Many companies in the construction sector rely heavily on lines of credit to meet short-term cash needs. In an ideal world, these credit lines are used to cover mobilization costs until the initial invoices on a project are paid. In the real world, they tend to end up covering general operating expenses while owners and general contractors delay payment of subcontractor invoices as long as they can.
As the availability of funds under these lines is often linked to accounts receivable balances, accurately forecasting receivables is critical to estimating how much cash you will have available down the road. There are two elements to forecasting your accounts receivable balance: billings and collections. Issuing invoices increases your accounts receivable balance, freeing up availability under the credit line. Conversely, collecting receivables pays down the line but also reduces availability by reducing the balance of accounts receivable.
A project’s billing schedule is critical to determining its impact on cash flow. Even if the project has a healthy margin, failing to match cash outflows with inflows can leave you scrambling for cash to cover costs.
The right time to consider the impact of the project’s billing schedule is at the bid phase. When drafting the bid, make sure that the proposed billing schedule gives you enough liquidity to cover projected costs until you can issue an invoice and free up funds on your credit line. Most importantly, factor in potential delays in project milestones, particularly where the owner or general contractor has to approve work before an invoice can be issued.
Once the project has begun in earnest, monitor any changes in the timing of invoicing and determine how it will impact your receivables balance over the project’s lifespan. Change orders can play a significant role here; while they may add a nice extra margin to the job, they may also involve large costs and cash outflows that impact your cash position.
The other half of receivables forecasting is collections. The timing of collections will depend on (a) the complexity of the project and (b) the customer. In this case, the customer could be the project owner, the general contractor, or any other party that you enter into a contract with.
The more complex the project, the more difficult it is to accurately forecast when you will collect on your invoices. The simple reason for this is that there are more layers of payment to deal with, and at each layer participants are trying to hold on to cash as long as they can. Owners will delay payment to general contractors, who will delay payments to subs, and so on down the line.
While there are mechanisms to force payment (e.g. liens, litigation), these are costly and not always effective against large general contractors who have the resources to wait out smaller players. All of this added complexity means that you have to allow for longer collection periods when forecasting collections in large, complex contracts.
The other factor in forecasting collections is your customer. If your main line of business is home renovations for individuals and families, you will have a very different collection pattern than a company pouring concrete foundations for housing developments. If your book of business relies on two or three large contractors, you should have a good idea of how long they take to pay on invoices. If you are bidding on a job involving a new customer, take some time to research them and their payment history. In times of tight cash flow, an extra sixty days on an invoice can be critical.
Most importantly, remember that collecting receivables when you are using a line of credit does not necessarily improve your cash flow. Because collections reduce your accounts receivable balance, they can also reduce the availability under the line unless you are replacing them with new invoicing. Delays in invoicing on one project, coupled with accelerated collections on another project, can create a nasty cash crunch.
Forecasting Complex Projects
While it can be relatively straightforward to forecast accounts receivable balances on one or two projects, companies involved in a large number of projects, or in multi-stage projects with significant duration, should consider using a forecasting model that can track multiple projects over time and that allows for sensitivity analysis to test the impact of project delays, change orders and short-term financing costs.