Even with all the work you can do, all the tools you need, and all the right people, your business can’t function without cash flow. This week, we’re discussing the seven things that drive cash flow in your business and how to optimize each to keep your business going for the long term.
Topics we cover on this episode include:
- The four basic cash flow drivers: price, cost of sales, overhead, and volume
- Why the basic cash flow drivers don’t always work as expected
- The Cash Conversion Cycle
- How Accounts Receivable and Accounts Payable days affect cash flow
- How inventory affects cash flow and why your WIP report is your inventory
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Rob Williams: Welcome to the Contractor Success Forum. Today, we are talking about the seven drivers of cash flow. At the Contractor Success Forum, we discuss financial strategies for running your more profitable, successful construction business. And we have Wade Carpenter, Carpenter, and Company, CPAs, and Stephen Brown, McDaniel-Whitley bonding and insurance agency. And I’m Rob Williams with IronGate Entrepreneurial Support Systems.
So drivers for cash flow, man. That’s an amazing, valuable topic. Wade, what are the big seven drivers?
Wade Carpenter: To kind of introduce that, let me just ask you a question. Rob, are you still driving that rental truck? That Dodge truck?
Rob Williams: No! My car got smushed by a tree, along with my garage. So I finally took my big Dodge Ram truck with a Hemi in it [00:01:00] back, because it’d been five weeks and the insurance company quit paying for it. So I paid for a couple of rentals and we actually have some other cars. So, I’m actually driving my mother’s big SUV right now.
Wade Carpenter: Okay, well, whatever you’re driving. Okay. Say you just drove it off the lot. It’s brand new. You got plenty of gas in there. You got plenty of fuel. You got all your exhaust system, your ignition system, everything working right, but you have no oil in that car, in that engine. What’s going to happen?
Rob Williams: It’s going to lock up.
Wade Carpenter: Absolutely.
Rob Williams: Stop running.
Wade Carpenter: And that’s exactly what happens in a business. You can have all the work you can do, you can have all the right people, you can have all the tools you want, but if you don’t have cash running through your business, it is going to stop. It will come to a screeching halt. Now you may have fits and starts, but this is based on some things that I’ve been, I put together a webinar on this, these seven drivers of cashflow.[00:02:00]
And my goal is to teach this more visually, because what people don’t understand when we start talking about cash versus accrual accounting, people don’t get it.
Stephen Brown: It’s just the oil that keeps your engine running, Wade.
Wade Carpenter: Absolutely. So I’m going to break these down into a couple of different segments here.
The basic drivers of profit and cashflow
Wade Carpenter: The first four drivers, these are not rocket science. The first four are drivers of profit and cashflow. The first one is price. You can increase or decrease your price. You’ve got cost of goods sold, or cost of sales in construction. You can increase or decrease that. You’ve got overhead, you can increase or decrease. And number four is volume. And all four of these, if you increase one you would expect cashflow would increase.
Rob Williams: Yeah.
Wade Carpenter: There’s one of them that doesn’t always work that way. Can you guys guess which one?
Rob Williams: The volume.
Wade Carpenter: Absolutely.[00:03:00] Based on these last three I’m going to tell you about, these are the reasons why you can actually construct a situation where you can increase volume. but it does not increase cashflow. It actually decreases cashflow.
Rob Williams: Yep.
Wade Carpenter: And by the same token, you can construct a situation, and it does happen where you decreased volume, and it increases cash flow. It doesn’t make good sense, but that’s where these last three drivers is mainly what I want to talk about.
Rob Williams: Say how you categorize these again? I missed that the top four or what? And the–
Wade Carpenter: Well, the first four, they affect both profit and cashflow.
Rob Williams: Okay.
Wade Carpenter: But not in the same proportion. So if you increase price by 1%, It may increase cash flow by 1.5%, or it could increase half a percent. It depends on these last three drivers. The same with the other.
Rob Williams: Those three. It’s awesome.
Stephen Brown: [00:04:00] Cost of goods sold. What was the third one again, Wade?
