How can a construction company manage cash flow while fronting costs and waiting on retainage?

Construction contractors rarely sell their shares publicly. Owners and their retained earnings are the usual sources of their working capital. This is supplemented by debt from banks. Every new job requires working capital to buy materials, pay labor, and tide the company over until that job is finished. For all of these reasons, cash management for a contractor becomes a survival skill.

Robbing Peter to Pay Paul

When a growing construction business begins to pinch for cash, the usual move is to start shuffling money between accounts. In construction this is called robbing Peter to pay Paul.

Now, think about a contractor’s first job. He funds it with his own money, a small bank loan, and cash from his uncle. The lumber yard gives him a first load on net 30 terms. He sends out an invoice as soon as he can.

His first payment arrives. He’s off to the races. He lands a second contract. He uses the money from the first to cover the initial payments for the second.

The contractor asks the lumber yard to extend his terms to 45 days.

He seeks a line of credit from his bank but the bank will only lend him as much as he can guarantee out of the pockets of the owners, partners, and investors.

Money keeps coming in from both jobs. He starts on a third job.

He tells the lumber yard the new payment terms will be 60 days.

A real fear for a young contractor is that larger customers will dispute and delay payments for work they’ve ordered and he’s done. More damage to the flow of incoming cash is done by lawyers for either party getting involved in any of these disputes.

The contractor gets a big new job. Once again, the contractor needs materials from the lumber yard. Once again, he stretches the terms for payments.

Does all of this sound familiar?

Then there is front loading, a practice in construction where contractors assign a disproportionate share of costs to the work done early in a project. This is unpleasant sounding for most people, but routine in construction. Basically, it gives the contractor a deposit like other businesses are routinely granted, and in all fairness, they deserve.

Contractors are often required to carry all up-front project costs. These may include engineering, procurement, licensing, fees, site preparation, and infrastructure. So they bill for them early rather than spreading them out across the whole job. This can cause problems with working capital near the end of a job, when all the final balances are due.

Now add retainage into the scenario. Simply put, an owner has the right to withhold a percentage of total project costs until the final punch list is approved. For a ten-million-dollar project, 5% or 10% is a lot of money. For the contractor, it could mean that the final payment comes months after the project is finished. Meanwhile, his suppliers still want to be paid on time and are already tired of being asked to wait.

The failure to control cash flow is the single largest problem contractors have when it comes to causing businesses to go under. It’s a sad truth.

Remedy These Cash Flow Problems

There are several courses of action for every contractor to take in order to remedy these cash flow problems.

Begin at the very start to keep a reasonable share of each job as retained earnings. It should stay in the company as the business grows.

Before a bid is submitted, run a go/no-go cash capacity plan for the job. Carefully examine whether the company can afford to do the work with the necessary cash flow and what financing options it has.

Always send invoices on time. Make sure they are accurate. Set a tight schedule for collections and enforce it. Contract terms for invoicing and payment should not be changed by the customer without serious and strong objections from the contractor.

Line up an adequate line of credit for a job before it’s bid. Calculate this based on how much the company expects to use on that job, not how much collateral it can pledge.

Arrange terms with suppliers before the work starts. A supplier may agree to extend terms or the timing of payments for a higher per unit price on an item.

Negotiate progress payment terms early and finalize them before signing any contract. Do all you can to reduce the retainage terms to a minimum and shorten them to the very minimum time possible. And do not accept standard boilerplate terms that work against the contractor.