Optimizing cash management in the construction industry

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Recently, a client told me how difficult bank discussions are for financing his construction company and asked me what you can do as a contractor to strengthen your liquidity. I touched on the topic in a blog post just under a year ago, but I'd like to take the question as an opportunity for a closer look.

I want to preface this by saying that while I believe it is always possible to complete entire projects "on the cash rich side," I believe a reasonable level of equity (between 10% and 25% of total capital, depending on staffing intensity) is necessary. Undercapitalized companies will run into problems sooner or later, even with the best cash management.

Measures in the sense of liquidity-oriented management arise in the following areas:

  1. operational measures vis a vis customer

The primary goal of liquidity-oriented management must be to get the money from the customer quickly. Central adjusting screws here are accounting deadlines, payment deadlines and the issue of claim reduction.

I distinguish between two types of customers.

Customer type 1, which often includes private individuals as well as real estate developers, does not have a liquidity problem, but only the fear of overpaying the construction company and being stuck with the damage in the event of a dispute or bankruptcy.

With those clients it is often possible to agree on short invoicing periods (e.g. weekly or fortnightly invoicing) and payment terms, provided that the sum is agreed and they do not take any risks.

Conversely, these customers fear overcharge claims, as these can easily lead to budget overruns.

In any case, with this type of customer, it is advisable to have a collaudit in advance at the construction site and to reach a timely agreement regarding possible claims.

Ideally, a meeting should be held every Friday afternoon to discuss the progress of work and thus the invoice amount, and to reach agreement on possible additional costs. If the latter is not possible in this meeting, at least the status should be recorded and a timely follow-up meeting agreed for the purpose of clarification.

Customer type 2, which often includes general contractors who are struggling for liquidity, often try to delay the payment deadline by means of extensive regulations (long inspection period, postal dispatch, long payment period, obstacle conditions, etc.). This type of customer also likes to "drag out" additional cost claims. Provided that the order is correspondingly lucrative from a results perspective and there is no fear of later disputes, there is nothing to be said against servicing these customers. From a liquidity perspective, however, there are many arguments in favor of receivables factoring for this type of customer. Depending on the volume, number of invoices, and history, the costs are roughly 1-2%. With an EBIT margin of 3%, this is certainly a lot, but 1% without capital investment is mathematically better from a return perspective than 3% with very high capital investment.

  1. Operational measures vis a vis suppliers

The opposite is true for suppliers, where the aim is to extend payment terms as far as possible. Towards sub-suppliers, the company itself can become customer type 2 as outlined above.

At first glance, one might think that a position at the end of the sub-supplier chain is particularly difficult. Interestingly, this does not have to be the case, as neither the building materials trade nor personnel are so strongly liquidity-driven.

In the case of personnel, for example, there is a fixed statistical payment target of 2 weeks, while in the case of the building materials trade, it is sometimes even possible to obtain a little more despite cash discounts.

However, the following measures have a stronger effect.

  1. Warranty management

An absolutely important point are down payments and guarantees, if they have to be backed by liquidity.

Let's start with the latter; from a liquidity perspective, the order is:

    • Corporate/holding guarantee (costs liquidity only when drawn and can still be disputed).
    • Insurance guarantee (costs liquidity only when drawn)
    • Bank guarantee (must be deposited at least in part)
    • Deposit (must be deposited in full)

In my perception, the insurance guarantee instrument in particular is underused by smaller and medium-sized construction companies. There are, for example, specialized providers who, on the basis of reasonably stable balance sheets, issue guarantees for a fee but without deposit. Since the instrument is not as well known as the bank guarantee, educational work is often required here.

The opposite is true for advance payments, which again only hurt some clients from a risk point of view, but not necessarily from a liquidity point of view.

Ideally, an advance payment should be agreed, e.g. in the form of a drawn security bond in accordance with 1170b, and the performance bond should be structured as a corporate or insurance bond. However, as a contractor, the minimum goal should be not to leave any liquidity "lying around" in guarantees.

  1. Renting instead of buying vehicles and construction equipment

The last big liquidity area is investments. Let's start with the favorite topic of an often slightly testosterone-driven industry - company cars.

Often I hear from companies that because of their great company car policy, they not only get the best employees, but they actually make a business from the cars. Typically the argument goes that new cars are bought at a little over 30% discount due to incredible negotiating skills and then resold after 1 year to unknowing private individuals who think 30% discount for a 1 year old car is a good price. In practice, I have not seen any company where the calculation has really worked out that way. There are many reasons. Let's start with the fact that the 30% discount may not be available on all cars (e.g. because the next facelift is still a bit away). But also the management effort or the increasing know how level of private buyers should not be underestimated. Just as little the expenditure from warranties, which are demanded by the buyer. And we haven't even talked about the fact that the special equipment, which is so important at the beginning, is not worth anything extra to the private buyer. Honestly, if the business were so easy, car rentals would be swimming in money. In fact, there is a lot of consolidation happening right now in this industry.

The solution to the problem is simple. Rent cars a little longer term at reasonable rates and resign yourself to the fact that it will cost a little something. But don't strain your liquidity and return the car without a headache when the employee leaves the company.

Honestly, I have to admit that internalizing fleet management pays off when you reach a certain size, but here we are talking about a few large companies, not SMEs.

Similar though not as emotionally charged applies to construction equipment. Here, too, renting is much less of a strain on liquidity than buying. And there is always the temptation to use existing equipment longer than necessary. Of course, every construction company needs a certain basic stock of machines, but this is smaller than one would expect. An experienced machine manager once told me that, according to his estimate, around 40% of the machine hours required over the year should be handled by the company's own machines, but the majority by rented ones.

Of course, these measures are not a panacea, but they can make the difference between being cash poor and cash rich. And for a construction company that is cash rich all the time, even very small margins are enough, at least mathematically, to be infinitely rich at some point...