Parables and cute sayings regarding money abound. One of my favorites is: “It doesn’t matter if you are rich or poor as long as you have money.” This logic applies to many contracting businesses.

Parables and cute sayings regarding money abound. One of my favorites is: “It doesn’t matter if you are rich or poor as long as you have money.” This logic applies to many contracting businesses. You can feel like your business is doing poorly merely because the business is short of cash. Ironically, whether you have cash or not may have little to do with the actual profitability of your company.

How you feel about your own personal finances is heavily dependent on cash. If you have cash in your pocket, then you feel rich on Saturday night because within reason you can buy, spend and do what you want. It is natural that these same feelings carry over to business. However, the facts of the situation may be totally different.

Having a positive cash flow is much like having a pocket full of money on Saturday night; it offers choices and allows for less stressful business management. Cash is the medium that keeps business activities moving along. However, feelings alone will have little to do with the actual cash management and analysis. Let’s start with some borrowing terminology that can help you understand what accounting cash tools you already have in place.

Balance Sheet Fundamentals

Too many contractors are confused by balance terminology and let their accountants manage depreciation and other transactions with few questions. A balance sheet can look foreign to a contractor, where a profit and loss statement looks more like a checkbook and is easier to understand. An income statement shows where you made a profit or loss by tallying your expenses. A balance sheet shows where that profit and loss are located and, with a few questions, is much easier to understand than first appears. Your balance sheet is made up of what you own (your assets) less your liabilities (what you owe), which equals your equity (what you are worth). Compare your current balance sheet to one a year earlier and see where and how it has changed. Tracking these changes will help you understand how it all works. It is not magic or some mysterious product your accountant creates using a magic wand.

Liquidity: This is an accounting term applied to your balance sheet that refers to how quickly you can turn assets into cash for paying bills. For example, if accounts receivable come in within 30 days, you can use that equity to pay bills as it is collected. However, if you pay cash for a truck and equity is tied up in the truck, it will not be turned into cash, and you will not have that money available to pay bills. Therefore, the truck is not a liquid asset.

Borrowing money is not necessarily a bad thing. Borrowing money to fund losses is subsidizing bad business practices and will lead to disaster. Borrowing money to buy necessary assets is a cash flow management issue.

Cash versus accrual accounting: Cash accounting is based on the cash you have received and what bills have been paid. Cash accounting does not include accounts payable and accounts receivable. Accrual accounting includes what you owe and what people owe you. For taxes, it might be wise to use cash accounting and let your accountant advise you in this regard. For financial analysis, always use accrual accounting.

To make sound business decisions, you must see the big picture, which should always be based on an accrual accounting method. Converting from accrual involves just a push of the button on your accounting software, or just takes a minute for your accountant to subtract accounts payable and accounts receivable.

Cash flow cycles: Every business has cash flow cycles and patterns. Understanding how those cycles work can help you understand what causes cash flow pinches and how they impact your business. The following simplified example explains how this works.

Take your last three months or 90 days in sales and divide it by 90. This will determine how much money you turn over each day. For our example, Acme Contracting had $180,000 in sales over the last 90 days, or $2,000 a day. Acme has accounts receivable of $100,000 - or, stated another way, they have 50 days of work they have done for which they have not been paid ($100,000 divided by 50 days). Now suppose Acme has $40,000 in accounts payable. This means they have 20 days of bills for items they have purchased that they have not paid for yet. If we take the 20 days of accounts payable, which is a loan from their suppliers from their 50 days accounts receivable, which is a loan to their customers, we come up with 30 days. These 30 days of cash represent the cash tied up in the company pipeline. If the company does $2,000 a day, this means there is $60,000 tied up in the company pipeline, and the company needs to somehow fund this $60,000.

In reality, this cycle can be more complex, and things like inventory, paperwork cycles, taxes and other things can also impact it. However, this simplified explanation helps us understand the basics of cash cycles, and accounts receivable and payable represent the largest items in most contractors’ cash flow cycle. Suppose Acme does commercial work, and the business grows because the company wins more bids from the contractors and property managers for whom they work. Let’s suppose the company’s sales went to $360,000 for 90 days, and the same 60-day cycle stays in place. Acme now needs $120,000 to manage this same cycle. Where would the money come from to fund this growth? How do they fund this growth?

Customer deposits: Many contractors, particularly residential contractors, receive deposits from their customers, and they use these deposits to help manage cash. If you take such deposits, make sure you understand your state laws regarding deposits and are doing it legally. Accounting practices for these deposits can be tricky. If you merely record these deposits into sales and deposit the money, it will distort your sales and income. Why? The deposits are not sales but rather a deposit from the customer which is really a liability or loan from the customer. It does not become income until the work is actually done. Mishandling these transactions can impact your true profit and loss and tax liability.

Collections: Too many contactors merely blame poor collections for all of their cash flow problems. You should have a collection policy, but you also must understand that your customers have a certain way they pay and process bills. In most cases, you are not going to change your customers’ billing cycles. You must take such cycles into consideration when building your business plan. For example, if you perform both residential and commercial work and you experience cash problems, you may find growing the residential business more realistic as the cash cycle is better, or you may just want to borrow the money to fund receivables.

You also should have a billing and collection policy and follow it. Remember, payment does not start until the customer is billed. If you are late billing the customer, you will be late receiving the money. You also should have a standard process you follow once the bill is sent out. The policy should spell out what you do in 30 days, 45 days, etc. Make sure you understand your local and state lien laws and apply them within this cycle. An office person, not a salesperson, should administer such collection policies. Why? The salesperson may be reluctant to do so in fear of losing the next sale.

Hopefully, the above information will help you better understand your cash needs. Have a monthly financial meeting where you review a balance sheet, profit and loss statement, accounts receivable by age and any other pertinent financial data. Ask questions and work the system. The more you ask, the more you tweak, and the better the system will be.