifications to accommodate the average contractor, is as follows:

EBITA, or earnings
+/− Changes in A/R
+/− Changes in Inventory
+/− Changes in Net WIP
+/− Changes in Fixed Assets
+/− Changes in A/P
+/− Changes in Accruals
+/− Changes in Debt
= Cash Flow

A Word of Explanation

To understand this formula, we must first recognize which line items are assets and which are liabilities. To make this identification easier, I have highlighted the liabilities with double-underscores. One clarification is needed, however, with the liabilities: Work-in-Progress (WIP) is shown as a liability, even though it generally has components of both assets and liabilities. Here’s why: If we are underbilled on a project, we have, in effect, an unbilled receivable, which is an asset. If we are overbilled on a project, we have a liability to that customer for future performance. Since we expect our offices to maintain a net overbilled status (a good, sound business practice), I have shown WIP as a liability.

What the Model Shows

An example of a Basic Cash Model appears below. In this example, we started with $10,000 of earnings (EBITA).

As you can see, Assets (A/R, Inventory, and Fixed Assets) decreased by $12,000 ($8,000, $3,000, and $1,000, respectively). Liabilities (WIP, A/P, Accruals, and Debt) decreased by $13,000 ($2,000, $9,000, $0, and $2,000, respectively). The sum of these three yields $9,000 cash flow for the quarter ($10,000 + $12,000 - $13,000 = $9,000). A respectable 90 percent of earnings have been turned into cash flow.

Now, referring back to the concept of minimizing assets and maximizing liabilities, if an asset (A/R, Inventory, or Fixed Assets) has been reduced, then “cash” has been increased. Note that changes in Fixed Assets will be the net of purchases and disposals of assets and depreciation applied. Similarly, if a liability (WIP, A/P, Accruals, Debt) has been increased, then “cash” has been increased.

Simplicity Is the Key

The beauty of this formula is its simplicity. When explained properly, it is easily understood by operations and other non-financial people. Managers and employees at any level in the business can be tasked with minimizing the assets and maximizing the liabilities within their control. The net result of this is that everyone becomes part of the cash management process.

As mentioned earlier, it is important to provide training to our non-financial, internal business partners, specifically project management. I typically identify for them the three largest balances on any contractor’s balance sheet, excluding cash. They are accounts receivable, accounts payable, and the net WIP (including both Costs in Excess and Billings in Excess). Not only do these three accounts make up the bulk of most balance sheets, but they are accounts that the accounting department cannot manage by itself. Project management is needed to effectively manage the conversion of these assets and liabilities into cash. The accounting department will handle all of the other little assets and liabilities. Since project management is best suited to the management of the three largest accounts, it is imperative that we provide training on how to best manage them.

Education and training concerning the use and performance of this model must be given a high priority, since internal business practices (which often vary considerably from office to office) have the most direct impact on our ability to minimize assets and maximize liabilities.

The Next Step

The next step is to take each component of the Basic Cash Model as presented here and discuss it from a practical perspective. As construction financial managers, we need to learn how we, as well as each of our employees, can practice effective cash management through our day-to-day business practices. Once we understand how to manage cash, we can then focus our efforts on forecasting it.

With these basic concepts under our belt, it is now time to put theory into practice by examining how operational procedures impact cash flow.

Construction Life Cycle

To facilitate a discussion, let’s follow the traditional stages in the construction life cycle:

• Pre-Bid and Bid;

• Contract Award;

• Pre-Construction;

• Contract Performance; and

• Contract Closeout.

In each of these stages, decisions are made, actions are taken, and business practices are implemented that will ultimately determine your company’s ability to accelerate receipts and decelerate payments, as well as to minimize current assets and maximize current liabilities. Although many of these decisions are operational, some are financial in nature. Yet, all too often, operational managers are making both types of decisions.

The Finance/Operations Connection

When I teach CFMA seminars, I often ask the construction financial managers participating about the extent of their involvement in each stage of the construction life cycle. I am always surprised by how few are actively involved with these contracting processes, other than with the related financial processes of generating billings and scheduling payments, and the scorekeeping process inherent in producing periodic financial reports.

