Why manage your cash now
Some contractors have said the construction market is slowing. Others report they are busier now than ever in the last 10 years. One contractor said this is the busiest construction downturn he has ever experienced. Obviously there’s some sarcasm there, but it indicates a cautious optimism about the near-term future of the construction marketplace.
Ultimately, the slower economy will have an impact on the real estate and construction businesses. Electrical contractors are well advised to hedge their cash flow and do some risk planning in case the situation worsens. The warning signs may be there (The Federal Reserve Board continues to lower interest rates, bankruptcies have increased by 17 percent, unemployment is rising, and new home starts have slowed), but because you have been going 100 mph for so long, you may have lost some focus.
Now is the time to reconsider some basics of financial management. Why? A well-managed contracting business always seems to survive downturns and often emerges stronger than before. Anticipating change and having a plan of action to deal with it could make the difference.
Begin with competent owners
Your financial condition is always of concern to construction project owners, because successful completion of the project rests with the electrical contractor. Financial responsibility is a two-way street, but paying your bills on time keeps your credit rating intact. You should be just as concerned, however, that the owner is capable of performing all contractual obligations.
The owner’s ability to pay may be your single most important concern when you’re considering whether to bid or negotiate a specific job. Losing money on unprofitable work can’t always be anticipated. Not being paid for satisfactory work is worse, but at least you can take steps to avoid it.
The competitive nature of bidding work to obtain contracts shouldn’t interfere with your right to firm assurances from the owner that you’ll be paid. These days, many customers ignore owners’ bills and collection efforts. They understand perfectly when someone asks for a “clean bill of health” and other assurances before signing with a weak contract or beginning a new project.
The financial information to be obtained about an owner or prime contractor will vary depending on the type and size of work and on the individual owner. The following list provides a good head start on gaining better control of your cash flow.
• Owner’s financial statement—Either a CPA-prepared, audited, or reviewed financial statement for the responsible company or individual.
• Owner’s data—Names of general partners, officers, bank and other credit references.
• Dun and Bradstreet reports.
• Project data—Descriptions of the property and the project, as well as land acquisition information.
• Project financing—Lender, loan amounts, repayment terms, equity required, permanent financing, and committed and construction loan agreements.
• Architect’s agreements.
• Insurance policies, bonds, etc.
• References from contractors on previous jobs.
• Work to be done and terms of acceptance.
• Deadlines for completing work.
• Fees to be paid.
• Terms of payment.
The financial perspective of management
Adopt the approach that you and the owner will work well together as partners. But take some precautionary measures as explained above, so the owner understands that you expect him to be as responsible as you are. Here are more pointers that many contractors use to reduce uncertainties in risk management.
• Select the jobs you bid and bid only those jobs you can perform profitably based on the size and type of project you can do most reliably. Update your estimating review factors to ensure razor-sharp estimates. Don’t bid jobs with 20 or 30 other contractors on the bidders’ list.
• Budget your revenue volume at a realistic level to minimize cash flow problems. The idea is to do the same amount of work for more profit.
• Eliminate or decrease your fixed costs for heavy equipment. Leasing or renting equipment or arranging for more favorable payment terms can reduce current cash outflows. If you have surplus cash flow, ask your accountant if it would save money to pay your debt off early.
• Reduce overhead. Review with your accountant every individual cost included in this category to determine which reductions will generate genuine savings without decreasing the quality of your work.
• Budget costs based on what you need to spend on forecasted projects, not on what was spent last year. Talk to your suppliers; tell them you need to be more competitive and that you’re looking for cost-saving measures in order to continue doing business with them.
• Manage your direct costs. Look at every aspect to each job to decrease costs and improve productivity. Prepare a revised budget for each project, review it monthly, and stick to it. n Knowing your cost structure helps ensure accurate bids and well-controlled job costs. Every dollar you save is another dollar of profit.
• Improve job productivity. This goal involves not only higher labor output per hour but also investments in labor-saving materials and equipment.
• Have superintendents and project managers spend more of their time planning with on-site labor crews on how to get the job done most efficiently.
• Coordinate your work closely with your subcontractors and key suppliers. Include them on your job management team.
• Use the job-productivity measurement tools of your cost accounting systems. If you don’t have any, ask your accountant to set them up.
• Investigate and implement new construction methods wherever they improve profitability, but make safety the first priority. If you don’t, the OSHA inspector will.
• Market more aggressively. Increase and refine your marketing programs to generate more of the size and type of work that you can do most profitably. Open up at least one new market opportunity; for example, start a service/maintenance division or get involved with voice-data-video work. These changes could help cut off the losses from reduced new construction jobs, should they occur.
• Service your customers regularly. Tell them you appreciate them. And teach all your employees to do likewise. Formalize customer feedback and pay attention to the results.
• Know your market area and target your customers. Train at least one person to sell your company’s services through personal contact with prospects. This should be someone other than the person responsible for producing marketing collateral materials, advertising, etc.
• Involve your employees in management decisions that affect them. Use their skills more. Emphasize life-long training and personal development. Give each one responsibility and control over his or her individual areas. Effective delegation may be the first priority of management.
• Ask your employees for suggestions on improving your organization, increasing profits and productivity, and cutting costs. See that they get appropriate recognition for responding.
• Keep your attitude positive. Make sure everyone in your company has a “can do” outlook and don’t keep the others. Make ruthless decisions but deliver them compassionately. Watch for opportunities and never be pessimistic. Emphasize quality, productivity, and service on all of your jobs; make it your business philosophy to exhibit confidence, enthusiasm and concern.
