Structuring project cash flow

In construction, we often hear that ‘Cash is king.’ If you think of the demise of large main contractors over recent years, it was not the lack of a full order book that lead to their collapse, it was insolvency due to a lack of cash at hand to fund operations and their funder’s confidence in their ability to recoup this money from their clients.

The cash flow of a company can be used to understand and analyse the forecast income versus the outgoings over a period of time, usually annually, but it is reviewed periodically throughout that time. The basis of a cash flow forecast is often used to analyse a company’s financial health by examining current year projections versus previous years’ cash reserves. For example, overly optimistic cash flow projections versus previous years draw down of capital reserves could indicate underlying financial issues.

If you are a developer, you may be using a cash flow forecast to demonstrate how you intend to utilise some of your own capital to invest in a development before depicting when and how much external funding is required in order to make your business case. In this scenario, how you intend to structure outgoings (e.g. supply chain payments) becomes important, as you seek to link your incoming funds to the outgoings as the project completes.

Front Ending Costs

In order to improve cash flow, some contractors and subcontractors may seek to ‘front load’ or ‘front end’ their pricing schedules, which is to artificially enhance the value of the early works or preliminary items within the pricing schedule such that a cash positive position can be achieved early on in the project.

Suffice to say that being able to front end the prices only works on contracts that use a bill of quantities or activity schedule type arrangement. Front ending the pricing schedule on a target cost will not provide any advantage as you will be paid your actual costs plus a fee.

From a client’s perspective, simply keeping your supply chain incentivised for their next payment is often viewed as a good way to keep the suppliers focused to maximise output and maintain programme, therefore a balance should be struck between keeping payments flowing but not to the extent that so much of the value has been handed over, thus losing the incentive to complete i.e. as there is no profit left in the project.

The risk here is that if a supplier becomes insolvent, but that supplier front ended their pricing schedule, then you will have paid a disproportionate amount compared to the true value of works completed. Therefore, when you approach the market again and obtain prices to complete the project, you could find yourself in the position that you do not have enough value left in your budget to pay a new contractor to complete the project.

As a client, you can avoid falling into this pitfall by undertaking detailed cost planning of the works you are seeking to contract, understanding the forecasted value of each stage of the works and then extrapolate this over a programme of works to generate your own cash flow forecast. You can then compare this against the price returns you receive after you have run the competitive tender. It’s not uncommon to allow some front-end loading, but ensure this is backed off against the contract provisions. For example, an advanced payment bond acts as insurance for the client if a contractor becomes insolvent.

From a contractor’s perspective, by front ending your payment schedule, you may be seeking to protect yourself from a notoriously slow paying client. Alternatively, it could be a project that you are aware may not get completed due to funding restrictions, therefore you wish to realise profit earlier.

If you are considering front end loading your pricing schedule, be prepared to explain your reasoning. If you are able to tie it to a cause, for example you can demonstrate that purchasing land is more cost effective then renting over the duration of a project, or that you have to pay for materials up front in bulk to get a more competitive rate, and for these reasons your set up costs are high but you have factored some of these savings into your overall price offering, then a client is more willing to consider your proposals as there is a clear benefit for them as well.

How does a visiting QS from a funder review progress and what are their milestones?

If, as a developer, you are using the services of a bank or other third party loan to fund your project, then assuming that funding is agreed, they will use the services of an independent quantity surveying company in order to monitor the progress of the works. The reason they do this is to ensure they are not paying more than value of works completed to date.

How much involvement the funder’s Quantity Surveyor has depends on the method of valuation between you and the contractor and what is required in order to release funding. Principally the following methods of valuation are common practice:

• Milestone Payments – payment linked to when parts of the project are certified as completed.
• Activity Schedule – Similar to milestone payments in that an activity must be complete before payment is made, but the activity schedule is generally proposed by the contractor and therefore can be more susceptible to front end loading.
• Traditional valuation of works completed – monthly valuations (or sooner if the contract requires) of works completed, allowing a fairly accurate financial representation of the works completed to date.
• Stage payments – Not overly favoured by funders as this is a system whereby projects are paid from a fixed schedule of payments irrespective of actual progress. This can be difficult for developers to manage, as if progress falls behind schedule they run the risk of agitating their funder by overpaying, but if they streak ahead and therefore make an application request for more funding sooner, this is equally disliked on the basis the funder may have to recover or pass over more arrangement fees.

