Cash Flow Options

The business side of remodeling is at least as tough as the unexpected challenges that remodelers routinely bring to light inside the walls of the homes. The trouble is that many remodelers come into the business knowing only how to uncover remodeling problems and not knowing the symptoms and pitfalls of business problems and how to bring them to light.

At a recent meeting of the board of trustees of the Remodelors Council of the NAHB, a side conversation centered on the proper qualifications for Remodelor of the Year. In particular, extra points are awarded to companies that have been in business for more than 10 years. On this issue there was unanimity among this group of leading remodelers. Yes. Length of time in business is important. And as one remodeler put it, “A newcomer to the industry can come in and make a splash for four or five years before the business catches up with them.”

This remodeler is referring to the legions of construction professionals who enter and exit the remodeling business each year because they can’t manage for profit. At most times in their business year, they are flying blind. They don’t know if they are charging enough to be profitable. Or worse, they don’t know until it is too late that they lost money on a majority of their projects.

Business consultant Leslie Shiner of the Shiner Group, and a senior industry adviser to Intuit Construction Business Solutions, works with 60 to 100 remodelers and residential contractors each year. She sees lots of companies where the principal uses cash from future jobs to finance current jobs.

“Typically remodelers get in trouble when they end up funding current jobs with future jobs,” says Shiner. “The practice is fine when your volume is increasing. But when it drops, you are going to get caught up and in trouble.”

Back to the group of remodelers discussing the virtues of longevity in the remodeling business, many agree that a newcomer to the remodeling industry can go as long as five years in business before they realize that they have a critical business problem. This problem may cause them to invest more personal savings into the company to keep it going, to acquire additional funds from other sources, or simply go out of business.

That said, Shiner believes even business-savvy remodelers can also fall prey to one big bad job, where scheduling delays and cost overruns pile on top of one another. In these circumstances, good remodelers typically find a way to get through the volatile period, but it often takes months for the remodeler to dig out and get cash flow on an even keel.

“I think cash flow is a leading cause [of remodeling companies going out of business],” says Shiner. “It could be that underlying problems cause the problems. And cash flow is the symptom and not the cause. For instance, a remodeler might not be charging enough and they don’t know it. Or they are overbilling. I tell clients to do it as much as they can, but to be aware of how much they are overbilling. Poor cash flow is one of those things that goes on forever and ever.”

Accounting 101
Like Shiner, Steve Maltzman of SMA Consulting LLC in Colton, Calif., is a business consultant who has worked with hundreds of remodelers and other residential contractors on improving their business. Maltzman’s firm also keeps the books for a number of the Builder 20 and Remodelor 20 clubs organized under the auspices of the NAHB. These clubs are comprised of groups of residential contracting firms from different markets that share detailed financial and business planning information. In turn, they get feedback from others in the group, which acts as an informal board of directors.

Maltzman advises his clients to take the time to better understand the four basic methods of accounting: cash, accrual, completed contract and percent of completion. (See Steve’s sidebar on page 28.) According to Maltzman, percentage-of-completion accounting is the only method that allows remodelers to manage their firm’s cash flow in real-time. When incorporated with one of the leading business software packages, percentage-of-completion accounting can give an owner a digital dashboard on job costs, cash flow as well as profit.

“Percentage of completion allows remodelers to look at financial reports in a methodology where the revenue that they are picking up matches the costs that are being incurred,” notes Maltzman.

When it comes to cash flow projections, Maltzman recommends one of two methods. The first ? for companies that have a good backlog of profit and cash equaling about six months operating funds or more ? is to set up month-by-month cash flow projections one year in advance and to update them periodically. For companies that do not have that level of cash and profit backlog, Maltzman suggests a six-week rolling cash-flow projection that is vetted and updated each week by management.

“The first type of projection, where you do a month-by-month cash flow projection, comes right off of your budget,” says Maltzman. “The other method, for people that are having tight cash flow is a rolling six-week forecast where they look at where cash is coming from and where the cash is going each week. It is used as a tool to say, ‘Wait a minute, I am going to be in the hole soon, so maybe I should do a little more work on this project so I can get a draw.’ It is a combination of looking at your schedule, looking at your estimate, understanding your billing cycle and then projecting out into the future.”

