Why Understanding Both is Critical
In custom homebuilding, it’s essential to understand that even if your company is making a profit, cash flow issues can arise if you don’t manage the inflow and outflow of money properly. While profit shows whether your projects are financially viable, cash flow determines whether you can actually cover your expenses as they come in.
1. Profit: What It Tells You
Profit is the money left over after all expenses are deducted from your total revenue. Builders generally track profit through Project Profitability Reports that account for the total project income and associated costs (materials, labor, subcontractors).
Example:
A builder completes a project and invoices the client for $800,000.
Total project costs (materials, labor, etc.) are $600,000.
Profit: $200,000 (25% profit margin).
2. Cash Flow: What It Tells You
Cash flow, on the other hand, is the actual movement of money in and out of your business. Builders may face situations where they have plenty of work (and profit), but insufficient cash in the bank to pay for current project costs, due to the timing of payments.
Example:
The builder invoiced $800,000, but the client pays in three installments: $200,000 upfront, $300,000 after the framing, and $300,000 upon completion.
The builder incurs ongoing costs during the project, including $100,000 per month for labor and materials.
If cash isn’t managed well, the builder could run out of cash halfway through, even though the project is profitable overall.
3. Key Differences:
Profit is based on total income and costs for a project, often calculated after the project is complete.
Cash flow shows whether you can meet your ongoing expenses as they happen.
Example:
A project might show a large profit, but if the client delays payments or the builder doesn’t manage their invoicing schedule, cash flow could suffer.
4. Managing Cash Flow in a Project-Based Business
For custom homebuilders, managing cash flow is crucial due to the long timelines of projects and irregular payment schedules.
Best Practices:
- Invoicing Milestones: Builders should invoice at project milestones or monthly to ensure a steady cash inflow.
- Track Expenses Closely: Use project management software to track costs in real-time, so you’re never caught off guard by a cash shortfall.
- Cash Flow Forecasting: Regularly forecast your cash flow for each project to understand when money is coming in and going out.
5. Balancing Cash Flow and Profit: Common Pitfalls
Builders can easily fall into cash flow issues even when a project is profitable. Here are common pitfalls:
- Delayed Client Payments: Even with a strong profit margin, delayed payments can cause cash shortages. Have clear payment terms in place.
- Underestimating Costs: If you don’t account for all costs upfront, you might find yourself with less cash than expected during the project.
- Seasonal Cash Flow: Builders often face a slowdown in cash flow during off-seasons or between projects. Cash flow planning helps you weather these periods.
6. Tools for Cash Flow Management
Cash Flow Forecasts: Use forecasts to project when money will come in and go out.
Construction Lines of Credit: Consider using financing options during cash flow gaps, especially for long projects.
For builders, both profit and cash flow are important metrics. While profit tells you if your projects are financially viable, cash flow tells you whether you have the money you need to keep the project going. Make sure to use both metrics together to keep your business running smoothly and avoid financial pitfalls.