Cash flow management for construction businesses

Cash flow management for construction businesses

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When it comes to managing cash flow, businesses in the construction industry have it tough. Developers and builders often face an uphill battle when it comes to maintaining liquidity and flexibility, with long project timelines, high upfront costs, and unpredictable payment schedules creating risks left and right. 

The fact is that managing cash flow requires regular and constant attention, from creating a plan at the start of the project to revising it on a regular basis. Conditions can change fast, so you need to be sure that you’re not only able to meet your financial commitments today but also keeping enough headroom to avoid cash shortages that can throw your projects off track when circumstances change.

Here we’ll dive into the importance of cash flow in the construction industry, identify common challenges, and provide practical solutions to manage and improve cash flow effectively, including how cash flow loans can support your business.

Understanding Cash Flow in Construction

Cash flow in construction refers to the movement of money in and out of a business or project. In the context of the construction industry, it encompasses all the financial transactions related to the costs of materials, labour, subcontractors, and other expenses necessary for completing a project. 

  • Due to the nature of project-based work, with funds raised upfront before many of the details are clear, managing cash flow is a moving target. 
  • Payments are often tied to project milestones or completion phases, which can lead to periods of high expenditure without immediate income. 
  • For those in charge, this makes planning and monitoring cash flow essential to avoid liquidity issues, with access to credit and liquidity an increasingly important tool.

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What is the S Curve Cash Flow Model?

The S curve cash flow model is a graphical representation of cumulative costs, labour hours, or other quantities plotted against time. In construction projects, this model helps illustrate the relationship between project progress and cash flow needs.

  • The "S" shape of the curve indicates that initially, expenditures are low during the planning and early stages of the project. 
  • As the project progresses, costs accelerate, peaking during the most active phase of construction. 
  • Toward the end of the project, expenditures taper off as work is completed and the project closes out.

This model is relevant because it helps construction managers predict when cash flow demands will be highest and plan accordingly. By anticipating these peaks, companies can ensure they have sufficient funds available to cover expenses and avoid disruptions.

Cash Flow in Construction Projects

Cash flow in construction projects operates through a series of inflows and outflows. Understanding these patterns is vital for project managers to maintain financial stability and project momentum.

Examples of Typical Cash Flow Patterns

  1. Initial Phase:some text
    • Inflow: Minimal, often limited to initial deposits or advance payments.
    • Outflow: Initial expenses for planning, design, and obtaining permits.
  2. Active Construction Phase:some text
    • Inflow: Periodic payments based on project milestones or completion of specific stages.
    • Outflow: Major expenses for materials, labour, subcontractors, and equipment.
  3. Completion Phase:some text
    • Inflow: Final payments upon project completion and client acceptance.
    • Outflow: Finishing touches, cleanup, and final inspections.

Effective cash flow management in these phases involves:

  • Forecasting: Anticipating future cash flow needs and planning accordingly.
  • Budgeting: Establishing a detailed budget that aligns with project timelines.
  • Monitoring: Regularly reviewing cash flow statements to identify and address potential issues early.
  • Contingency Planning: Setting aside funds to handle unexpected costs or delays.

Cash Flow Formula for Construction Projects

When looking at cash flow, there are a range of views you can take. The precise calculations that are most relevant will vary depending on the stage of your project. Let’s take a look at the most common formulas you might come across.

Net Cash Flow Formula

Net cash flow represents the difference between cash inflows and outflows over a specific period. It indicates whether a project or business is generating enough cash to sustain operations. For construction projects, the formula is:

Net Cash Flow = Total Cash Inflows - Total Cash Outflows

  • Total Cash Inflows: Includes all payments received from clients, loans, and other financial income.
  • Total Cash Outflows: Includes all expenditures such as payments for materials, labour, subcontractors, equipment, and overhead costs.

Example: If a construction project receives £500,000 in payments and has expenditures amounting to £400,000, the net cash flow would be £100,000.

Operating Cash Flow Formula

Operating cash flow (OCF) measures the cash generated by the core business operations. It focuses on the cash inflows and outflows directly related to construction activities.

Operating Cash Flow = Net Income + Non-Cash Expenses (e.g., Depreciation) + Changes in Working Capital

  • Net Income: The profit after deducting all expenses.
  • Non-Cash Expenses: Expenses that do not involve actual cash outflow, such as depreciation.
  • Changes in Working Capital: Adjustments for changes in current assets and liabilities, such as accounts receivable and accounts payable.

Example: If a construction company's net income is £200,000, depreciation is £50,000, and changes in working capital result in a £20,000 decrease, the operating cash flow would be £270,000.