Nor do I often hear about any significant participation in the bidding process, or in the negotiation and detailed review of contracts before they are signed.

I also like to ask seminar participants if they have ever attended a project pre-construction meeting. Once again, generally less than one-third say they have.

As a group, I believe that construction financial managers have much to contribute to the preliminary construction processes. However, for whatever reason, we have not successfully communicated our interest and knowledge to the operations side of the house. This is a big mistake: Throughout the construction life cycle, decisions will be made that could greatly benefit from both financial knowledge and a financial perspective.

That’s why we will now relate the activities that take place during each phase of the construction life cycle to our cash flow formula and its underlying cash management principles. In addition, we will discuss how to achieve the “buy-in” of management and other operations staff to our new cash management approach.

Pre-Bid and Bid Stage

In this stage, focusing on certain three key areas can help prevent the possibility of a project negatively affecting a company’s cash flow.

Credit Review

No amount of financial controls or superb project management can assure payment from an unethical or insolvent customer. Yet, many contractors seem willing to work for anyone who will give them a contract, often without checking creditworthiness or ability to pay.

This problem usually arises from a disconnect between who sells the work and who is responsible for performing on the contract—and ultimately being paid. That’s why incentives to both the sales force and project management should be tied to collection on the related contract. This will keep everyone focused on the fact that contracting is more than selling and performing; it also includes collecting on the contract.

Remember: The project won’t make its calculated profit margin at completion if your company fails to collect part of the contract price.

There should be policies and practices in place to check both the reputation and ability to pay (financing) of all new customers and all large projects; additionally, there should be periodic checks on all existing customers. The same type of assessment should also be performed for the contractors and subcontractors with which your company expects to work. This credit management process is most effectively handled or supervised by the finance department.

When assessing the creditworthiness of customers, contractors, and subcontractors, it makes sense to use the same criteria banks and sureties use—namely, the Three Cs: character, capacity, and capital. This assessment is probably best handled as part of a joint effort between management and finance. Here are some tips to ensure a successful assessment.

Character

The “character” of an entity is created and perpetuated by its owners and management. It is an assessment of an entity’s people, rather than of the entity itself. Character includes integrity, fair and ethical business practices, and overall work ethic.

Character can be assessed by calling references that have done business with the owner, contractor, or subcontractor. However, there is no substitute for face-to-face meetings, where managers from your company get to personally know the owners and managers of the intended project partners. Remember, too, that changes in a company’s ownership and/or management will result in a change in the company’s character.

Capacity

There are two primary areas of focus here. First, verify that the customer, contractor, or subcontractor has significant previous experience with projects of the same type, size, and scope as the one being proposed. For contractors and subcontractors, determine that their project management staffs also have prior experience with this type of project. A lack of such familiarity will likely result in increased costs for your company to perform on its contract.

The second aspect of capacity to assess (specifically for contractors and subcontractors) is unused and available bonding capacity. This can be a useful measure of their ability to handle changes, as well as an indicator of how busy they are on other projects. Remember, with change orders, a $1 million job can become a $2 million one—does the contractor or subcontractor have that additional bonding capacity?

Capital

Make sure that potential customers, contractors, and subcontractors are well capitalized and that they have sufficient financial strength to support a construction project of this size, even if the project doesn’t go as planned. From an owner, obtain confirmation of both interim and final financing on the project. From contractors and subcontractors, obtain recent financial statements (preferably audited) and review them closely.

Pre-Bid/Bid Stage Contract Review

The subject of contract review is an entire topic, in and of itself. But, here are a few points to consider. Although this may sound obvious, and you think your company’s contract review process is adequate, ask yourself this: Is finance involved in this review? Many of the terms and conditions in construction contracts relate to financial issues, such as payment due dates and methods, retainage provisions, etc.

Certainly estimators, PMs, and other managers can be educated on important financial contract provisions and taught to request beneficial terms. However, there may be other, more complicated, contractual provisions that do not lend themselves to routine coaching.

