Cash flow management is a critical aspect of running a successful construction business.
By successfully monitoring cash inflows and outflows, construction firms can ensure there is enough liquidity to cover expenses and keep their projects on track.
However, compared to other industries, construction cash flow can be particularly challenging due to factors like project delays, unexpected costs and lengthy payment terms.
Predicting future cash flow can be even more complex as a result of interlinking supply chains and frequent changes in project requirements.
Many construction firms choose to manage several projects and clients at once, each with their own budget, needs and requirements.
In this article we explore the difficulties faced in this volatile sector, while offering practical solutions to help maintain positive cash flow in your construction company.
What is cash flow?
Cash flow is the term used to describe the amount of money flowing in and out of a business at a given point in time. This flow of cash is closely linked to the operating activities of a business, and impacted by factors like goods / services sold, overhead costs / operating expenses and accounts receivable collection.
A business may have positive cash flow and enough liquidity to meet its immediate financial obligations, but that doesn’t necessarily mean the company is profitable (as profit is the difference between costs and revenue).
Similarly, a construction firm can be profitable but still have negative cash flow. This happens when revenue is higher than its expenses but hasn’t received all of its earned income).
What affects cash flow in construction projects?
More specifically for the construction industry, cash flow involves meticulous planning around exactly when costs will get incurred and how much these costs will be during the lifetime of a given project.
Project cash flow forecasts are used to handle payments within specific construction contracts. These forecasts are designed to work symbiotically with the construction firm’s cash flow forecast.
With this being said, many profitable construction businesses suffer from periods of negative cash flow. This tends to be due to factors like retention, extended payment terms, high operating costs and poor invoicing cycles.
What causes cash flow issues in construction firms?
The construction sector requires several parts to work together as a whole to get projects completed. The cash flow cycle is therefore interdependent, and issues can trickle down the supply chain from top to bottom. Some of the main causes of cash flow problems include:
Inaccurate estimates when bidding
Employee payment obligations
Fluctuating material costs
Extended terms and late payments
How to maintain positive construction cash flow:
To help keep cash flow positive in your company, we’ve drafted together seven solutions to the construction cash flow problems listed above.
1. Inaccurate project estimates during the bidding phase
During the initial stages of a construction project, it’s important to make precise estimates when predicting revenue, expenses and profit margins.
After submitting a tender and presenting their bid to a client, the tender becomes a legally binding business contract that specifies that maximum project-generated revenue.
Any error during the tender process can lead to substantial cash flow challenges and require the construction firm to dip into its reserves.
Solution: Comprehensive project estimates
Prior to bidding, take time to assess whether your firm has the financial capacity to weather potential cash flow strains that could arise.
Ensure your cost analysis fully considers all materials, labour, equipment and overhead costs required. While it can be tempting to underestimate costs, not doing this ensures a healthy buffer.
Conduct a risk analysis to determine any uncertainties that could impact the financial viability of the project. By identifying risks before they happen, you can implement strategies that allocate resources to mitigate them accordingly.
2. Employee payment obligations
Because construction projects involve labour-intensive work that require regular payment of employees on a weekly or bi-weekly basis, careful financial planning is required to ensure your company has enough cash on hand to meet payment obligations in the event client invoice payments get delayed.
This is typically less of a concern for businesses that engage subcontractors, as these payments tend to align with those from clients. However, challenges can occur when the business disburses payments to suppliers and subcontractors before receiving project payments.
Solution: Synchronised cash flow
Your cash flow projections should factor in payroll, supplier payments and client invoice receipts. In doing so, you’ll have a clearer overview of your financial commitments and be able to proactively plan ahead.
Where possible, try to align your contract payment terms with clients and subcontractors to minimise cash flow gaps. Negotiating your payment schedules can ensure collection of outstanding invoices quickly and help prevent employee payment delays.
3. Project delays
One of the most common construction cash flow challenges comes from project delays. In this sector, changes to timelines can be caused by a number of factors - from adverse weather conditions to permitting issues, labour shortages to unforeseen site conditions.
When these delays occur, cash flow projects can be seriously interrupted, as expenses continue to accrue even when work gets halted.
Solution: A contingency fund
One of the best ways to mitigate project delays impacting your firm in real time is to establish a contingency fund within your budget.
This cushion can be used to cover additional costs during unforeseen delays, and can be completed during the project budgeting process when you conduct your risk assessment.
4. Fluctuating material costs
Market conditions, trade disputes and supply chain disruptions can cause the prices of construction materials to fluctuate regularly.
Unfortunately for construction businesses, these fluctuations can lead to unexpected cost increases, which can cause cash flow strain if not initially accounted for.
Solution: Hedge material costs
By hedging your construction material costs, you can take proactive steps to protect your business against fluctuating prices.
After identifying the potential risks, you can implement strategies to keep costs low, such as:
Entering into fixed-price material contracts
Bulk purchasing materials at a lower price
Considering forward contracts that enable you to purchase materials at a predetermined price in the future
Diversifying suppliers to spread the risk of price increases on the overall project
Exercising cost escalation clauses that allow for price adjustments based on specific material cost increase causes
5. Payment retention
In long-term construction projects, clients often choose to retain a portion of the progress payments made to the construction firm until the project reaches completion.
This practice, known as ‘retention’, sees a percentage of the total project value withheld, typically set at 5%.
While this approach helps clients ensure that work meets the required standard, it can cause big issues for construction cash flow.
Typically, half of the retained funds are released upon project completion. However, the remaining half only gets disbursed to the construction firm after the defect liability period expires, which can extend anywhere from 12 - 24 months.
Solution: Work around retention clauses
Propose a progressive release schedule that releases a portion of the retention funds at specific project milestones
Consider obtaining a retention bond from a third party insurance company. With this financial guarantee in place, clients are able to retain a percentage of the value for quality assurance, but your firm can receive the full value upfront (minus the bond cost).
Establish clear contract terms related to retention, including a dispute resolution plan in the event disagreements arise that further delay the release of retained funds.
6. Extended terms and late payments
Receiving timely payments from clients can be a major struggle in construction cash flow.
According to Atradius, payment periods in this sector average between 75 - 90 days, the longest in any UK industry.
There are lots of reasons why delayed payments occur, such as work-quality disputes and because of financial constraints on their own end.
Solution: Consider Construction Finance
There are various strategies to improve cash flow in construction caused by late payments. Offering early payment incentives is one option, and financing client invoices is another.
To ensure cash inflows are received without delay, many construction companies choose to sell their outstanding client invoices to factoring providers for a small percentage of the invoice value.
In doing so, payment terms are reduced from three months to 24 working hours.
Many construction finance companies offer flexible setup and invoicing models that enable firms to factor invoices on-demand.
Compared to traditional invoice finance facilities that require a long-term contract and the sale of your entire ledger, selective invoice finance offer a number of benefits.
7. Seasonal workloads
The construction sector is subject to seasonal fluctuations that cause slower periods and often lead to reduced income.
According to the Construction Product Association’s Winter Forecast, the upcoming autumn and winter months are expected to see UK construction output fall by 4.7% before recovering slowly in 2023.
Solution: Diversity projects
Diversifying your project portfolio can help to ensure steadier cash flow throughout the year. When conducting cash flow analysis and budgeting for the year, use peak seasons to set aside funds that can be used to cover expenses when demand takes a dip.
Depending on your business type, you could consider engaging in projects within different sectors that are more popular during winter months - such as residential, interior renovations, maintenance and repairs.
Construction cash flow is complex but key
Effective project management of cash flow in the construction industry is a complex task, but with proactive planning and implementation of well-thought out strategies, navigating these challenges becomes easier.