Rob Williams: Overhead.
Wade Carpenter: Overhead, and then volume.
Rob Williams: Price, cost of goods sold, overhead and volume.
Wade Carpenter: Yeah. So you would expect if you increase price or decrease cost of goods sold, that’s also going to have an effect on cash flow. But it’s not necessarily in the same proportion.
Rob Williams: And I would say those are the top four that people traditionally think about.
Wade Carpenter: Absolutely.
Rob Williams: It’s these next three that’s the magic dust, isn’t it?
The Cash Conversion Cycle
Wade Carpenter: Well, in a way. This is kind of going back to the cash versus accrual, but if you thought about it, say you bought something and sold it that same day. So you bought it from somebody, your supplier gave you 30-day terms for that materials and you turn around and send a bill the same day. You got 30 days to pay it and you send a bill and your customer is going to pay you in 30 days. Well, if that all worked out exactly right, well, the cash would come in and you’d pay it. [00:05:00]
Rob Williams: Yep.
Wade Carpenter: It doesn’t work that way in construction, right?
Rob Williams: Yeah.
Wade Carpenter: So, practically speaking, we pay for materials at a certain point, and then we install it and then we send the bill, and there’s a lag.
Now there’s this thing in finance, we talk about the cash conversion cycle. I know Rob’s probably talked about it a time or two, but that’s where we’re going with this. So, we do have, the receivables, there’s a lag in, by the time you collect your receivables, but you’ve got some float in accounts payable.
Now say we were buying and selling computers. Or manufacturing computers. We put all this cost into the computer and we’ve got it sitting in inventory, right? It sits there until we sell it. So you’ve got another lag in your working capital that’s been sitting there for a while. Now, this kind of explains where the cash conversion cycle is.
And if you’re a contractor saying, I don’t have inventory, hang with me for a minute. But this cash conversion cycle, that concept [00:06:00] is the number of days sales you have outstanding, plus days in inventory outstanding, minus the accounts payable. Days of payables outstanding. So let’s just say we paid our payables in 32 days, we collected our cash in 30 days, and we had 40 days in inventory. We add receivables plus inventory minus the payables. If my math is right, I think we have come out to 28 days, right? So that is 28 days you’ve got working capital tied up.
Rob Williams: Yeah. So when you said number of days of sales, you mean the number of days of sales receivable? Like how long it takes you to collect your sales money? Okay.
Wade Carpenter: Right. So, if you average 30 days to collect your money– and there are formulas for this, you can get averages and people don’t look at that. We talked about recently looking at simple numbers like gross margin, well, looking at [00:07:00] these percentages, how they go, that is how they’re cash flow. If you’ve got a contractor, number one, if they’ve got retainage on their job, they may not collect them for six months or a year or later. So you’ve got to think about that extra working capital that is sitting in that retainage that you’re not collecting.
Rob Williams: Hmm.
Wade Carpenter: You’re only talking about 10% of it, but you know, 60, 70 days.
Rob Williams: Times to a bunch of days. A lot of my retainage was a year.
Wade Carpenter: Yeah. So again, this cash conversion cycle, these are the last three factors. They have absolutely nothing to do with profitability, but they have everything to do with cash flow and they affect the first four we were talking about.
Rob Williams: Yeah.
Accounts Receivable and Accounts Payable Days
Wade Carpenter: For instance, if we collect our receivables one day faster, Or we pay our payables one day slower, that affects our cashflow. We actually talked about, you know, recently return on investment and that whole model about return on investment, that [00:08:00] goes into what we talk about, like the sustainable growth rate model. A construction company, or any company, can only grow as fast as they have capital to grow it. And it either needs to come from profit or outside sources like loans and things like that.
So let me stop right there because I’ve been talking quite a bit, but am I making sense at this point?
Rob Williams: It does. And it’s so great because I just had a conversation with a new client yesterday and he came to me, not from Profit First so he had never heard of Profit First. So I said, look, we’ll, let’s talk in a few weeks, go read Profit First or listen to it, whatever.