Creating proper draw schedules and deft handling of change orders are both critical to good cash flow management, agree Shiner and Maltzman. For some types of project a draw schedule of 30 percent down, 30 percent in the middle, 30 percent near the end and 10 percent on closing, works fine. For other projects a 50/40/10 draw schedule may be the better choice, depending on when a project will require the most amount of labor and materials.

“You always want to be ahead of the customer,” says Maltzman. “If you have a draw schedule in there that is 30/30/30/10 and the way the job is being built differs from that schedule ? the way you have to pay for labor and materials does not match up ? you will be in trouble from day one.”

Better Cash Flow with Percent of Completion Accounting
by Steve Maltzman

For industries other than construction, matching revenues to costs is relatively straight forward. In the remodeling business the distinguishing characteristic that makes accounting different is that the project is not completed at the time of sale (contract) and the ultimate cost to produce it is unknown.

Special rules deal with allocating a remodelers’s profit on contracts to specific project periods. There are several ways to measure this performance and establish a basis for allocating profit among periods.There are four different methods that are frequently used to recognize income, costs and profits on construction contracts - cash, accrual, completed contract and percentage of completion.

Under the cash method, income is recognized as cash is received. Expenses are recognized as cash is disbursed. This method may be advantageous for filing tax returns, but it is not recommended to generate management reports. Using the cash method, transactions are not entered until cash is received or disbursed, thus accounting information is not available on a timely basis.

The accrual method works well for time-and-material or cost-plus type contracts. Income is recognized when it is earned (typically when the invoice is prepared) and expenses are recorded when they are incurred (when invoices are received). This method provides more timely accounting information than the cash method but for most remodelers may not be giving a true picture of the company’s financial position. To maximize cash flow it is common to “front-end load” the billings resulting in billings amounts unrelated to actual costs incurred.

Under the completed contract method, revenue and expenses are not recorded until the contract is complete (for home remodelers, the transactions are not recorded until closing). This method is good for single family spec home production where the contract price is not known at the time production begins and billings are not done until closing. Under this method costs incurred during construction are considered as assets (work in process) while customer deposits or loans are recorded as liabilities.

Percentage of Completion Method
The percentage of completion method recognizes gross profit, cost and revenue throughout the life of each contract based upon a periodic measurement of progress. This method is most desirable for longer term remodeling contracts because it more accurately matches costs with revenues, and therefore profit, for a given period. To best explain, we‘ll look at the same project using different accounting methods:

Sample Remodeler just obtained a contract for $500,000 to remodel a home for Mr. & Mrs. Smith. Sample Remodeler estimates his total costs on the job to be $400,000. During the first month of the job, the following transactions occur:

1. Cash of $10,000 is paid for permits, fees and other start-up costs. 2. An invoice is received from the excavation sub for $10,000. 3. The first progress billing is prepared for $60,000.

If the above transactions were the only ones that Sample Remodeler had for the month, his or her income statements under each method would look as follows:

 

Cash

Accrual

Completed
Contract

Percent of
Completion

Revenue

$0

$60,000

$0

$25,000

Costs

$10,000

$20,000

$0

$20,000

Gross Profit

($10,000)

$40,000

$0

$5,000

 

Under the accrual method revenue earned equals the amount that was invoiced on the first progress billing, $60,000. Revenue under the percentage of completion method was computed as follows:

1. Calculate what percent the job is complete. Costs to Date / Total Estimated Costs = percent complete $20,000 / $400,000 = 5% complete

2. Calculate the amount of revenue to be earned. Contract Amount x % Complete = Revenue Earned $500,000 x 5% = $25,000

By examining the four income statements you will see that the percentage of completion method best reflects the company’s revenue, costs and gross profit for the period. If the president of Sample Remodeler received an accrual basis statement, he may think that the company is really prospering. The job is only 5% complete and they already made $40,000.

However, this statement does not give a true picture of the company’s profitability as of the end of the month. Since the job was only 5% complete, only 5% ($20,000) of the total projected gross profit of $100,000 has been earned.

The costs and revenues calculated in the percentage of completion method are at best still estimates of the true outcome of the job. This method also requires that the contract be properly estimated, and that the job cost system be accurate, up to date, and easily comparable to the estimate. The remodeler must have the ability to produce the information necessary to make a reasonable estimate as to the progress of the job.