If traditional valuations are chosen, the funder’s Quantity Surveyor will seek to spend the highest time on site compared to the other options as they will need to satisfy themselves that the in-month and cumulative amounts to date are an accurate reflection of. If this recommendation proves to be incorrect, the Quantity Surveyor’s professional indemnity insurance could be at risk of claim being made for negligent advice.

For milestone payments, these visits can be less frequent than monthly and will likely need some technical input alongside to ensure that due diligence has been carried out.

Stage payments are favourable for developers on the basis they have a fixed income schedule for the project, but for the funder they are more exposed as to the accuracy of the stage payments compared to the true value of works completed.

Materials on-site and off-site

Cash flow is vital for the construction industry, however if the contract only permits certification of payment once materials have been incorporated into the works, then on a project with high material cost you could be faced with financing the project for some time until you are able to be paid for the materials you have purchased.

There are some options available to bridge this gap in the way of a vesting agreement between the contracting parties and a third party, usually the manufacturer of the materials. A vesting agreement operates whereby the ownership of the goods transfers from one party to the other once payment has been made. The vesting agreement usually includes details on how the materials are to be stored, what security arrangement is required, who is responsible in the event of damage, and the insurance provisions.

An example of vesting could be the cost of steel for bridge beams i.e. the beams are fabricated but not due for incorporation into works until a later date. To secure a better steel price and de-risk the programme, you have instructed the fabricators to start manufacturing early, but with a high value of goods you would seek the clients’ buy-in to this and payment once a vesting agreement is in place.

For materials on site, this tends to be for goods that are due to be fixed into the permanent works imminently such as lead flashing etc. It is important to note that under the JCT Design and Build Contract, any ‘Site Materials’ that have been paid for by the Employer then become the property of the Employer.

However, as the materials are not fixed into the works, what happens in the event they are damaged or stolen? Does it by default become the Employer’s issue as they subsequently owned the materials and therefore are responsible for replacing them? Even going as far as to pay the contractor again? It is for this reason that any payment for materials on site needs to be thoroughly considered as to the risks involved and ensure you have the correct contractual cover in place before payment is made.

How to Structure Subcontract Payments

If you are a developer and you have an agreed payment structure in place with your funder, and you intend to pursue the development on a management contractor basis, then consider what the best way is to structure payments to your supply chain. There are pros and cons with each option and it is worth considering your existing relationship with the suppliers when deciding.

With most agreements between the developer and funder, you will be looking to step these down through the supply chain contracts, but if you are using an arrangement such as stage payments, this may not be appropriate. If you value price certainty, when sub-letting any works look to lump sums. However, subcontractors will price for a higher level of risk for lump sum contracts. Lump sums are only as good as the contract documents they are based on. If there is ambiguity that requires post contract variations to resolve, you will be paying a premium and variations on the top, thereby losing any advantage of using a lump sum.

If you utilise measurement contracts, you will only pay for the value of works completed as the works progress. As a developer on milestone payments, this could provide the back-to-back agreement, but with a measurement contract the final value will be at risk until the design is finalised.

Notwithstanding the pricing option, the issue of the timing of payments needs to be thought about. For example, if the funder is paying you as a developer in thirty days, should you consider putting your supply chain on sixty-day payment terms or somewhere in between? Note that you will pay a premium in interest charges and other financing charges that will be built into your supplier’s tender prices, but you may decide this is a premium worth paying in order to maintain a cash positive situation.

Conclusion

It is rare that a cash flow forecast is fixed for both income and outgoings, and should therefore be considered a ‘live’ document with project progress dictating updates alongside any amendments to the funding conditions that may impact on income. The original outgoings for a project may have been based on a standard curve, whereas once you let contracts you will be better placed to provide a more up-to-date forecast.

Changes in sequencing, variations, delays or acceleration can all materially affect the original cash flow forecast, so understanding the impact and making allowance for it and taking account of changes as early as possible is important for financial control.

Image credit: iStock.com/1111IESPDJ

About Dean Suttling

A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.