Why Construction Companies Go Broke — It’s Not What You Think

You know what the number one thing is that bankrupts construction companies? It's cashflow. It's not profit, it's not revenue, it's not having too much overhead, it's not paying attention to cashflow. So if you're running a business, you have a lot of money flowing in and you're wondering at the end of the day, where is all my cash? This video is for you.

I'm gonna walk you through exactly how cash flows through a construction business and what you must pay attention to in order to avoid going bust. All right, let me break it down here. Starting with the top line on the income statement, we have revenue.

This represents all the income that's generated from selling your products and services. So when you're out there doing projects and you are putting in place work, you're finishing scopes, this is gonna be recorded up here. As you finish this work, it's gonna be recorded in revenue, right? This is your top line, pretty easy, right? All right, let's keep going.

Underneath revenue, we have COGS, which is just short for cost of goods sold. This represents all the costs associated with putting in place this work, all right? So you go out there and you buy materials, you spend money on labor, and I'm talking about direct labor associated with putting in place the work. So you have your superintendents, you have project managers, you have foremen, you have laborers.

Everybody who's doing work on the project should hit cost of goods sold. You may also use subcontractors. That would also show up here in cost of goods sold.

And then any other direct or indirect costs associated with completing the project are gonna be recorded in your COGS. A lot of times, when I'm working with businesses, they have things that should be up in COGS down in their overhead, and that misstates their gross profit. All right, so you don't wanna do that.

You wanna make sure your numbers represent the true economics of your business. All right, so we have revenue, cost of goods sold. We arrive at gross profit.

The reason why I love gross profit is because it's an indicator which tells you how effective are you at bidding work and doing work. So when I was the CFO of this billion-dollar company, this is one thing I'd pay attention to, and this was a really good indicator, like I said, to tell us, okay, are our bids off, or are we not completing these jobs according to what we thought, right, what we were estimating? And this is where the battle comes in. So I've run multiple construction companies on my own.

I've been a CFO, and I've been an advisor to many more, and I hear the same thing all the time. You have the office, they're bidding the work, and then you have the field, they're doing the work. And the estimators are like, we can't put more cost in here.

We can't have more hours because we're getting beat up in the market with our pricing. And then the field's like, you're not including enough labor hours, because that's usually where the problem is. I mean, when it comes to estimating, usually you can estimate materials, and you can mark up your subcontractors appropriately.

Usually the disparity occurs with production hours. So estimators are like, you can't meet the production hours, right? You're not meeting the standards, what the heck? Like, you're slow, you're inefficient, there's a ton of waste. And then the field's like, you're not bidding it correctly, you're squeezing us, and you're putting unrealistic expectations on us from a field perspective.

That's where the battle happens, but this is what you have to manage, gross profit. But that's not the whole story, because we also have to account for op-ex. Op-ex is just short for operating expenses.

It represents all the costs associated with running your business. It may include items like sales and marketing spend, your general and administrative payroll, so people in your accounting department, your marketing staff, legal people, or like estimators, they may hit op-ex, that's where I used to classify them, in my operating expenses, because they were a cost of getting work, of procuring work. All right, so you have op-ex, you may also include items like office expenses, rent, utilities, insurance, et cetera.

All right, like I said, all the costs associated with running your business. If you take gross profit minus your op-ex, you arrive at EBITDA. I'm gonna keep things really high level in this video, by the way, too.

There's some nuances when it comes to the income statement, but I just wanna walk you through things just from a macro level, so you can understand how to influence each of these line items. All right, so EBITDA, it's just a fancy way or a nerdy way of saying profit. It stands for earnings before interest, taxes, depreciation, and amortization.

When it comes to cashflow, all right, I like to look at cashflow from an operation standpoint. In other words, I wanna know how much cash is the business generating from its core operations. So I'm gonna exclude things like interest, all right, because interest, for example, like interest income or interest expense, we're not a bank, we're a construction company, right? We're not in the business of earning revenue or income off interest, right, by lending money or by putting our money in an account.

And I wanna ignore interest expense because it's not related to operations. That's a financing decision in a business. There may be some other things, like let's say you sell a piece of equipment and you have a gain on the sale of a piece of equipment.

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That's gonna hit other income. We don't wanna account for other income in this evaluation of the business because remember, we're trying to determine how much cash is being generated from your core operations. So I'm excluding those items, all right? So I'm keeping things high level.

So earnings before interest, taxes, depreciation, and amortization. And this is a really good metric, and I pay attention to this with all the companies that we manage in our portfolio. So when we're working with businesses, we're advising them, helping them to grow and scale, we're paying close attention to their EBITDA, and this gives us an apples to apples comparison from one company to the next.

So make sure you're measuring this in your business as well. All right, but we're not there because EBITDA is not the same thing as cashflow. Although some people like to use it as a shorthand estimate of cashflow, that's incorrect.

I'll show you why. All right, so depreciation and amortization, just a side note. If you're wondering what the heck is that, let's say you go buy a truck, and I don't wanna do a big lesson on depreciation and amortization, but I'll keep it simple.

You buy this truck, and let's just say it's 50K. Well, according to generally accepted accounting principles, GAAP, right, in the United States, or IFRS, International Financial Reporting Standards, you can't just take this $50,000 and record it to cost of goods sold or record it to OPEX in one year. Now, there's some nuances.

