1.0- Contract cash flow
When we are considering the project’s level, the difference between a certain project’s income and expense is named as “The project’s cash flow”. On the other hand, the company’s cash flow will be the difference between the company’s total income and total expense at the construction level.
Cash flow= Cash in – Cash out = Income – Expense
Why is it necessary to forecast the cash flow?
- To get an idea about the ability to meet the demands with the cash.
- It helps the contractor to determine the maximum amount of cash required.
- Lending companies consider it as a reliable indicator.
- It proves the utilisation of resources to gain profits for the owners and investors.
Three main ingredients in the determination of cash flow
- Expenses (Cash out)
- Income (Cash in)
- Timing of payments
1.1 Construction project costs
Computing the cost is very important while preparing the cash flow for the project. Use of the materials, subcontractors and labours lead to the principal components of the contractor’s costs. Taxes, interests on loans, supervision, support staff and insurances create the overhead cost. There are three types of classifications of costs that spend on a particular project. They are fixed cost, time-related cost and quantity-proportional cost.
Project direct costs
According to the resources, productivity data and detailed analysis of contract activities, these direct costs can be identified.
Project indirect costs
These are the overhead costs. There are two types of indirect project costs. They are Project overhead and general overhead. Project overhead means the expenses related to the site, and we cannot directly allocate these types of costs for a specific work element. For instance, supervisors, feeding costs for staff, workshops and stores. General overhead is also the same as the project overhead. They are also cannot be attributed to a particular project.
Genral overhead for a certain project= Project direct cost x general overhead of the company in a year Expected sum of direct costs of all projects during the year
When we are studying about the cash flow, it is essential to get an idea regarding the dates when the expenditure is going to occur. So, the following figure shows the difference between the expense and the costs of a construction project.
1.2- The S-Curve
S-Curve is a line that shows the cumulative expenditure of a project direct and indirect cost per time. As you can see in the below figure, this line gets the S shape. Most of the time, the owners ask the contractor to present such S-Curve for the lifetime of the project.
The steps to develop a S-Curve
- construct a simple bar chart for all tasks of the relevant project.
- Use the task duration and assign the costs to each task.
- Plot the cumulative amounts of the expenditure against the time by connecting the amounts of expenditures over the time.
1.3- Project income (Cash-in)
The form of the progress payments is the flow of money from the owner to the relevant contractor. The contractor makes the estimates of the completed work periodically. Then, an owner’s representative verifies it. The percentage of the total contract completion or the actual field measurement of the placed quantities are the evaluations that work as bases to estimate them. Usually, the owner retains 10% from all validated progress payment that was submitted by the contractor. Moreover, the contractor receives all the accumulated retainage payments with the last payment.
In the calculation of the contract income, it is crucial to think about the retention and the advanced payment to the contractor.
Retention is the amount that the owner kept from all invoices before paying for the contractor. Why is it important? Because it ensures that the contractor will continue the work and any problem won’t arise after the completion. Furthermore, this retained amount will be paid to the contractor at the end of the relevant contract, and it is an amount between 5% to 10% from all invoices as mentioned above.
There are mobilisation purposes, and this is the amount that paid for such requirements. After that, advanced payment will be reduced from the contract progress payment. In addition to that, there are many benefits of this action. It helps to prevent the contractor from loading the price at the start of the contract. Most of the time, the projects that use an expensive site preparation apply this strategy.
1.4- Calculating Contract Cash Flow
How do we get the cash flow? We can take by plotting the contract expense and the income curves. The difference between those points of the curves become the cash flow. According to the below figure shows, the hatched area is the difference between expense and the income curves.
If we consider the figure 4, the contractor may ask for an advanced or mobilisation. It causes to arise a shift in the income profile. As a result of that, as shown in figure 5, there won’t occur an overdraft. If there are a low number of payments, it will create an increase in the overdraft. (as shown in figure 6) So, it is better to consider the factors that create an impact on project finance.
- The project bar chart
- Activities direct and indirect cost
- Contractor’s method of paying his expenses
- Time of payment delay by owner
The steps of calculating the cash flow
- Perform project schedule and decide the project and activities timing
- Take the early or late timing as the base and draw the bar chart
- Calculate the cost per time period and the cumulative cost
- Consider the method of paying the cost to produce the expense and adjust it
- To determine the income, take the retention and delay of the owner payment as the base to adjust the revenue
- Calculate the cash flow at the contract different times. (cash flow= income- expense)
1.5- Minimising Contractor Negative Cash Flow
The actions follow to minimise the negative cash flows
- Adjust the work schedule to late start timing to delay payments.
- Reduce the delays in receiving revenues
- Requesting for advanced or mobilisation payments
- Decrease the retention and increase the markup
1.6- Cost of Borrowing (Return on Investment)
If there is any cash requirement, the company has two options to solve that problem. They can borrow money or use the reserved funds. If they use those funds, a charge must be calculated against it because it could have invested elsewhere and earned profits. Moreover, the difference between the income and expense curves represent the amount of interest that should be charged. The area situated above the expense curve is named as the positive area. On the other hand, the underneath of it becomes the negative area.
Cost of borrowing= net area x interest rate
2.0-Project cash flow
Project cash flow is valid for the whole lifetime of the relevant project. Because there is no income in the early stages of the project, it will create negative cash flows. However, the income tends to increase within the operational stages.
Figure 7:Typical project cash flow
2.1- Project Profitability Indicators
Profit is the difference between the total payments and total revenue. This amount is calculated without considering the impacts of time on the value of money. At a comparison among alternative projects, the one that has the maximum profit becomes the best choice.
Maximum capital means the highest demand for money. Choose the project that has a minimum capital requirement.
The payback period is the time duration that takes to cover the initial cost. In simple words, it is the situation that the cash out equals to cash in. Choose the project that has the shortest payback period.
3.0- Discounted Cash Flow
The value of the money does not exist the same every day. It depends on the time that it generates. The amount of money that you receive today is more valuable than an amount that you are going to receive in the future. Furthermore, the following subsections are very important in studying the present value.
3.1- Present Value
The process that is used to calculate the present value is called as discounting. And the interest rate that is used there is called as discount rate.
If P is invested for n years, then the future amount C will equal,
C = P (1+r)n
3.2- Net Present Value (NPV)
In the calculation of Net-Present Value (NPV), the expenses are considered as negative, and incomes are considered as positive. If the NPV gives a positive value, that project is acceptable. When there are alternatives, choose the highest NPV positive value. According to the results of the NPV, you must select the project A because it gives you the largest NPV.
3.3- Internal Rate of Return (IRR)
IRR is the situation that the discount rate where the NPV of a specific project equals to zero. According to the assumption, the IRR is constant over the project lifetime. You must accept the project that becomes IRR higher than the minimum return on capital. So, choose the project with the highest IRR.
This Article is written based on the- Elbeltagi, E. (2020). CONSTRUCTION PLANNING AND SCHEDULING. (Lecture notes on construction planning and scheduling by Dr-Emad Elbeltagi, Ph.D., P.Eng., Professor of Construction Management Structural Engineering Department, Faculty of Engineering, Mansoura University). Full lecture note available in this link