For instance, the contract may require that records or documentation be kept or provided in a very specific format or manner that may not be compatible with your company’s financial accounting systems. Non-financial people may not recognize this as a problem; nor would they be able to suggest acceptable alternatives within the capabilities of your system.

I recommend that finance review all significant contracts over a pre-determined dollar amount; in addition, finance should be consulted whenever terms or provisions relating to financial or record keeping issues are not well understood.

Additionally, seek legal counsel when choosing preferred contractual languages for a broad range of standard contract provisions, as well as for minimum acceptable alternatives when the preferred language is not obtainable. Legal counsel should also be sought whenever unusual contract terms are encountered.

The Effect of This Stage on Cash Flow

Decisions made and actions taken in the pre-bid and bid stage have the most direct impact on A/R, WIP, and A/P. Both the specified contract terms and a company’s internal business practices determine whether a contract has a positive or negative cash flow.

So, when operations management and staff are educated on the relationships between business practices and cash flow—and, more especially, when their incentives or bonuses are tied to maintaining good cash flow—they will be more likely to “buy-in,” changing poor operational practices and implementing those more conducive to good cash flow (a.k.a. increased profits).

Contract Award Stage

Once the contract has been awarded, an even more intensive review and negotiation of contract terms begins. Here is my philosophy about such review and negotiation: If a company does not at least try and negotiate more favorable terms, it has chosen to be a victim and deserves whatever bad results come of this decision.

We do not have to be victims. Almost everything in life is negotiable, except death and taxes—and, sometimes there is room for negotiation on taxes! We may not always achieve our preferred language and terms, but we should continuously try. And, we should be willing to walk away from a contract with terms that do not, at the very least, meet minimum acceptable standards.

The Major Terms

There is not room in this article to go into depth about each and every contract term that should be reviewed. However, here’s a list of those terms I think are the most important to review and negotiate:

• Timing of payment;

• Method of payment;

• Penalty provisions for not adhering to payment requirements;

• Reporting and documentation requirements;

• Allowable contract costs (for cost plus contracts);

• Negotiating around “paid when paid” and, especially, “paid if paid” clauses; and

• Performance penalty provisions.

Remember, too, that this stage generally includes the buy-out and award of related subcontracts.

Forms

Each contractor and subcontractor should have their own contract forms, which should be reviewed by the appropriate legal counsel to make sure that adequate and proper protective provisions, indemnities, and risk sharing are in place. Equally important is to ensure that your company’s contracts contain the provisions it would be willing to accept itself. AIA standard or consensus documents are a start, but they may not necessarily address your company’s individual circumstances or the legal and market conditions in the states where your company operates.

Pre-Construction Stage

During this stage, the contractor and subcontractors develop the specific details and plans for how the project will be built. Often, detailed charts and schedules are laid out to show the staging of men, materials, equipment, and subcontractors throughout the specified duration of the project.

Unfortunately, during this stage, not enough attention is given to the planning and scheduling of the paperwork flow, which is what ultimately assures that your company is paid on time for its efforts.

Performance and Billing Schedule

Once the contract has been awarded, the bid details must be converted (generally simplified or rolled up) into a schedule of values consistent with your company’s contract management and accounting systems. From this, an estimated performance and billing schedule should be developed for submission to the owner or party with which you have contracted. The billing schedule will show, month by month, exactly how much of the total project is expected to be put in place and billed for.

This schedule should be reasonably front-end loaded. Costs for such items as mobilization, bonds and insurance, and a majority of the materials—along with your profit on these items—are incurred early on in the project; as such, they should be recognized early on in the project. Doing this will allow your company to stay reasonably overbilled on the project.

Establishing the performance and billing schedule before construction begins puts the owner on notice re: how much your company expects to bill each month throughout the life of the project. As long as the project stays on schedule, your company is going to bill according to the schedule it provided before beginning construction. (Unless, of course, it can justify billing more!)

Providing the schedule, and following the estimates as closely as possible, can mean fewer disputes over the amount of your company’s monthly pay requests.

The Pre-Construction Meeting

Schedule and hold one or more pre-construction meetings and include appropriate representation from all subcontractors and major suppliers for the project. This meeting will provide an opportunity for all parties to meet one another, and for your company to provide an overview of the project.

