Do you know how much you have to bill this month to cover your expenses? Do you know how many construction projects you need to bid to cover your expenses four months from now?
These are important questions that every contractor should know about their business. These numbers and other key metrics give us the information we need to properly manage our cash flow, a must for any business to be successful. To avoid times where we struggle to pay bills or make payroll, we must properly plan and track our key metrics.
Take control of your cash flow by making a commitment to know and live by your numbers. The following seven key metrics are the numbers that every small business contractor should know by heart.
Projected Monthly Billings
How much do you expect to bill on each project for the month? This should be calculated on all projects and summarized for making decisions about expenses. In order to plan ahead we need to know what we expect to bill out and we also need to track what we actually billed. For example, if you are projecting to do $1,200,000 in business in a given year then you should expect to bill about $100,000 per month. So each month you can track your billings to know when you fall below the target. This will have a direct impact on your cash flow in a future month.
Projected Monthly Project Cost
This is the cost you incur to complete the work on a given project, also known as cost of goods sold. This does not include your overhead. You should plan these costs so that you understand how much cash is needed each month on top of overhead to complete the projects. This is a key part of our planning in construction businesses.
For our example, let’s project the cost for a project at $80,000. So we know we need approximately $20,000 per week over the next month in order to complete enough work to bill $100,000. We can project that number out over the month and compare that to our expected deposits. This example is simplified. To know the true number, we need to look at the cost in more detail to determine when the money is actually needed. For example, a supplier may give you 30 days to pay the invoice, so you will not need the cash upfront but you will need it in the future and often before you get paid.
Projected Project Gross Margins
This number is the difference between the billings and the project cost — or, the amount of money left over after you pay all direct project costs. This is what we have to operate the business on each month. We need to track this on each project and summarize for the business. In our example, this number comes out to $20,000 or 20%.
Monthly Overhead Burn Rate
How much do you spend every month just to keep the business running? This is our overhead burn rate, which includes items such as advertising, insurances, administrative costs, etc. These expenses exist independent of any project. It’s important to know what this number is in order to make sure you are completing enough work each month to pay for your overhead. Your company-wide gross margin needs to exceed this number in order to make a profit. For our example, we will use a cost of $15,000 per month. Based on what we have calculated so far we are billing $100,000 per month with a gross margin of $20,000. After we pay our overhead we should have a remaining profit of $5,000.
Average Accounts Receivable Aging
This is the average time between submitting an invoice and receiving the funds in our bank account. This number helps us to understand how long we have to wait for our money. We also use this to identify upcoming months that we may be short on cash flow. When you have a month that falls short of your required billings then you can plan for the future shortfall in the cash flow and manage it. For example, if we only bill $80,000 in April, we know that we did not bill enough to cover our overhead. If our average aging is 60 days, then we know that in June we will not receive enough cash to cover expenses. This allows us to work on solutions now to cover the shortfall.
Backlog
In construction we often have projects that last several months. Backlog is a calculation of how much work you have under contract that is not completed. This number will give us an indication of how long we can continue before we run out of work. Looking at our example, if we have $500,000 of backlog we know that we have enough work to cover us for the next five months. We can use this number to understand when we need to get aggressive in our sales efforts.
Sales Cycle
The sales cycle that we need to be concerned with is the actual time from estimate to billings. In other words, the average time in days it takes you to go from providing a client a proposal to actually submitting an invoice. We need to watch this number because this in conjunction with the backlog will help us understand when we need to get serious about winning more work. If we have five months of backlog and we know our sales cycle is 90 days, we would know that we have about 60 days to win some more work or month six will be a slow month.
Bottom Line on Managing Cash Flow in Construction Business
By tracking these key metrics, we can properly plan and adjust for future cash flow. We can understand when we need to hustle on the sales side, when we need to be aggressive with managing cost and when we can expect some extra cash flow. Take these key metrics and project them out month by month and you can gain valuable insight into the future of your business.
Knowing your numbers won’t eliminate future cash flow struggles but it will give you ample time to solve the problem. When you review the numbers you can determine if you have a future cash crunch coming, and take the time to properly plan and correct the problem. Perhaps you can adjust your overhead expenses in future months or increase your billings. Maybe you need to take out a loan to cover the shortfall.
The key to managing your cash properly is knowing your numbers, making adjustments and finding solutions that fit your business.