All too often, businesses find themselves using tomorrow’s job to pay yesterday’s subs. This can result in a never ending feedback loop – cashflow issues with each project cycle that are difficult to break. How business owners get themselves in this situation is fairly straightforward: a lack of formal accounting practices per project and a combination of either low profitability, too much overhead, or excessive owner’s discretionary spending.
Even the most well run company might have a job go bad but they usually have reserves to cover this.
We usually see multiple reasons a business may have to “borrow” from future jobs to close out the previous; it’s more of a habit or multitude of factors vs. a single job or two. Even the most well run company might have a job go bad but they usually have reserves to cover this. Usually it starts with low margins; the contractor isn’t generating as much profit as it should which puts a strain on finances. From there, we usually see wasteful spending on overhead like too much staff, large/expensive office space, or other excesses as another blow to good cash flow
The other most common culprit is the owner is taking too much out of the business for non-business related things. We had one client who complained about his cash flow and that he “made a lot of money and paid a lot of tax but there never is any money in the bank.” He even wondered if someone was stealing from him. After looking into it, we realized the business account was being drafted for the following things: lake house mortgage, boat payment, motorcycle payment, and country club dues, in addition to whatever cash he took out. Very quickly we realized that was the problem!
Here are some accounting strategies to prevent and/or break the cycle of needing to use future jobs to pay subcontractors from completed projects.
- Perform Effective Job Costing – Accounting for project-based businesses can be particularly challenging since there are far more considerations than just capturing revenue and expenditures on an income statement. There are project costs like labor and materials – that all hit at different points in the project. Job Costing tracks the costs and revenue of specific jobs so that you can tell how profitable each job is and plan for expenses. A formal methodology for job costing will account for the cost of subcontractors and also try to allocate indirect costs (expenditures that aren’t attributable to a specific job but are related to one or more projects (think superintendent salaries, truck maintenance, etc.). This will get you as close as possible to the true profit of a project, and therefore, how much cash is available.
- Control Overhead – Knowing your overhead rates is essential vs. just waiting for whatever is “left over” in the bank to count as profit. Not taking steps to proactively control overhead can strangle your profitability overall and per project. Make sure to look for any overhead costs that are unnecessary, or open to efficiencies or negotiation. This can give you the wiggle room you need to break the cycle.
- Retainage – Most commonly used to ensure that work is completed successfully, retainage is an amount of money withheld from contractors until work is completed. This has a dramatic impact on cash flow for a subcontractor- the work is done but 10% or more is being withheld until a future date. We encourage our clients to aggressively negotiate their agreements and push back on the General Contractor to either hold less retainage or release it sooner (preferably both!). GC’s love retainage because it gives them security that a sub will finish the job as well as helps their cash flow (they are sitting on the subcontractor’s money!)
- Pay Subs Immediately – It’s no surprise that the clients we see who pay their subs in full immediately get good rates, quick turnaround, and don’t have problems with cash flow. The owners of these companies treat their subs the way they want to be treated and run their business with a good bit of financial discipline. We’ve even seen some clients who enter an estimated bill to “reserve” funds on a project if they have not been billed by the subcontractor. Only when the jobs are done and fully complete and a final accounting is done do they consider what profit is available for distribution.
As a contracting company gets bigger, it may not be practical to time expenditures and distributions on individual job profitability but the tools and way of thinking described above is still applicable. Finance professionals and business owners need to develop cash flow forecasting tools and ensure that the overhead matches the revenue, jobs are being done profitably at the right margins, and owners discretionary purchases are in line and only done after sufficient reserves are present and maintained.
With proper management, financial oversight, and a little bit of discipline, contracting businesses can build up sufficient reserves to prevent having to “borrow” from future jobs. We all “lay an egg” once in a while but if reserves are sufficient, the infrequent bad job is easily handled without having to rely on future work to pay yesterday’s bills.