Why main contractors also struggle with cash flow
With the launch of the new Supply Chain Payment Charter, the construction media is harking back to a familiar theme: how main contractors are the “baddies” of the industry because they hold on to subcontractor and supplier cash. However, recent analysis from broker and analyst Liberum, which demonstrates that the UK’s six biggest contractors experienced a cash outflow of £400m over the last year, shows that cash flow management is a key issue for main contractors as well.
Accountants call the strong cash flows that main contractors enjoy “negative working capital” – which occurs when work is completed and invoiced to the client before the contractor has to settle its bill – on the grounds that working capital is normally an investment where cash flows out, so two negatives translates to cash flowing in. In other words, in contrast to most types of business, as turnover grows there is more immediate cash in the bank.
However, I recall the managing director of a substantial divisional contractor telling me that “cash comes in like a train and goes out like a rocket”. And when turnover reduces – as we have seen over the last two to three years – there is a corresponding reduction in contractor’s cash/debt balances. This is the counter “curse” of negative working capital, exacerbated in construction because the outflow is much stronger when sales are reducing to a lower level, than when they have stabilised at the new lower level. In other words, the cash position is worse on the way down than it is when you get to the bottom!
To understand the reason for this, it helps to appreciate how main contractors generate positive cash flow. Their methods include:
- Front loading rates, milestone payments, and site set-up costs.
- Getting paid quickly by clients and taking a longer time to pay suppliers.
- Billing for work that has not yet been actually done or which the suppliers have not yet billed for.
- Holding back greater retentions and claims against suppliers for longer than those held back by the client.
Some of these ways are rather fairer than others, and in the good times many contractors were consistently able to generate cash of up to 15% of turnover.
When turnover is reducing, however, there are a surplus of projects that need to be finished where the above strategies have already been used to maximise cash flow. This leaves many more payments to be made than receipts to be taken, at the same time as when the final settlements for additional works/claims have still to be agreed. For all these reasons, this downward path is one of the toughest issues for the management teams of contractors.
The core and remarkable reason for the stress around cash flow is that many construction companies do not fully understand how their cash flow works. Time and again I have sat opposite finance directors who cannot give a clear explanation as to why the company’s cash deteriorated (or improved for that matter) by millions in the previous month.
This failure is normally due to one or more of the following:
- They do not have the appropriate measures in place;
- There is insufficient communication between commercial and financial functions;
- There is an absence of cash management process.
For the big main contractors analysed by Liberum there is some good news. Order books are improving, turnovers will be rising, and their cash flow situations should only get better from here on in.
As welcome as this is, there is a lesson for the future. A contractor with money in the bank will be tempted to invest it in other opportunities like housing or property development. They can subsequently easily find themselves in a turnover trap where they have spent their cash but cannot sustain the level of business and hot cash that they have enjoyed historically.
The contractor then faces some tough choices: raise cash by selling assets (if any); under-price new contracts to provide some more short-term cash flow; squeeze suppliers harder; or go bust. Too many insolvencies happen in just this way.
There are some concrete steps that main contractors should take in order to understand and manage their cash flows better:
- Measure your cash and profit in ways that will tell you where you stand. You need to know where your projects and business stand in terms of: cash received in advance; over-measure; under-measure; claims (to client and with suppliers); retentions; stocks; and accruals.
- Reinforce an open and transparent internal culture so that these disciplines of measurement are robustly and honestly adhered to.
- Target and hold internal management teams accountable for collection of specific sums owed in the pipeline.
- Don’t spend the “surplus cash” that isn’t actually surplus. Plan and model your cash needs on the basis of a potential drought in customer orders so that you know that you will always have the financial resources that you need for the business to thrive.