Signs of trouble
Implementing these strategies before the economy takes a downturn in your area prepares you to sail through it with minimal damage. However, if you think it takes too much effort or money to change your company environment, your firm may be in the first phase of trouble if you experience the following symptoms of a cash crisis.
• Cash flow is tight—often caused by owner not paying timely or bills not issued on schedule. • No comprehensive business plan—a business plan is a company’s road map to success, citing goals and objectives, marketing approaches, financial forecasts and resources needed.
• Ineffective financial information system—must provide management with both financial and productivity information on a timely basis.
• Bidding jobs at or below cost—sometimes done to keep key field people busy but cannot be done on a sustained basis just to get backlog. You cannot make up losses by bidding more volume.
• Revenue and margins decrease over time—either job management is suffering or jobs are being bid incorrectly.
• One or more prime contractors or owners have a legal claim on your assets or future earnings.
• Major negative surprises in interim or year-end financial statements.
• Bank lines of credit are at their limits or are not being renewed by your bank
• Bonding company is scrutinizing every job and is uneasy with your current financial condition.
• Vendors are extended to where material orders are accepted only on a c.o.d. basis.
• Loss of loyal repeat customers—decreasing reputation for the company’s ability to deliver a timely quality product with little disruption.
• Continued operating losses.
• Profit fade on contracts-poor track record in being able to estimate cost to complete interim and year-end financial statements.
• Inability to get reasonable prices on change orders.
• Constantly involved in litigation.
If your company has many of these warning signals, take immediate action. It literally could save your company. In the short term, consult with your accountant or financial advisor about stop-loss measures you can take immediately. In the longer term, increase your knowledge of financial management and cash flow planning.
Cash flows versus profit—don’t be deceived
Because cash is King, electrical contractors should monitor not only profit but also their cash balances and various trends related to cash flows. Yes, job profit and net profit are important. However, the construction industry’s profit is dependent on accurate estimates. And, if the estimates are not reasonably close to reality, the profit reported may be significantly over- or understated. This is why, until a job is completed, monitoring cash flow may be as important or more so than monitoring profit. Some measurements of contractors’ cash flows you should monitor include the following:
Days of Cash indicates the number of days in cash available to cover annual volume. Generally, a ratio of seven days or more is considered adequate. The Days of Cash is calculated as follows:
(Cash & Cash Equivalents) x 360 / Revenue
Quick Ratio, also known as the “acid test” ratio, is a refinement of the current ratio and is a more conservative measure of liquidity. The Quick Ratio indicates the liquidity position without inventories and prepaid expenses, and indicates the extent to which liquid assets are available to satisfy current liabilities. Inventories and prepaid expenses are excluded from this ratio because they are more difficult or impossible to convert into cash on short notice in order to satisfy current liabilities. A ratio of less than 1.0 indicates that other assets, such as inventory or long-term assets, must be relied on to satisfy current obligations. The Quick Ratio is computed as follows:
(Cash + Accounts Receivable + Marketable Securities)/Current Liabilities
The Operating Cycle indicates the length of time it takes for a company to complete a normal operating cycle. An operating cycle is the time period commencing with the time cash is paid for costs on a project until the cash is collected related to the amount billed on a project. A low ratio may indicate a need for more permanent working capital. A high ratio may indicate the ability to increase contract volume. The Operating Cycle is calculated as follows:
Days in Cash + Days in Accounts Receivable – Days in Accounts Payable
Days in Accounts Payable indicates the number of days it will take to liquidate trade payables. Restated, this ratio tells creditors how many days, on average, they will have to wait before receiving payment from a customer. Though this ratio should be compared to vendors’ credit terms, a ratio of 45 days or less is generally considered adequate; however, if this ratio is lower than the Days in Accounts Receivable, cash flow may be negatively impacted. Days in Accounts Payable is calculated as follows:
Net Accounts Payable x 360 / Contract Costs
Days in Accounts Receivable indicates the number of days it will take to collect the accounts receivable balance. A lower ratio indicates faster collection, thus greater liquidity. A lower ratio can help place greater reliance on the Current and Quick Ratios. A higher ratio may indicate a need to depend more heavily on financing in order to meet obligations. Consideration should also be given to the Days in Accounts Payable because a Days in Accounts Payable Ratio less than a Days in Accounts Receivable Ratio may indicate a drain on cash flow. Days in Accounts Receivable is calculated as follows:
Net Accounts Receivable x 360 / Revenue
Managing for profit
To effectively manage a project, the project manager must understand the difference between profit and cash flow. Profit during the job has little effect on the cash flow maintained during that job.
All project managers must establish and use a single, clear definition of profit. Even among project managers at the same company, there can be different definitions of profit. Various project managers in one company defined profit as: billings less costs paid, billings less costs incurred, cash received less cash paid, revenue (percentage of completion) less costs paid, and revenue (percentage of completion) less cost incurred.
Just imagine the confusion when trying to determine the profit in this company. Each definition provides a different result and is often the reason project managers and accountants have a difficult time communicating on this issue. Identify and thoroughly spell out your profit calculation method for projects and make sure all project managers can understand and consistently apply it. This minimizes communication breakdowns and allows project managers to precisely determine job profit. EC
TAGLIAFERRE is proprietor of C-E-C Group in Springfield, Va. He may be contacted at 703.321.9268 or e-mail email@example.com. CUMMINS is a Certified Public Accountant and consultant to electrical contractors with Construction Industry Service Group of Aronson, Fetridge & Weigle in Rockville, Md. He can be reached at firstname.lastname@example.org.