In addition to discussing such operational issues as the schedule, job site organization, and safety requirements, this meeting also provides the best opportunity to discuss the project’s reporting and documentation requirements.

Finally, make sure that your subcontractors and major suppliers know and understand what is expected in terms of contract compliance, relative to both performance and paperwork.

Contract Performance Stage

This is the stage of the construction life cycle in which the contractor, subcontractors, and suppliers execute their trades and manage men and materials to put the work in place per the detailed plans and specifications. It also encompasses the activities that will have the most dramatic affect on cash flow, either positively or negatively.

Although this stage is composed of a number of processes and individual activities, we will focus primarily on five processes and how they affect cash flow:

• Contract Performance;

• Contract Costing;

• Contract Billing;

• Payment Tracking; and

• Collection and Posting.

Contract Performance

The overall objective, for professional as well as financial reasons, should be to satisfy the customer by building a quality project per the plans and specs, and to do it according to the terms of the contract. Generally, this means doing the job right the first time.

Stick to the estimated performance and billing schedule wherever possible, and document the circumstances and reasons for any significant departures from this schedule through the use of change orders. All paperwork should be submitted on time, on the right forms, and completed properly. Remember: A satisfied customer is more likely to pay on time.

Contract Costing

There should be consistency within your company relative to contract costing. The schedule of values developed during the bid stage should flow logically into the schedule of values that is used to manage the performance of the contract.

This same schedule can be provided to the owner or general contractor to demonstrate your company’s progress on the project. Consistency helps eliminate errors in job costing and provides valid historical cost information for use in estimating future projects.

Keep the paperwork moving, particularly between project management and finance. This requires processing schedules that are well-thought-out, known, and understood by all involved. It also requires that individuals be organized and able to adhere to their schedules.

In order for project cost reports to be both timely and accurate, the information flow between project management and finance must be consistent and correct. These reports should have broad distribution among project management, including on-site superintendents and foremen.

When these job site professionals learn about project problems (or opportunities) on a timely basis, they are generally masters at finding solutions. However, if they don’t learn about a problem until the project is almost complete, there is little they can do.

Contract Billing

Progress billings should be prepared on the proper forms (with all of the required backup documents) and submitted on time and per the contract terms. Adhering to the estimated performance and billing schedule will help avoid disputes over the amount of your company’s pay requests. In addition, a “pencil draft” of the pay requests should be prepared for preliminary review and approval by the owner or contractor.

It is also important to make sure you know who must approve pay requests (often a lengthy list of individuals and/or entities). I recommend tracking a pay request from submittal through payment to discover all of the hands it passes through. Meeting these people face-to-face will make it easier to resolve any issues if and when they arise. The overall objective should be to remove all excuses or reasons for non-approval or non-payment.

Payment Tracking

Make sure you know the individual contract terms and conditions related to the submission of pay requests, as well as payment timing and method. For each significant project, track both your company’s compliance with the terms of submitting pay requests and the owner or contractor’s compliance with the timing and method of payment.

If necessary, discuss departures from these terms in a proactive and cooperative manner to determine how to get the process back on track. Keeping all parties satisfied generally results in a more successful - and profitable - project for all involved.

Collection and Posting

Make it as easy as possible for the customer to pay by providing them with remittance advices, pre-addressed envelopes, payment instructions, etc. Develop a close working relationship between the project management, finance, and collections staffs so that billing and payment disputes can be resolved quickly and efficiently. Implement a dispute management process that will quickly do the following:

• Identify owner payment disputes;

• Deliver information to the person(s) best able to resolve the dispute; and

• Forward unresolved disputes to management, when appropriate.

Contract Closeout Stage

This final stage of the construction life cycle can be a potential hazard for cash flow as you attempt to collect your final payment and retainage held on the project. However, collection problems usually result from one thing: The customer is dissatisfied.

Your focus, then, should simply be to satisfy the customer. This includes not only managing a successful completion of the project (including all punchlist items), but also making sure that all required paperwork is submitted accurately and on time.

