Many transactions and agreements are made on the fly in the construction industry, sometimes even departing from what’s contractually agreed upon. This fact makes construction financial management in construction extra challenging. Handshake deals are not unusual, and ensuring that each financial decision is in line with business strategy can be difficult.
However, if a construction business is not meticulous about its finances, it can spell disaster. Profitability is still the ultimate goal for businesses, and financial traps may not be apparent until it has already dealt a blow to your business. It’s best to be prudent and smart! To help, here are five financial pitfalls you need to watch out for.
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1. Relying solely on accrual accounting
Accrual accounting is an accounting method where a business records revenue before invoices are paid, or expenses are recorded as incurred even before they have been paid. Though this simplifies record-keeping during the planning and other preliminary phases, it can create a distance between your actual cash position and what’s on paper. In construction, where delays in payment and delivery are not uncommon, relying solely on accrual accounting can lead to poor construction financial management and operational decisions. Many companies fall into the trap of relying on accrual accounting to monitor the costs and running payments on a project, even if the actual transactions have not been completed yet.
2. Inaccurate estimation
Estimation is a significant component of running a construction business. Many deals and even contracts rely on estimates; that’s why many solutions help contractors and suppliers make accurate estimates to inform their dealings. However, poor estimation is also a practice that is common in construction. It can stem from not reviewing actual costs regularly and using outdated pricing to make estimates for new projects.
Especially over the last few years, price fluctuations have been drastic and making wrong estimates can sometimes favor your business profit-wise, but that can bite you back quite fast. It’s best to regularly review actual costs and project financials to get a feel for the actual cost of things, but always be prudent with checking prices at the point of creating estimates and bids.
3. Not protecting lien rights
Delayed payments are unfortunately the norm in construction, with the average days sales outstanding (DSO) numbering up to over 60 days in 2021, one of the longest across business industries in the US. Encouraging timely payments is good for your cash flow, but sometimes there are situations where the client cannot pay what’s owed on time or might even forgo it altogether. Lien laws protect contractors, material suppliers, and other construction professionals in these instances.
Mechanics liens work by placing a hold on the title of the project you’ve worked on or are working on as a security in the event of non-payment. However, to have the right to enforce a mechanics lien when you’re left unpaid, construction businesses are tasked with adhering to pre-lien requirements in the timing and manner stipulated by law.
Especially for companies that deal with many projects across state lines, ensuring that preliminary notices are duly filed can be cumbersome, sometimes leading to incorrectly filed or missed notices. Missed or incorrect notices often result in the loss of the right to lien–which is costly if ever you’d need to use a lien to recover payment but have already lost the right to do so.
Ensure that you protect your lien rights on all projects. You can automate this process by using lien construction financial management software that streamlines the process of protecting your payments and ensures that notices are filed on time and accurately.
4. Poor change order documentation
Change orders are part and parcel of construction projects. They are often made with little planning, with paperwork always “to follow” but sometimes never completed or adequately documented. This often results in the contractor getting the shorter end of the stick, completing unpaid work outside the contract, or having to front for materials and labor costs for work that’s ultimately not profitable or will not be included in the project price.
Examine your current change order process and ensure that the requested changes or additions have been cleared with the client–including all details regarding cost and timeline–before commencing new work.
5. Poor liquidity and cash management
Cash is still king, especially in construction, where many projects force or require contractors to make significant upfront financial investments into a project. The profits come in only at the end of the contract when the last payment has been made. This puts many contractors at great financial risk, primarily when their liquidity is tied up in a single project and taking on a new one is predicated on getting paid on the current project.
This painful and high-risk setup might have already been a place of comfort for contractors who have been able to make it work for many projects. However, one financial blow or delayed payment can force you to make poor financial decisions like delaying payroll, denting relationships with suppliers, or taking out loans where the interest rates eat up your profits.
One workaround is to require a substantial down payment on all your projects and establish progress billing on your projects. While this approach is a good stop-gap and can help you not “rob Peter to pay Paul,” establishing a sizeable cash reserve is still the wisest approach and can protect your company’s profitability in the longer run.
Protecting the long-term health of your construction business
Avoiding these pitfalls might seem like common sense, but many contractors fall into the trap of skipping over facing these issues head-on even when the effects are apparent in their business. Hardened practices take time to shift, and it takes intentional steps to create a culture of financial prudence to ensure that your business is financially healthy and profitable. It can be challenging, but facing truths about the state of your business earlier is better than being forced to come to terms with the harsh reality with no option but to close doors.
About the Author:
Patrick Hogan is the CEO of Handle.com, where they build software that helps contractors and material suppliers with lien construction financial management and payment compliance. The biggest names in construction use Handle on a daily basis to save time and money while improving efficiency.