So he just loved it. He just went crazy. He was like, oh my god, I’ve got all these books and they’re on accrual. Oh, I don’t like accrual, profit is cash. And I was like, well, no, no, no, no, wait. Accrual’s great too. Don’t forget that. You need to do both though, because the accrual is going to let you know whether you’re profitable in terms of like, how much is your balance of everything. [00:09:00] But the cashflow lets you know how much cash you’ve got and that’s the bottom line. But you’ve got to have both of these to sustainably, stay with this stuff in the long run. You, you got to have both sides. And I love this cash driver talk.
I was just listening to this thing on this Verne Harnish Scaling Up things that I’m following right now, and one of my favorite rules that he said, he said, The number one rule of cash is don’t run out of cash. And he said, that’s it, don’t run out of cash. So when you’re growing, you’ve got all these formulas of what you can do and how fast you can grow, but you can’t run out of cash or all this growth is not only going to not be good, it’s going to put you out of business. It’s going to break you.
So you can have all the accrual profits in the world and completely go broke. Because, because you don’t have enough of these cash drivers that you’re talking about. We hear that story. But what [00:10:00] you’re just talking about is maybe it takes you too long to collect that, and you start growing this early cycle of your inventories and your accounts receivable, that number grows and grows and grows, and your payables don’t grow as fast with them. They probably won’t. They’re probably a percent of that. That difference between the two is negative cashflow, as you’re going. The money in, how can we say that in a better way? You know that the more money you come in and go ahead.
Inventory Days and Your WIP
Wade Carpenter: Well, that’s where I was trying to go with this webinar that I’m doing. I’m trying to teach this visually, because if you say this comes in at this point, and then this has got to go out at this point, I think it makes a little more sense. So that’s where I was trying to go with this, because I think at some point I showed you the model that this was based on where, these drivers will affect the bottom line different from what it affects your cashflow. But from the [00:11:00] standpoint of a contractor, this is where things are very different. Number one, if you tell a contractor you’ve got inventory, they’d tell you you’re crazy. Most of them don’t, or maybe they get some pipe and they bill for stored materials.
But if your inventory is your WIP–
Rob Williams: WIP is Work In Process.
Wade Carpenter: Sorry, I’ll do that all the time.
Rob Williams: There. Yeah.
Wade Carpenter: Work In Progress. If you’re a spec home builder, maybe you keep your books that way. Basically accumulate your cost on the balance sheet. I’ve only seen maybe three companies in my career where if they’re not in that industry, they’re keeping it more on a completed contract basis in house. Sometimes we’ll do that for tax purposes.
Most GAAP financial statement, we’re not putting this on the balance sheet. So people don’t realize how much money is actually tied up in, those guys got to get paid every seven days, or whatever, putting the materials in, your subs, you don’t realize how much money is actually tied up [00:12:00] in that. That Work In Progress– I’ll stop saying WIP- is your inventory. It is a tough calculation for construction because construction books are not set up that way. But if you’re trying to do cash flow and figuring out these drivers, yes, there are measures of it. And they’re actually just simple calculations to do it. But a lot of times, it’s tough to figure on that piece of it.
But looking at these three cash drivers, this is where a contractor can find that lost cash. Where they can accelerate their cash flow just by looking at the pieces of this.
Just taking the WIP part, the Work In Progress part. If you’ve got a contractor’s bill just sitting on the project manager desk, it doesn’t get into accounting, so it doesn’t get billed that month. Well, you still got to pay that payable in 30 days or whatever, but you got to wait another 30 days before you bill it. And then you’ve got to wait another 30 days beyond that [00:13:00] to collect the money that you’ve already put in place before.
So there are simple things that we can do to, it may sound counterproductive, but accelerating, getting those payables. I feel like I’m preaching, but there’s so much that people never think about with this.
Rob Williams: That’s really interesting. So yeah, because people don’t understand how they can get negative cash flow when they’re building and growing the things. So if I could try to reword that, the time that you spend some money until you’re waiting to receive that money from them paying you, that is negative cashflow.
