by Jeffrey C Kadlowec, Architect
19 FEB 2024
Abstract
Cash flow management provides a means for analyzing the value of construction projects. These calculations are used to determine cost and schedule variance, and to estimate final costs. This information aids in decision-making throughout the project lifecycle, reduces a variety of risks, and mitigates budget discrepancies. With proper understanding of project financing, property owners and construction companies are better prepared, leading to improved performance and increase profitability.
Keywords: cash flow, cost estimating, financial planning
Cash Flow
Adequate cash flow and financial planning are required to complete construction projects and for the long-term success of development organizations. Lack of assets will prevent growth, have adverse effects on operations, and remains the leading cause of business failure [Sunagar 2022]. For general contractors to perform work, they must first obtain materials and mobilize labor; this comes at a substantial upfront cost. Timely invoicing of owners and on-time payment to subcontractors and suppliers is essential to avoid costly delays and project failure. Accurate projections for the flow of money based on production and consumption rates becomes an increasing challenge with size, scope and complexity of the work.
Construction cost estimating is inherently risky due to limited project information and high levels of uncertainty. Effective cash flow management is crucial to the competitiveness and survivability of a contracting firm. Companies may be able to operate for short periods without profit or even at a loss, but research shows failure rates of roughly 27 percent over the past decade due to poor financial position and lack of liquidity [Zayed 2014]. Financial forecasting is crucial towards long-term success. Discrepancies between actual and projected revenue must be accurately monitored to cover expenses and avoid collapse.
Economic cycles continue to have a major impact on the construction industry. Increased competition and high expenditures are forcing companies to accept greater risks, making them more vulnerable to financial losses. Contract agreements are the core of relationships between owners, designers and builders. Achieving time, cost and profit objectives requires a proper strategy and negotiation of terms and conditions. Cash flow modeling provides construction companies with predictions for timing and borrowing of money along with scheduling of repayment [Purnus 2016]. Project type, specificity of work, sequence of activities, utilization of resources, and application of technologies affect price distribution and can lead to imbalance of cash flow. Specialized banking may be required due to the large amount of funding necessary to perform work.
The construction industry brings together a variety of stakeholders to improve quality of life and generates substantial amounts of wealth. This requires a significant investment of capital and adequate management of cash flow throughout organizations [Omopariola 2019]. Problems arise from insufficient financial analysis, difficulties with funding, poor budget control, delays in payments, and failures by suppliers. Cash flow forecasting (CFF) predicts future excesses and shortages, helping contractors better manage funds throughout the project lifecycle. Contract disputes that disrupt cash flow can lead to insolvency, arbitration, litigation, and project abandonment. Arrangements should be made to secure financing in advance and avoid late payment to mitigate these risks.
Cash flow management (CFM) of a construction company must be practiced at the project and organizational levels. Financial analysis of individual projects looks at earned value (EV), cost and schedule variances (CV & SV), performance indexes (CPI & SPI), and estimate at completion (EAC). Strategic analysis of organizational finances aids in corporate planning and policy development. Lack of experience with CFM principles and inefficient financial practices are the common cause of failures within small and medium enterprises (SMEs) [Abdullahi 2017]. Commitment of management to CFF, training of staff in CFM, verification of forecasts, review of financial processes, and improvement to company procedures will lead to greater profitability.
The construction industry is impacted by labor markets, and is a major contributor to society and the economy. Maintaining a competitive advantage through continuous improvement in performance and procedures is critical to any business endeavor. Greater investment of capital increases financial risks, making cash flow predictions and financial controls more important [Mahmoud 2021]. Cash flow risk index (CFRI) is a tool that quantifies the impact of risks on a project and improves the accuracy of CFF. CFRI allows owners to forecast and assess a variety of risks that affect projects, providing early detection of issues and opportunities for mitigation. Being able to make informed decisions related to investments in real property increases their likelihood of success.
References
Abdullahi, Muhammad; Ibrahim, Yahaya; Ibrahim, Ahmed & Ahmadu, Hassan. (2017). Effects of Organizational Characteristics on Contractors’ Construction Cash Flow Forecasting Capabilities. Journal of Engineering, Project, and Production Management. 7(1): 33-44.
Mahmoud, Hasan; Ahmed, Vian & Beheiry, Salwa. (2021). Construction Cash Flow Risk Index. Journal of Risk and Financial Management. 14: 269. 10.3390/jrfm14060269.
Omopariola, Emmanuel; Windapo, Abimbola; Edwards, David & Thwala, Wellington. (2019). Contractors’ Perception of the Effects of Cash Flow on Construction Projects. Journal of Engineering, Design and Technology. 18(2): 308-325. 10.1108/JEDT-04-2019-0099.
Purnus, Augustin & Bodea, Constanta-Nicoleta. (2016). Multi-Criteria Cash Flow Analysis in Construction Projects. Procedia Engineering. 164: 98-105. 10.1016/j.proeng.2016.11.597.
Sunagar, Prashant; Nagashree, B; Mohan, S D Venkataraja & Honnanagoudar, S S. (2022). Cash Flow Modeling for Construction Projects. Neuro Quantology. 20(7): 1053-1060. 10.14704/nq.2022.20.7.NQ33135.
Zayed, Tarek & Liu, Yaqiong. (2014). Cash Flow Modeling for Construction Projects. Engineering Construction and Architectural Management. 21(2): 170-189. 10.1108/ECAM-08-2012-0082.
