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  • cash flow
26 Jan 2018

Cash is King

by Mark Woodward-Smith, Group Managing Director -

Mark Woodward-Smith explores potential cash flow issues for contractors in the construction industry.

The construction industry is credit-heavy and complex, and this is a very dangerous combination that often leads to you neither getting paid on time nor what you deserve. With most of the work and/or materials being furnished on credit, coupled with a long and convoluted chain from the client sponsoring a project down to the end of the payment chain, there are many opportunities for money to fall through the cracks.

It is generally the case that subcontractors must wait until their own payment is received from above before they can pay their supplier’s invoices. As a result, the structure of financial risk on a construction project increases in direct proportion to your distance from the source of the money.

The often long and convoluted nature of the payment chain provides many opportunities for payments to become delayed, any little inconvenience, delay or dispute about any component of the work can impact payment for everyone on the project, regardless of whether you were directly involved in that situation.

With slim margins and the fact that many parties need to wait to receive payment from above before they are able to pay the parties below, cash flow problems soon become amplified and inevitably this creates problems throughout the payment chain, from the contractor all the way down to a sub-subcontractor and its suppliers.

To put this in context the average time for Tier 2 and Tier 3 subcontractors to receive payments is reported to be between 80-100 days with only 5% being paid within 30 days. Business survival under these circumstances can be extremely challenging, it only needs a payor to default to push a business into failure. The government has estimated that 30% of all late payments occur in the construction sector with 15% of your turnover tied up, this equates to approximately £22.5bn a year, wow! And finally, a recent research paper concluded that around £700m of retentions are lost each year because of insolvency.  Some pretty disheartening statistics don’t you agree?

There are various phrases such as “revenue is vanity, profit is sanity and cash is reality” which all ring true, we see all too often in the news another major subcontractor going into administration, the impact on the employees, supply chain and clients is far reaching. We have also seen in very recent times how Tier 1 Contractors are faced with major profit warnings resulting in selling significant parts of their business portfolios and assets to satisfy banking covenants i.e. generating cash.

Hopefully with the introduction of the Small Business Enterprise and Employment Act 2015 section 3, which came into force in October 2017 changes to payment practices should start to occur which provide far more transparency, the biggest impact of which will be on the major contractors.

The Small Business Enterprise and Employment Act 2015 Act is aimed at medium and large sized companies with two out of the following three factors determining the size of the business:

  • Annual turnover of £36m
  • Balance sheet total of £18m
  • Average of 250 employees

There will be a requirement for those companies to publish statements on payment practices, standard payment terms, dispute resolution and various reports on late payments, these must be completed every six months for everyone to review. Failure to do so may lead to criminal sanctions; you have been warned!

It is also encouraging that much of the construction industry has signed up to the Government’s Prompt Payment Code and Construction Supply Chain Payment Charter, the aim of which is to reduce payment terms to 30 days for tier 2 contractors from 2018 and ultimately withdraw retentions, however, lets hold our breath and see how this is generally accepted in the industry.

It goes without saying that when agreeing contracts contractors should be fully aware of the payment terms and any specific requirements such as the timescales for issuing notices with regard to payment, suspension and delays.  It’s important to maintain dialogue on both sides before issuing written notices due to non-payment as there may be genuine and acceptable reasons as to one off’s, however persistent and continued late payments should start alarm bells ringing and requires close monitoring, particularly if its across multiple projects in different areas and sectors.

It’s somewhat different for suppliers and wholesalers who tend to react differently to payment delays by simply suspending further deliveries, putting whole accounts on stop and requiring all outstanding payments to be brought up to date before normal service is resumed. It’s usually Tier 2 & 3 contractors who are squeezed in the middle to maintain progress on site whilst continuing with their commitments to labour, staff, and suppliers.

The above shows how cash is much more on the governments agenda for SME’s, however recent reports have highlighted that Government departments themselves are also struggling to maintain payment practices on frameworks to tier 1 contractors, its therefore clearly important for everyone to follow a few simple steps that will help to improve their cashflow.