Operational Links to Cash Flow

Generally, PM and field staff understand all of these operational practices; however, these professionals are not always able to connect these practices to the effect they have on cash flow. In fact, at various times, location managers have repeatedly asked me what they can do to positively control or affect each component of the cash flow formula.

The answers are not always simple. While implementing the operational practices discussed in this article will have a positive effect on cash flow, it is often difficult to measure that effect. Generally, I tell managers that adhering to these practices will mean that cash flow is moving in the right direction. If we do more of the right things and do them consistently, more good results will come of it. However, this answer is rarely adequate. Accordingly, I have developed the following guidelines for each component of the cash flow formula:

EBITA, or Earnings

This is the first component of the formula and arguably the most important, as it is the only income statement component. All of the others are balance sheet components. So, what does that mean? Without earnings, cash management would be nothing more than shuffling cash between the balance sheet components. Earnings are what provide additional cash (remember that cash is defined as spending power) to the cash flow formula.

This component of the cash flow formula is the one most easily controlled by operations. The message here is to keep the focus on achieving and maintaining profitable operations.

Accounts Receivable

Since A/R is an asset, the objective is to reduce it as much as reasonably possible. However, the answer is not to bill less but, rather, to increase collections.

The easiest measurement is “days sales outstanding,” or DSO. This measurement can be calculated at a project, individual, department, location, or company level. Aging of receivables, and the related DSO, should be reviewed by operations management at least monthly.

Here’s a simplified method for managing A/R: Each month, collect as much (if not more) than was billed for the month. The actual figure collected will depend on whether volume is increasing or decreasing, and on whether the current status of the DSO is acceptable when compared to industry averages.

Inventory

For many contractors, inventory is not a significant item on the balance sheet; nevertheless, even small efforts can have a positive impact on cash flow. The goal here is to maintain as low an inventory as possible, while still meeting construction needs. Do this by using suppliers that can provide quick delivery of materials for the best prices. Another strategy is to use vendors that will hold materials on consignment until they are needed.

Work-In-Progress (Over- or Underbillings)

Generally this component is the second most controllable by operations. Although WIP may consist of both over- and underbillings, the net balance should be maintained in an overbilled status.

Remember that we are trying to increase liabilities. Therefore, the objective of operations should be to maintain a reasonable overbilled status. In fact, a construction company can be managed on an exceptions basis by monitoring debit WIP, or underbillings.

An overbilled status can be maintained if billings keep pace with progress on the job and the schedule of values is appropriately front-end loaded. Please note, however, that we want to see at least ninety percent of the overbilled amounts in cash; otherwise, our ability to pay for future performance is in serious question. An inability to achieve and maintain an overbilled status is generally the result of cost overruns, which means that your company is going to lose money on that job.

Fixed Assets

This component of the cash flow formula is a combination of the net additions and disposals of fixed assets and the depreciation (an expense that does not represent an outlay of cash) on total fixed assets. Generally, project management has little control over this number; top management sets the guidelines for purchases and disposals of fixed assets.

Typically, this is not a significant area of focus. Management simply needs to ensure that your company does not own and maintain idle assets.

Accounts Payable

Since A/P represents a liability, the objective should be to maintain a reasonably high level of payables. This objective is mitigated by the need to maintain good credit standing, pricing, and relationships with suppliers and subcontractors. Generally, terms and policies for the management and payment of A/P are set by top management and administered by finance. The role of operations is three-fold:

(1) To understand and support A/P terms and policies;

(2) To keep A/P paperwork flowing so that the accounts can be managed according to terms; and

(3) To avoid promising early payment, unless doing so is absolutely necessary.

Accruals

Although accruals are a part of the cash flow formula, they are typically not significant, and generally do not represent an important opportunity for cash flow management. Since A/P includes all of the normal liabilities inherent in our business, accruals should be limited to estimates of future liabilities, such as accrued incentives, accrued taxes, etc. The focus should be to maintain accruals at balances that reasonably represent the liabilities coming due in the future.