You could depreciate the whole thing in the United States sometimes under Section 179, right? I get that, but we're talking about the economic reality of your business, not accounting treatment. So the IRS, in these generally accepted accounting principles say, look, you have to recognize the economic benefit in the period in which it's incurred. So if this is gonna last for five years, and at the end of five years, let's say the truck is worth zero, because you beat it into the ground, then that means 50,000 divided by five years equates to $10,000 a year in economic benefit you're getting from the truck, and therefore, you can record $10,000 a year in depreciation costs.

The only difference between depreciation and amortization is this, because this is really confusing. When I first started out in accounting, depreciation is for tangible assets. So that's when you're capturing the economic benefit used up or what you're depleting for tangible assets.

So trucks, tractors, your building, et cetera, will be depreciated. Amortization is the same thing, you're just doing it for intangible things. So say you develop an internal estimating software, and you're amortizing that.

You wouldn't say depreciation, you would say amortize. The same thing is true if you have patents, or you go out there and buy another business, and you're amortizing the purchase of that business. It's gonna hit here.

All right, so that's depreciation and amortization, and we wanna account for that for taxes, because it is a tax write-off, but just remember, we're not writing off the whole thing up above. So you have EBITDA minus depreciation and amortization, and we arrive at EBIT. So we're just taking off the DA, or canceling the DA, all right? So we have EBITDA, take out depreciation amortization, we arrive at EBIT, but we're still not at cash flow, because fortunately, or unfortunately, we have to pay taxes.

Sad face. Okay, so we pay taxes, and we arrive at NOPAT. Here's just a quick side note.

If you're running an LLC, or an S corporation, in the United States, guess what? Your entity does not pay taxes. You don't pay corporate taxes. C corporations do, but your business doesn't pay taxes.

Instead, guess what? These taxes, they flow over here on a K1, this tax form, and they go to the owner of the business. And the owner of the business pays the taxes of the company, but the company itself doesn't pay taxes. So if you're looking at your income statement, you may not see a line item, or you shouldn't see a line item if you're an S corp or an LLC for taxes, because you don't pay any.

But at the end of the day, you have to pay for taxes. And so you may be looking at your income statement, and this is why the income statement's so incomplete, but you're looking at your income statement, and you're like, oh yeah, I'm making like 10%. And it's like, no you're not, because you have to account for taxes, and you have to account for these other things, which I'm gonna show you here in just a minute.

So really, you're not earning that, and you're probably broke. You're busy, and you're broke, okay? And so many construction companies run like this, because they don't understand how this all flows. So let's keep going.

So we have NOPAT, which is Net Operating Profit After Tax. Note that I'm talking about operating profit. Remember, because we're excluding the other stuff that's not part of core operations.

But this shows us how much are we making after taxes. And for your business, you may just want to estimate this. So you just say, okay, I'm gonna apply a 30% effective tax rate to my business to calculate this, because remember, you're not gonna have a line item to know exactly what it is.

If you're a single owner, you go to your tax return and see what rate you're paying, and then come back to your business and calculate that. But if you have multiple owners or multiple partners, everybody's paying different tax rates based on their tax situation. So I just use like 30, right, as a general rule of thumb.

Okay, so that gives me Net Operating Profit After Tax. This is where so many companies, like, they miss it. So don't miss this, all right? We're trying to get to cash flow.

And remember, depreciation and amortization, we're just accounting for the economic use of the truck, but the actual purchase of the truck comes out of some other line item, which I'm about to show you. So we're just accounting for this 10,000 for taxes, but it's not a true cash outflow. And since we're trying to get to cash, I need to add this back.

So I'm gonna add back this $10,000 that I subtracted up here, because this is gonna be my net of taxes, right? Add back to cash flow, because it's not a true cash outflow, like I was saying. So you add back depreciation and amortization. The next thing is, you wanna subtract out CapEx, which is just short for capital expenditures, but this represents the money that's flowing out to buy trucks, and trailers, and trenchers, and skidsters, and buildings, et cetera, all right?

So this CapEx, you're gonna account for this 50,000 is subtracted out here. See, that's why, if you don't do this appropriately, you're double counting things and you get yourself in trouble. So in a business, you could go out there and buy all the bling bling, fancy trucks, fancy tractors, and that equipment is showing up down here.

But remember, most business owners, they're just, they're stuck right here. They're looking at EBITDA. They're not even paying attention to all this other stuff. And they're like, oh yeah, hooray, we're making all this money, but they're not.

They're not, because this stuff is not showing up on the income statement. This shows up on the statement of cash flows. And guess what? Most leaders don't pay attention to the statement of cash flows.

Right, we're not done, we're almost done. This is the next thing I'm gonna draw a triangle. This is your change in net working capital.

All right, let me show you this, and then I'm gonna get you down to cash flow. You go out there and you do work. So you go put in place work and you have this invoice, and this is your accounts receivable.

So you send this invoice to this customer, right? You're like, here you go, you owe me 15K. And the customer's like, cool, how long do I have to pay you? And you're like, I'll give you 30 days. Well, guess what? This revenue that's on this invoice, right? This $15,000, you're recording that up here in revenue.

And guess what? All the costs, so you paid your employees, you paid for the materials, et cetera, are already recorded up here. So you're looking at this profit number, but guess what? You don't have the cash because your customer has the 15K. They haven't paid you yet.