And when you’re growing, they all add up together. So when people say, well, Rob, you’re telling me I’m going to have to go three to $500,000 in the hole for this new growth that we have. Well, I don’t have $300,000. How can that be? Well, it’s because you’re going to be waiting to receive $300,000 on this job for 90 days or maybe [00:14:00] 120 days. You’re waiting for that money for 120 days. And then you’ve got another job that’s going to stack on top of that. So there’s $400,000 that you’re waiting on. If they happen to be at the same time, that’s 120 days that you don’t have that. And so you probably had to pay your bills in, say, 30 days or maybe that week.
So you’ve got a hundred days that you don’t have that $400,000 from those two jobs, that’s negative cashflow. How are you going to do it? The homebuilders really don’t see this a lot of times because they usually get construction loans. The volume guys are usually set up to get those maybe on a monthly basis. So they got a 30 day thing. So if you’re somebody that’s working with a bank loan, you’d have to add that other cash driver to that. But that’s when you talk to Wade and get somebody to really project that out.
The problem is they don’t see it, but then understanding that, I think most of our guys don’t have that situation. They don’t [00:15:00] have a construction loan. They’re doing this out of pocket. They probably have a line of credit in the bank, so it’s still negative cash flow. And then you just look at that line of credit, not exactly as an asset, it’s a debt, but it’s available cash.
So anyway, I don’t know if that helps you guys understand that. The more you grow, you’re going to need more cash. So where does that come from? It’s all that time that you’re sitting there waiting for those three drivers that Wade just said. The money that’s not coming yet, that your accounts receivable, in case you guys are not clear what an accounts receivable is, and then that inventory that you’ve already paid for. That inventory, you’ve got it. But you spent cash for that. Or that job that you paid all those subs to build this.
So those two times go together. And yes, maybe you get to float some of the costs of your material because you get 30-day terms, and a lot of these guys don’t have it. And a lot of the guys I’m talking to right now, because we’re in COVID, they’re paying up front for this material to lock in those prices. So their cash cycles are much [00:16:00] worse than normal because they don’t have any accounts payable terms. They’re paying for this stuff right then. Or maybe they’re delivering it and still getting 30 days. But I think a lot of these guys are actually paying for it. So we’re seeing a major negative cashflow that these guys are having to lock in the profit.
So you’re talking about cash drivers in this really unusual time, and you got to understand what your cash drivers are because you’ve got an extreme price protection situation. You’ve got extreme growth and everybody wanting the job. Hang on to it, because as Verne Harnish said, you don’t run out of cash or you’re in trouble. And the bond agents don’t like this, do they, Stephen? If you run out of cash?
Stephen Brown: Well, that’s right. Wade was talking about the WIP, Work in Progress report. Work On Hand, Work in Progress report. The items that constitute that report, it’s usually important to bonding underwriters to see an in-house balance sheet and income statement that coincides with your WIP [00:17:00] report.
And the reason is, is because backlog gross profit is real. And they look at age receivables and payables to see if you’re in trouble with any particular customer. And they give you a bonding credit for that. I think one of the best points you made, Wade, was about analyzing that report to see where the cashflow is lagging. Where it’s slowing down, where it’s not producing for you.
And then at today’s materials everybody’s buying the materials, locking it in, and usually they have some contract language that allows them to get reimbursed by the owner as long as the design team, architect, and engineer can confirm that that material is at a safe place and it’s set aside for that project.
Rob Williams: Yeah, that’s a great point, with some of the bigger contractors, some of the littler guys don’t have those things in place. That’s a great point.
Wade Carpenter: That’s what I’m saying. Looking at all these three drivers. Sometimes we see contractors that it takes a week to get the bill [00:18:00] out the door because it’s been sitting on the project manager’s desk or whatever, they don’t get the costs in, somebody is lazy and they don’t understand how this affects the company’s cashflow. Every day that it’s sitting on somebody’s desk that it could have been billed is working against you.