Debt

Once again, although debt is part of the formula (because increases and decreases affect cash flow), it is generally not manageable by field operations. Top management and/or finance usually control the level of debt maintained by the company. The focus should simply be to manage debt in such a way that the company has adequate cash for operations.

Setting the Stage/Learning the Secret

At the outset of this article, I said that cash is the basis of our economic systems and the lifeblood of any organization. Now, with our broader definition of cash, and an understanding of how operations can affect cash flow, we are ready to move to the next, and some feel the most crucial, element of cash management: forecasting cash.

Call it an art; call it a science. Whatever you call it, understanding the secret of successfully forecasting cash requires an understanding of how the components of the cash flow formula relate to cash forecasting. To recap from earlier, those components are:

• EBIDTA, or earnings;

• Changes in Inventory;

• Changes in NET WIP;

• Changes in Fixed Assets;

• Changes in A/P;

• Changes in Accruals; and

• Changes in Debt.

EBITA, or Earnings

The key to effective cash forecasting (whether long- or short-term) is the ability to forecast Earnings, or EBITA (earnings before interest, taxes, and amortization) with a reasonable degree of accuracy. Although this task may seem daunting at first, the process can be simplified.

First break down, or back into, the basic components that lead to Earnings: Sales, Cost of Sales (or Cost of Construction), Gross Margin, and SG & A Expenses. Then, use this simple formula to calculate EBITA:

Sales − Cost of Sales = Gross Margin; Gross Margin – SG&A Expenses = EBITA

It is important to exclude interest, taxes, and amortization because these three factors are significantly affected by differences in organizational structure and taxing authorities. Also, by doing so, Earnings can be more easily compared with other companies in our industry.

Breaking down EBITA into its basic components readily shows that Earnings can be predicted with a reasonable degree of accuracy by forecasting each component individually. Here’s how.

Sales

I have often heard contractors say they can’t forecast Sales for their company. Generally speaking, this is because contractors may not have repeat customers. After all, once the building is built, the customer probably won’t need another one constructed in the foreseeable future (though this may not be true for larger or geographically disbursed business customers).

In addition, contractors often say they have difficulty forecasting Sales because they don’t know if they will win the next bid. However, while this may be true, astute contractors know that, with a sound understanding of our business and the markets we operate in, we can forecast Sales.

Most well-run construction companies manage their estimating departments based on reasonably accurate estimates of the volume of contracts they expect to bid during the coming year. This bidding activity is usually separated into the broad categories of Hard Bid and Negotiated contracts. These same companies also calculate their “success rate”—that is, the percentage of contract bids that result in contract awards. Here’s the formula to estimate Sales volume:

Annual Bidding Volume × Success Rate % = A reasonable estimate of the volume of work going into backlog during the coming year

In reality, new contracts are not secured ratably (evenly from month to month). However, for long-term Sales forecasting, it is reasonable to add new contracts to backlog on an average monthly run rate. This rate is based on the success rate for Hard Bid and Negotiated contracts (or by a vertical or other market focus, if the company has “success rate” data on this basis).

When forecasting cash, forecast Sales (Billings) by month. In order to more effectively forecast monthly Sales, separate Sales activity into Sales for Existing Backlog and Sales for Projected Future Contracts.

Sales for Existing Backlog

While most contractors track their backlog, they may not forecast when this backlog will be worked off and billed. When a contract is awarded, a front-end loaded, estimated project billing schedule should be developed (as discussed earlier in this article).

Each month, this schedule should be updated by project management to include the following:

(1) Actual billings for past months;

(2) Any change orders; and

(3) Any changes in estimated future billings by month through the end of the project.

This schedule, along with the project’s current status report on estimated costs to complete, should be submitted to finance. The sum of these schedules, corresponding month by month for all projects currently in backlog, will provide a reasonably accurate estimate of future Sales (Billings) for projects in backlog.

Sales for Projected Future Contracts

The next step is to create estimated billing schedules for projected future work. For existing contracts, such schedules are developed based on contract terms and expectations, along with the detailed project construction schedule. Since this data does not yet exist for projected contracts, we must look elsewhere for guidance.