Companies pride themselves on strong cash balances, however they can soon become vulnerable. Below are some of the major issues and warnings to be aware of:

  1. Levels of Credit
  • Are you contracted to the correct company? It’s not unheard of for businesses to have multiple operating units and the contract to be with a subtly different name to the one you have assumed. Companies often operate with trade names which can disguise the underlying business.  It is always worthwhile checking with Companies House for active companies. See the case of Liberty Mercian-v- Cuddy Demolition.
  • Credit checking and approval sign off. Do you have an adequate system and process for checking the credit worthiness of a company you intend to do business with? Are you kept regularly updated with changes?  Companies such as Dun and Bradstreet produce credit scores which are very useful.  Are such reports being regularly reviewed, and warnings issued where appropriate?
  • Arranging credit insurance in case of insolvency can be an inexpensive way of protecting your cash, however it’s no excuse for not treating the money as if it wasn’t insured. Insurers will want to be satisfied that all contractual routes were pursued before paying out and even then, there are still likely to be excesses on most policies.
  • Credit insurance companies will also advise on the level of credit which they are prepared to offer. If you have multiple contracts with a single company it is worth checking if any overall caps have been reached as they will require regular updates of any payment issues.
  • Having a good credit control department. It is essential to know the process under which payments will be made, get to know the accounts payable department as they will be able to advise if everything is on track for payment to be received by the final date for payment.
  1. Managing Valuations and Variations
  • Keeping up to date with identifying, pricing, submitting and agreeing variations as the work progresses is probably the biggest area where cash flow could be improved.  It should be possible with the right resources to have a progressive variation account agreed, there are always areas of unagreed variations but paying substantial parts on account is at least some way to recovering the outflow of cash.
  • Contra charges, set-off and the like should be discussed, agreed and settled whilst the work progresses, as this will avoid any disputes near the end of the project. Don’t be naïve to think your final account is nearly agreed if you haven’t progressively discussed and presented assessments and challenged unsupported deductions.
  • Resolving disputes over payments. If you are not happy with a payment notice, it should be challenged as soon as practicable, there may be a genuine error which can be corrected before all the information is processed by the accounts department, alternatively look at resolution through a dispute process such as adjudication
  • Agreeing timely final accounts goes without saying, the earlier they are agreed the sooner the cash comes in. There are also situations were retention release is linked to agreement of the final account, if there are disputed accounts, it can hold up retention releases.
  • It’s worth adding interest to late payments, as small as it may be, keep track of when the cash was received relative to each date when the payments were due and include any late payment interest charges as a variation. This should remind everyone how serious late payments are, quite often contracts have very low interest charges compared with the governments statutory charge rate of 8%.
  1. Payment Terms
  • Agreeing payment terms. Accepting standard payment terms offered by Tier 1 contractors/clients or agreeing discounts for better terms is usually the case. It is worth putting forward alternative terms, if you don’t ask you won’t get. It’s usual to see “these are our standard terms”.
  • Understanding payment requirements. It’s important to understand how a client or contractor physically makes a payment, what internal process does each payment go through? Whether there are additional levels of sign off for higher value payments? Make sure you are aware of what happens during holiday periods and holiday shutdowns?
  • Payments. How often do the accounts payable department make payments? Are you on the payment run? It’s not unusual for payments to be made on one specific day each week, there it is important to make sure you’re on the “next run”.
  • Have you issued all the correct paperwork to the accounts department? Accounts department can be put on a stop on payments if up to date insurance documents have not been presented
  • Agreement to payment schedules is usual so all dates are clear, but having the ability to extend the dates beyond the completion date came to light in the case of Grove Developments-v-Balfour Beatty (2016) where no further payments were due until agreement of the final account.
  • Having a Pay Less notice too close to the final date for payment is something to be mindful of. Try to ensure that it is at least 5 business days before the final date for payment, the Prompt Payment Code is striving for 7 days.
  • Payment for offsite materials and getting payment for listed materials agreed upfront. It’s worth reviewing what materials will be stored off site due to programme and site restrictions and are there opportunities to include these in a schedule of off-site goods, indemnities are usually required along with photographic evidence before payment will be considered
  1. Cash Flow Forecasts
  • Clients will expect spend/cash forecasts to be issued and regularly updated. There may be capped cash flow forecasts already included in contracts due to the way financing may have been arranged, and it is therefore sensible to ensure forecasts are robust and properly take into account all programme changes.
  • Public Sector contracts usually have cash flows based around budgets and year end forecasts, updates are required should changes occur either through change or delay.
  • It’s important to produce internal cash flow forecasts showing income and expenditure for a detailed period of at least 13 weeks, along with scenario planning for the longer term of a project. This should be regularly updated with applications, certifications, invoices and actual payments received and this information will then be fed into the businesses overall financial planning.
  • It’s not unheard of for contractors to have to maximise cash flow at year ends and half year ends to bolster their results. These do not always coincide with when you would normally expect them to occur.  Knowing these dates in advance would be a benefit, for example a June financial year end could mean the previous April/May’s work is not paid until July, probably due to published balance sheets!
  • Some businesses operate volume rebates or cash discount schemes which should be considered when reviewing cash flows as some are taken at source whilst others are taken annually depending on turnover and circumstances.

