Cash Flow and Net Profit Are Not the Same Thing!
Achieving profitability in the construction business can sometimes be more of a challenge than the work itself. Between the tight margins, managing change orders, the burden of retainage, and the typically long wait to actually get paid, making a decent profit on a construction project can sometimes seem more like a miracle rather than an expected outcome.
But cash flow is not the same thing as profit. Moreover, successfully managing cash flow can be even more of a challenge that managing profitability.
Please read on for a brief discussion on the challenge of staying cash flow positive on your construction projects.
Net Profit is on Paper – Cash Flow is in your Hands
It’s entirely possible for a “profitable” construction project to have negative cash flow for the entire time the project is active. Being “in the red” (or negative) from a cash flow position on a construction project can last right up until the last payment is received and any retainage withheld is released. This stark financial reality isn’t the exception — on a typical construction project, it’s to be expected.
The term “net profit” is intended to be more of a financial report — an accounting of how a company performed financially over a certain time frame (year, quarter, or month) or for some other measure (like a single construction project). Tellingly, the net profit metric comes at the end of a time period or at the end of the project — after the action has already taken place.
On the other hand, cash is immediate. If you need $10,000 by Thursday afternoon to cover your next payroll on Friday, you need that entire money in cold, hard, cash. Cash isn’t a performance measure that comes after the action is over — cash is the action!
While cash flow and profit are certainly related, they’re not the same thing, and there are too many examples of companies that appear to be profitable on paper, but still experience significant, and even fatal, cash crunches during their projects.
Here are a few reasons why this happens in particular with the construction business:
Delayed Payments With Immediate Costs and Expenses
It takes a long time to get paid in the construction industry, on average, around 73 days (though we’ve heard plenty of stories of subs and others waiting much longer than that). However, most construction businesses don’t have the same luxury when it comes to paying their bills. On many projects, labor gets paid on a weekly basis. Materials and supplies often must be paid for upfront or at best with 30 day terms.
If it takes you almost 2 months to get paid, that means you’ll have to cover up to 8 weekly payrolls and at least 4 weeks worth of material costs (or even more if paying upfront) before you see the first dime of revenue from your customer. The amount of cash this ends up requiring will depend on your individual circumstances, but there’s no getting around the “immediate,” cash-dependent nature of these costs and expenses.
It Takes a Lot of Cash to Get a Project Off the Ground
Not only are many costs and expenses in the construction business immediate, many of these costs and expenses are often “front-loaded” (meaning, they occur at the beginning of a construction project). This can include labor, materials, deposits, and other uses of cash.
But as we discussed above, a lot of these costs and expenses are “cash costs” which means that they’re immediate, and the incoming revenue to offset these expenditures can be a long time in coming. This means that many construction companies are often forced to float the costs and expenses that are sure to come when getting a new project off the ground.
The cash needs to get a new project off the ground will of course vary according to the type of project it is and the resources required. But if you’re a company that has a large project volume (which can mean that you’ll be kicking off several new projects every week), or even if you’re trying to kick off just one large, resource-intensive project, be aware that you’re probably going to need a lot of cash in the beginning just to get it going.
Retainage can be a huge burden for all of the contractors (the GC, as well as all of the subcontractors, the sub-subs, and so on) involved on a project. While the amount of retainage withheld will vary from project to project (we’ve seen anywhere from 5% to 20% and sometimes even more), the most common rate used industry-wide seems to be 10%. However, according to the CFMA, the average net profit margin for specialty subcontractors is around 6%.
That means that, on average, most construction companies don’t even make enough profit on their projects to cover the amount of retainage withheld. If the retainage rate is greater than your net profit margin (and chances are that it is), that means that you’ll be running at a cash deficit and at a net profit deficit until you get all of that retainage released. And until that happens, you’re going to have to come up with another source of cash to replace that retainage withheld. On large project or long-term projects with extended timelines, managing retainage can be a huge financial burden.
Not only is it hard to make a buck in the construction business, it’s even harder making sure that you have those dollars around when you need them for important expenditures. That’s why it’s important for construction companies to do everything they can to make sure that they get paid as fast as possible. And one of the best ways to make that happen is by actively sending preliminary notices on all projects. Follow the preceding link for more information about how sending notices can work for you, and please download our free resource on preliminary notices for some additional information.