A sampling of past construction projects can help establish the average length and the pattern of monthly billings for an average project. This data can be plotted on a bell curve, then used to make projections.

Say the sampling shows the average project length is one year and the average monthly billings are:

(Remember, we have made reasonable attempts to front-load the projects as described earlier). With these assumptions, we can create a simple Sales Forecasting Schedule, like the one shown in Exhibit 1.

This schedule shows a six-month forecast; however, the same format applies for forecasting periods of one year or longer. I recommend forecasting one year out; longer forecasts can be done, but they tend to become less and less accurate as your knowledge of future market conditions diminishes.

According to the schedule, Projects A & B are currently in backlog, with billings prior to July ($286K for Project A and $105K for Project B). The estimated monthly billings for projects in backlog is based on the estimated project billing schedules submitted to finance each month by project management.

You can reconcile to the current actual billing status for each project by maintaining the Contract Balance line (the prior month’s remaining contract balance, plus or minus change orders and the current month’s billings).

New contracts have been added to the schedule for July and August and subdivided by Hard Bid and Negotiated contracts, since your company’s success rate in bidding these two categories may be significantly different. New Hard Bid contracts have been added at a run rate of $2,900K per month; new Negotiated contracts at a run rate of $1,250K per month. These monthly run rates are based on the following formula:

Forecasted annual bidding activity × Appropriate success rate (%)
12

The monthly billing amounts for these future projects are entered based on your company’s average billings by month over the life of an average 12-month project. The schedule can be expanded for additional projects in backlog, and for the additional months of new projects added in the Hard Bid and Negotiated categories.

Small Contracts and/or Service activity are added in aggregate. Forecasts are based on average run rates for new small contracts and/or service work and monthly billings for the same. The schedule in Exhibit 1 shows a flat run rate; however, your individual company may experience more seasonality and/or growth.

Reconciling Billings vs. Sales

In construction, the difference between “Billings” and “Sales” is reconciled through entries to create over- and underbillings (or more properly, Costs and Earnings in Excess of Billings and Billings in Excess of Costs and Earnings).

To handle the monthly Changes in Net WIP, or net changes in over- and underbillings, I have simply added a line at the bottom of the schedule following Total Monthly Billings. With this factored in, we have a proper monthly forecast for Monthly Billings or Sales.

Cost of Sales and/or Gross Margin

Cost of Sales and Gross Margin are the inverse of each other; therefore, if we can forecast one, we can forecast the other. Since Gross Margin on projects is the focus of most estimating efforts (and subsequently becomes the base measurement of project profits in the construction industry), this will be our measurement focus.

Our best estimate of future Gross Margin on construction projects begins with the Gross Margin percentage your company has achieved on its most recent projects; this should be modified up or down for current market conditions or specific changes planned in methods of performance. To convert Gross Margin percentage to dollars, multiply it by forecasted Sales.

SG&A Expenses

Just as Gross Margin is a standard measure of profitability for the construction industry, SG&A Expenses are a common business benchmark and a standard component of most P&L statements. Once again, most astute contractors know what their overhead (SG&A Expenses) rate is as a percentage of Sales. This rate may change with significant fluctuations in Sales volume, since some components of SG&A Expenses are fixed, rather than variable, costs.

Estimate future SG&A Expenses by taking the SG&A Expenses percentage achieved over the most recent past and modifying it for current market conditions or specific changes planned in spending patterns. (Note: I have discussed the Cost of Sales and/or Gross Margin and SG&A Expenses to address the predictability of all parts of our simplified formula for EBITA. For forecasting purposes, only the Sales and EBITA numbers are required).

All Other Components of the Cash Flow Formula

Returning to our formula, we are only interested in changes in A/R, Inventory, Net WIP, Fixed Assets, A/P, Accruals, and Debt. Our ability to predict these changes will be based on our knowledge of how individual balances have changed in the past. We will need to establish predictable patterns (trends) for each component, and to understand the underlying reasons for these trends, as well as how operational practices affect them.

These patterns can be established by using the same schedule we will ultimately use for forecasting future cash flows. Exhibit 2 that follows shows a sample Schedule of Monthly Cash Flow. Collecting the data and filling out the schedule for prior months should get you comfortable with how the schedule works, and make it easier to forecast future months.