Free Cash Flow Formula

Free cash flow (FCF) indicates the cash available after accounting for capital expenditures, which are the funds used to acquire, upgrade, or maintain physical assets such as buildings and equipment.

Free Cash Flow = Operating Cash Flow - Capital Expenditures

  • Operating Cash Flow: Cash generated from core operations.
  • Capital Expenditures: Investments in physical assets.

Example: If the operating cash flow is £270,000 and capital expenditures are £100,000, the free cash flow would be £170,000.

Cash Flow to Debt Formula

The cash flow to debt ratio measures a company's ability to cover its debt obligations with its operating cash flow. It's a crucial indicator of financial health and risk.

Cash Flow to Debt Ratio = Operating Cash Flow / Total Debt

  • Operating Cash Flow: Cash generated from operations.
  • Total Debt: The sum of short-term and long-term debt.

Example: If the operating cash flow is £270,000 and total debt is £1,000,000, the cash flow to debt ratio would be 0.27, indicating that the company generates 27% of its debt in cash flow annually.

Cash Flow Yield Formula

Cash flow yield measures the return on cash flows relative to the company's value or its market price. It is a useful metric for investors.

Cash Flow Yield = Operating Cash Flow / Market Capitalization

  • Operating Cash Flow: Cash generated from operations.
  • Market Capitalization: The total market value of the company's outstanding shares.

Example: If the operating cash flow is £270,000 and the market capitalization is £5,000,000, the cash flow yield would be 5.4%.

Common Cash Flow Issues in Construction 

Cash flow issues can come from a range of sources, including:

  • Delayed Payments: Construction companies often face delays in receiving payments from clients, which can disrupt cash flow and affect project timelines.
  • High Upfront Costs: Construction projects typically require significant upfront investments in materials, labour, and equipment, which can strain cash reserves.
  • Variable Cash Flow: Due to the project-based nature of the industry, cash flow can be highly irregular, with periods of high expenditure and delayed income.
  • Cost Overruns: Unexpected expenses or project changes can lead to cost overruns, impacting the planned cash flow and budget.
  • Inefficient Billing Processes: Inefficiencies in invoicing and collection processes can delay cash inflows, making it challenging to maintain a steady cash flow.
  • Seasonal Fluctuations: Construction activity can be seasonal, leading to periods of low revenue and cash flow issues during off-peak times.
  • Poor Financial Planning: Inadequate cash flow forecasting and budgeting can result in liquidity problems and financial instability.
  • Supplier Payment Terms: Strict payment terms from suppliers can create cash flow pressures, especially if the company's inflows are delayed.

How to Manage Cash Flow in Construction

Accurate Cash Flow Forecasting

Accurate cash flow forecasting is the baseline for successfully managing your finances in construction projects. By preparing detailed cost estimations and cash flow statements, project managers can identify potential cash flow issues, anticipate cash needs, and make informed decisions about financing, billing, and expenses.

Establish Payment Schedules

Setting clear and realistic payment schedules with suppliers, subcontractors, and clients ensures cash is available to cover project expenses. This involves negotiating favourable payment terms and maintaining open communication about payment expectations.

Monitor Expenses

Expenses quickly mount up, so monitoring costs on a regular basis is essential for preventing overruns. Project managers should track expenses in as close to real time as possible, comparing actual costs to the budget, and identifying areas for cost reduction. 

Efficient Billing and Invoicing

Implementing a streamlined billing and invoicing process ensures timely payments. Accurate and prompt invoicing, along with clear communication about payment terms, helps avoid delays and maintains a steady cash flow.

Manage Project Timelines

Keeping projects on schedule is crucial for cash flow management. Detailed project plans with clear timelines, regular progress monitoring, and proactive corrective actions help minimise delays and meet milestones on time.

Accessing Finance When You Need It

Construction finance provides access to liquidity when you need it most, allowing your firms to keep project moving forward when cash is tight, That could be by purchasing materials, hiring equipment or paying contractors. 

iwoca Flexi-Loans offer quick access to funds, helping construction companies manage cash flow effectively during lean periods, with decisions available in as little as 24 hours.

Words by
Henry Bell

Henry is an experienced financial writer with 8+ years of expertise covering the financial industry and small-to-medium enterprises (SMEs). Specialising in the intersection of regulation, technology, and small businesses, his professional experience includes working with leading start-ups like Dext and DueDil, established financial institutions like MSCI Financial and Nium, and prominent investors such as Dawn Capital and Creandum. He is also a staff writer for AccountingWeb UK, covering key issues in compliance and regulation.

Article published on
June 17, 2024
Last reviewed on:
July 17, 2024

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Cash flow management for construction businesses