One of the things I usually do when I’m sitting down and working through this is just walk through the entire process of most of the costs and the whole collection process. Does that make sense?
Rob Williams: It does. And this is one of those subject matters that I think we just have to keep saying over and over and over again. It took me decades to really get it. And I still, when I have these conversations, it clarifies it a little bit more. There’s so many moving pieces that it just stays a little bit fuzzy. You’ve got to write it down.
So the more we can say this, hopefully our listeners can get this down in our head. If we just keep saying some of these points over and over and over again and saying it in a different way that [00:19:00] might just click and register to somebody that day, then boom. Maybe they’ve got it forever.
Wade Carpenter: Yeah. I mean, that’s where I was trying to go with this webinar. If you look at the model of Michael Dell and how he built Dell computers, or Amazon, they actually have negative cash conversion cycle. That’s how they built with other people’s money.
Rob Williams: The more they sell, the more cash they actually get in because they charge up front.
Wade Carpenter: Right.
Stephen Brown: They build it when you order it.
Wade Carpenter: Yeah.
But like I said, I think a lot of those points that we talk about, I hope it’s maybe sparked some things in your brain and I hope I made some sense without going into too much detail, but it’s amazing when you see the drivers and how if you increase profit, it doesn’t necessarily bring your cash up, or as much as you would think. It’s not dollar for dollar usually.
I guess to wrap this up, we were talking about the oil in your car. Do you really want to go pop the hood open and pull your dipstick and make sure you got– you know, it’s one thing to go do that. It’s a little tougher to see, but [00:20:00] there are indicators in a business of what’s going on with cash flow. And if you know how to read them, you’re not sitting on that, you know, your dashboard and then this idiot light comes up and says, you’re oil pressure is gone. You just wrecked your engine. Does that make sense, guys?
Stephen Brown: Yeah, then look at your rear RPM gauge in it, and you’ll notice it’s red lined at that point.
Rob Williams: Yeah.
Stephen Brown: It does make sense, Wade. It makes a lot of sense.
Rob Williams: Oh, yeah. That’s a huge. Cash is king. Don’t run out of cash. Understanding your cash drivers to stay in business as a long-term company through all the different cycles that you’re going to have is understanding what that is so you can make decisions on it.
We can talk about it, but, you as the contractors, you need to understand this so you can do something about these cash drivers. And understand what it is, and it just becomes like instinct, boy, you’re going to have such a [00:21:00] more longterm, profitably cash flowing business that you can sustain. And make some of those decisions because you’re the one out there doing this stuff.
And if you get it, you can really make this happen. We explain it, but you guys gotta make it happen and make those deals and pick the . Right ones.
Wade Carpenter: Pick those key performance indicators that turn of your, your gross profit, but also your cashflow drivers look at how to calculate these cash conversion cycles. It’s like having that dashboard on your car and hopefully in a gauge instead of an idiot light. You know, looking at your bank account and it says you’re out of money. That’s your idiot light. So.
Rob Williams: Yep. I like that. Our bank accounts and some of these that’s, that’s our dashboard with that oil temperature or catastrophic engine light comes on. So, man, this is great. This is definitely one of those topics that people should mark in Google and come back and listen to this cash driver thing like every month until it really sinks in their [00:22:00] head.
Wade Carpenter: That, or get some help. Call one of us, glad to talk to you about it.
Rob Williams: Yep. Go to ContractorSuccessForum.com. And look on there. You got questions about the cash drivers, something go there and there’ll be a button that you can go and join our discussion groups in there.
So do that. Ask questions. Maybe you got a question that can spark a new episode for us, or maybe you just want to contact us, which our information is on there as well.
All right guys. Well, thanks a lot. So, don’t run out of cash and have those seven cash drivers. And we are the Contractor Success Forum, Wade Carpenter, Stephen Brown, and Rob Williams. Thanks and listen to our next show. We’ll see you on the Contractor Success Forum.