The Basics

The schedule includes all of the basic benchmarks that we have discussed this far. The data is listed in columns by month, and totaled by quarter, in the same order down the page as the Cash Flow Formula.

In addition, a line for Sales has been inserted at the top of the schedule, and lines for SG&A Expenses and SG&A Percentage have been added at the bottom. Sales, EBITA, and SG&A Expenses are the only three non-balance sheet items on the schedule and, accordingly, are single entries by month from the company’s P&L statements.

The other components of the Cash Flow Formula are presented in three-line sets that show the beginning and ending balances, and the monthly change in each. Only the changed numbers for Fixed Assets and Debt are provided; however, these are calculated in the same manner as the other components. (For my company, changes in Fixed Assets and Debt are typically inconsequential, so I have chosen to simplify the presentation. You may choose to break them out into the same three-line presentation as the other components). Cash Flow (at the bottom of the schedule) is calculated as the sum of EBITA and the change number for each component, just as the Cash Flow Formula dictates.

Trends and Analyses

Trends can be established using just this data; however, it is useful to expand the analyses by providing benchmarks of how the four main components (A/R, Inventory, WIP, and A/P) change relative to Sales. Since A/R is generally composed of more than one month’s Sales, the schedule compares the monthly balances as a percentage of the most recent three months of Sales (noted on the chart as End A/R / MR 3 Mos). I have used this same three-month benchmark for all four components. (You may choose to use a different comparative benchmark that you feel is more representative of your company).

Problems and Opportunities

In addition to providing cash flow data for forecasting purposes, the schedule can also highlight developing problems and areas where cash management might be improved. For example, note the following:

• The A/R-Net balances (net of allowances for bad debt) as a percentage of Sales increased significantly at the end of Q1 and the beginning of Q2.

• The WIP-Net credit balance (net of credit and debit balances), or overbilling, significantly improved during Q4 and has remained there.

• The balances in A/P regularly drop at the beginning of each quarter, then build through the end of the quarter. (This may be important for publicly traded companies, as it strengthens a company’s overall cash position, and less important for privately held companies).

Forecasting Future Cash Flows

So, using these theories and practical tools, you can now begin forecasting future cash flows for your own company, as shown in Exhibit 2.

• Sales figures would come from the Sales Forecasting Schedule explained earlier.

• The EBITA forecast would be derived from a combination of prior actual results and knowledge that, for example, your company’s profitability is stronger during the summer months.

• Changes in the other components of the cash flow formula are forecast based on trends established over the prior months and quarters, as well as expectations based on such things as market conditions, changes in company policies, operational practices, etc.

In the interest of not overstating estimated cash flow, it is best to be conservative when forecasting, especially as it relates to factoring in market conditions and improvements based on changes in operational practices. Once you understand the schedules, you can customize them to fit your company’s individual needs. For instance, you may not care to see the numbers presented by quarter, or you may want additional breakouts on Fixed Assets and Debt.

Short-Term Cash Forecasting

So far, we have been talking about long-term cash forecasting, which is forecasting at least a year out. But, the same principles apply to short-term cash forecasting and the same schedules can be used. However, your assumptions should be more accurate relative to the short-term since you can rely more on known circumstances.

For instance, your Sales forecasts should be more accurate because you can look at monthly billings for specific projects. EBITA estimates can take into account recent profitability, rather than last year’s averages. However, changes in the balance-sheet components of the formula will tend to strongly follow the trends that you have identified—and you will probably not want to forecast any significant short-term changes anticipated as the result of improved business practices. Generally, it takes a while to see the effect of such changes.

Conclusion

With your expanded definition of cash and grasp of the concepts that drive cash flow, along with your understanding of the Cash Flow Formula and how operational practices affect cash flow, you should be able to produce a reliable cash forecast with confidence.

Since every construction company is unique with its own individual culture and set of strengths and weaknesses, your challenge as a CFM is to apply your new knowledge and tools in the manner most appropriate for your company.