 5.   Managing Cash

  • If appropriate and when payment terms upstream can’t be adjusted it may be necessary to renegotiate extended terms and arrangements with your supply chain if you are a trusted business and have a history of previously paying on time.
  • It may be a contractual requirement for milestone payment schedules, they can have a detrimental effect on cash flow so it’s important to describe specific activities in line with a programme of work. Having milestones which are clear and sufficiently descriptive to determine when they have been achieved such as “delivery of ….” rather than “building watertight”.
  • With the introduction of the updated NEC4, cost based contracts Options C, D, E, & F have introduced clause 50.9 which allows the contractor to instigate reviews and acceptance of defined costs as the work proceeds. The Project Manager has 13 weeks in which to respond. This is a step forward from previous drafts where the exercise could be deferred until the project had completed.
  • There is usually a high outflow of costs in the early part of a contract such as with preliminaries, design fees, etc, in addition there are often several upfront fees to be paid such as utility charges and planning costs and therefore utilising pre-contract service agreements (PCSA), letters of intent or early engagement agreements is a way of positive engagement between client and contractor to assist in such circumstances.
  • Providing a prefabrication solution as part of the construction process has many benefits, however it can involve significant upfront expenditure usually with no recovery of costs until delivery to site, as much as this is a benefit to site activities and progress of the works it should be considered at the outset of a project such as steelwork and lifts.
  • Delays to construction programmes. Any delay will inevitably have a financial consequence either to the client or contractor and costs either for prolongation or disruption should be prepared as soon as the event occurs. There may be other consequences related to cash flow which should be considered.
  1. Getting paid on time
  • Some contractors are using early payment facilities like reverse factoring which facilitates faster payments through to their supply chain. This can certainly speed up payments and release cash quicker but be aware these facilities can be withdrawn leaving you exposed to significantly longer payment terms than those to which you have become accustomed, in addition there may be early draw down fees which need to be factored in.
  • If it’s necessary to agree letters of intent with fixed periods or caps and you are engaged initially on such a form its worth confirming, there are adequate payment provisions included in case the situation arises where a contract is not concluded. Letters of intent are often increased in value so it’s important to include clear payment terms.
  1. Retentions
  • Retentions, defects and latent defects, require attending to swiftly and reviewing regularly. Because of the changes to the Housing Grants, Construction and Regeneration Act 1996 made by The Local Democracy, Economic Development and Construction Act 2009, retentions are no longer linked to other matters or contracts, what is worth noting are the release dates for the 1st and 2nd moieties, these can be extended for periods considerably longer than the payment terms for interim payments in some cases 2/3 years as opposed to the usual one year.
  • Certain subcontractors, such as lift and escalator installers, have developed a retention free practice by offering retention bonds in lieu of retaining cash payments. These along with performance bonds should be considered in lieu of retention sums and not in addition to.
  • Remember £700m of retention is lost each year due to insolvency, don’t let it happen to you.

The above is just an overview and having considered each of the points raised, hopefully it will lead to Tier 1, Tier 2 and Tier 3 Contractors having a better understanding of the importance of cash collection and cash management to their business.

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