For further information about the percent of completion method of accounting speak with your accountant or go to www.smaconsulting.net.

In the Field: How remodelers manage their cash flow
Qualified Remodeler asked several remodelers to tell us how they manage cash flow. Many generously explained their processes. Here are some selected tips from the field.

We hold bi-weekly meetings between sales, operations and accounts receivable/payable. During these meetings, we also review the project schedule. The schedule contains current projects and their anticipated completion dates. The schedule also contains pending contracts. These elements are combined to produce an average expected weekly cash flow. The meetings are vital in helping us manage this portion of the business. We can project far enough out to identify where any potential soft spots may be and prepare for them by adjusting the schedule, moving projects up or down, etc. Wade Bergeron, GM Bergeron Inc.

I use a tool that I call the sales predictor. It is a spreadsheet that consists of two parts. The first part is cash flow for projects that are under contract/construction. The second part takes prospects and establishes a hypothetical budget, timing for the start and milestone payouts and the probability of a prospect actually becoming a job. If the prospect is only a 60 percent chance of going to contract, the projected numbers are only represented at 60 percent of the project value. While this is more art than science, it clearly predicts a direction the future is heading. Ted Brown, Traditional Concepts Inc.

We typically ask for 50 percent down on a project. After all, our windows are custom made-to-order goods. We collect all remaining amounts at the time of completion. If there is an outstanding service issue during install, we have it repaired before the end of the job or allow the customer to retain 10 percent until the service is completed. We stay within budgets. For a company our size, $15 million annually, it’s easy for a lot of small expenses to add up. Each job is expensed-out before install and compared to actual afterward. Lastly, we use other people’s money to grow our business. It takes money to make money. Be in a position where banks want to give you money. Randy Shepherd, Renewal by Andersen Colorado

We have been in business for 27 years and when we got serious about making money about 24 years ago, we came up with a plan to keep a certain amount of money a year and pay taxes and let it grow. We keep our promises to ourselves to prevent going to the bank to make payroll. All our major purchases are financed. Greg Bowles, Bowles Construction

We require deposits on all jobs (50,40,10 on small jobs and 30,30,20,10) on larger projects. We have clear accountability for payments internally, sales person for down payments and final payments and project manager for progress payments. We monitor receivables with twice monthly reports and have a special report we call “cash in excess.” This report tells us if we have a job that has more cash spent on it than received, except for some time-and-materials jobs that would indicate a missed payment or other problem. Our controller does a daily cash report and a quarterly cash flow forecast. We utilize sweep accounts. Tom Kelly, Neil Kelly Co., Inc.

Pay your bills as soon as you can, always! We pay weekly. Stay on top of cash coming in. You will know when you are in a comfort zone. Don’t spend more than you make. Know your numbers. Reward yourself for your efforts. Garry Marrakol, Marrokal Construction

We find that cash flow management is one of the most vital tools we use in our operations. We track the future cash flows four weeks out, which may be on the short side, but the closer in we monitor it the more accurate it becomes.

I total our payroll and payables for each week, then subtract it from the cash on hand in the bank. I add back receivables based on due date. We may not get it right each week, but we are accurate over a two or three week period.

Another important component in forecasting cash flow is in the contract negotiation phase of each project. We have clear conversations with our clients to determine payment dates that are both realistic and equitable to them, and then we communicate the reasons why it is important that they maintain the schedule. By doing this, we can set realistic goals as to when our invoices will be paid. Rob Black, Chastain Const.

We are $8,400,000 company. We typically run about 10 to12 percent in receivables, usually 80 percent is less than 30 days. We use QuickBooks Pro construction version and export data into an Excel spreadsheet for cash flow projections and work in progress. Our contracts allows us to stay ahead of our customers by requiring 40 to 50 percent down payments before work commences. We have a bi-weekly finance meeting. During this meeting we review our collection accounts, aging summary, and work in progress (WIP). This allows our accounting manager to quickly determine the next week‘s progress billing. We closely monitor our WIP report by sales rep and project manager to track gross margin and percentage of completion. We enter all A/P as each comes into the office in order to project our weekly cash requirements. We have a large credit line with a sweep account if we need to cash to pay bills or receive vendor discounts. When we have extra cash it sweeps to pay of the credit line to lower interest payments. Mark Tiffee, Cut Above Construction

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