No 'Surprises'!

November 9, 2023

by Thomas C Schleifer, Ph.D.

Too many contractors are "surprised" when they run out of money. In the construction business, the chronic shortage of working capital and the complexity of the financial transaction demands that CFOs prioritize working capital capacity and cash flow planning. The old Chinese proverb says it all: "If you don't know where you're going, you're probably not going to get there." Anyone who doesn’t know how much liquid capital they are going to need to conduct their business will definitely be surprised when they run out of cash. Cash flow planning is critical and requires protocols to constantly track the flow of cash in and out of the company's balance sheet. 

Navigating Financial Risks

Contractors consistently face two major financial risk factors:

  1. a chronic shortage of working capital
  2. a highly complex financial transaction

Chronic Shortage of Working Capital

  • Unlike all other major industries in the U.S., the construction industry has never taken advantage of public funding on a meaningful scale to finance growth.
  • Closely held construction companies seldom retain earnings sufficient to seed working capital going forward.
  • Banks rely on a contractor's credit worthiness to determine the amount of a working capital line of credit they will extend. However the credit analysis does not extend to the creditworthiness of the other parties to the project contracts.
  • Contractors have to utilize already strained credit capacity to finance long term asset purchases like heavy equipment, land, and buildings.

Highly Complex Financial Transaction 

  • This is no cash and carry business.
  • Most construction contracts have evolved into punitive legal documents designed to discipline contractors to meet budget and schedule.
  • Deposits to cover the costs incurred before the first progress billing are rare.
  • The first progress billing is not submitted until a month after the project starts and then owners have up to 30 days to process the payment, but often take longer. Contractors are responsible for all expenses for at least 60 days into the project and often longer.
  • My research into hundreds of failed contractors demonstrated that it is not unusual for a project 70% complete to have as much as a third of the value completed unpaid. On a typical sample one-year $10 million project, $3.6 million was owed the contractor after ten months of work. No small amount.
  • Punitive construction contracts allow for retainage of up to 10% as a hedge against contractor error or misconduct. A substantial sum on any project and an  serious strain on working capital on all projects.
  • Rarely do accounts payable terms match accounts receivable terms during construction's complex financial transaction. Most construction materials suppliers offer 30-day terms while owners take at least 60 days to pay and often much longer.
  • Construction workers do not offer terms to contractors. Payroll waits for no one.

Financing Working Capital 

The contractor's ability to identify and finance working capital is a crucial management challenge. Each new project presents additional working capital needs which are fluid, variable, and unpredictable. The flow of cash demands constant attention by CFOs, who must be prepared to make alterations to cash flow management as needed.

  • First, CFOs must ascertain how much liquid capital they will need to fuel both ongoing projects and projects under consideration in the near future.
  • Negotiate annually a sufficient working capital line of credit at their bank and keep lines of communication open to making adjustments as necessary during the year. Good banking relationships should be a CFO’s responsibility and is essential to their organization’s survival.
  • CFOs should be participating in all contract negotiations with a careful eye on payment terms and conflict resolution. Be unwavering when insisting on prompt payment and reasonable conflict resolution. Negotiate retainage aggressively at the outset. A firm stance will often reduce excessive amounts.
  • Accounting processes must assure accurate and on-time billing. Do not invite conflict with the owner's representative by significant overbilling, but at the same time do not tolerate late payment from the owner under any circumstance.
  • Utilize "friendly" material suppliers whenever possible who will extend payment terms beyond thirty days if necessary. Flexibility in accounts payable is an important working capital safeguard.
  • Lease heavy equipment whenever possible. It cuts down the use of working capital for long-term asset purchases.