Been pondering the question “What is retainage in construction?” without an answer? Read on.
What is retainage?
Retainage is a common word all subcontractors and construction-related businesses need to be aware of AND account for in their cash flow statements. The meaning comes from the words root, retain, or to hold. With contracted work, it is very common for the project owner or their bank to hold retainage back from the GC’s contract and, therefore, for the GC to withhold or not pay out a percentage of the contracted price until specific milestones are met, or the project is fully completed. When you think about the uncertainty in construction work from labor challenges, material shortages, and weather delays, this makes perfect sense as to why a portion of funds, retainage, would be held until the end of the project. This “security deposit,” if you will, ensures the contractor completes the work in its entirety and does it to the satisfaction of the GC and the overall scope of work outlined for the finished project. Generally, retainage ranges from 5-10% of the project’s contracted price. Oftentimes, payments are paid to the subcontractors in progress payments, of which retainage can be held out from each payment, OR one lump sum is held until the end of project completion. The GC and the subcontractor will agree upon the exact percentage ahead of time, and that amount will be stated in the contract.
This covers the basics of “what retainage is in construction.” However, it is important to mention that there are some legal considerations based on state regulations for retainage rules. In the state of New Mexico, withholding retainage is not allowed, whereas in Texas, there must be a 10% retainage on all private construction projects. In the state of Florida, with regard to any contract for construction services,” a public business can only withhold a maximum of 5% of the payments as retainage. When determining what retainage to establish, be sure to check out your state’s laws. If contracts violate the local and state laws, then the contracted amounts can risk becoming invalid. Paying close attention to how retainage is designated within your contracts is extremely important. There have been a lot of lawsuits and manipulation when it comes to contractors and developers underpaying for work being done.
How can retainage in construction affect my cash flow?
Retainage is common practice and therefore, contractors are aware roughly 5-10% of their payments will not be received until a later time. However, when not properly accounted for in their financial statements, this can create working capital challenges. For example, a plumbing contractor may finish work on their building, but the project will not be completed for another 6 months (sometimes even years!!), leaving 10% of their full contract value payments not hitting their bank accounts for a significant amount of time. Consider this: 10% of the contract may be as much as 50% or more of the actual profit from this job. Meanwhile, the plumbing contractor needs to move on to other projects and oftentimes, they are short on cash, waiting on the retainage from prior projects to come in. This is why understanding the query “what is retainage in construction” while utilizing a cash flow template that is well structured in timing the inflow and outflow of cash on a weekly basis is imperative. Retainage must be accounted for on each project within cash flow statements. Let’s review how to properly account for retainage in your financials.
Incorporating retainage into your cash flow statement
When you have the cash flow of every project estimated and scheduled, you have a solid foundation on which to build your business’s profitability. When inputting data into your cash flow tracker, look for a tool that will auto-calculate each of your pay apps net of retainage. Otherwise, deduct your retainage percentage from every expected pay app when you are accounting for how much cash will actually be coming into your bank account. Your cash flow tool should have a function for when you will actually be paid by your customer. Contractors include the full amount they are invoicing each month, including the retainage amount, but it is then deducted when determining the amount to be paid in cash for that invoice. In other words, it is earned at the time you invoice but then held till it is due when you meet the milestones. You GET retainage when you submit a FINAL invoice for retainage at the end of the project AFTER the project has met the requirements to invoice retainage per the contract. The moral of the story, proper recording is key! Your cash flow tool needs to have the functionality to show when that money is coming into the business. Or you can just use the one that we created and have on our website for you (https://mobilizationfunding.com/cashflow/). Our tool keeps track of the percentage of retainage you enter and when you expect the retainage to be paid. It is important to update the dates you actually receive the funds. If the retainage payments are delayed, other project cash flows may also need to be re-estimated, especially if you are relying on the funds to get started on other projects.
Cash flow is not hard to manage once you are aware of what information you need to track. First and foremost, you need to know what the costs are. Make a list of everything needed for your project. This will include expenses such as materials, travel, labor, tools, etc. Managing cash flow for small business starts here.
Second, you need to model the project out to see how you will be spending the project-related costs according to the schedule you plan to maintain. Stress test the model to see what happens if the schedule gets pushed faster or the project gets delayed. What if the payments you are expecting in 30 days take more like 45 – does that blow up the project for you? Do you have the right terms with your suppliers? Should you use your contract labor or direct labor? Is it more important for me to have the right payment terms with the vendors I choose, or should I be more concerned about the price I pay them?
A Project Cash Flow model is another key tool to managing cash flow for small business and will help answer all these questions for you. Make sure you know how much money you need to execute the project as planned and earn the profit you expect to make when you bid on the project. For an easy-to-use cash flow tool and calculator to accomplish everything discussed in this article, check out our MF online Cash Flow Tool here.
Cash flow comes in three forms: operating, investing, and financing. We’ll focus on operating cash flow, which is the money your business makes from selling goods or services. Basically, the money your company makes doing whatever it is your company does. Financial cash flow shows the money you use to fund your business, including debt, equity, and credit. Investing cash flow is money created from investment opportunities. Now let’s dive into the different types of cash flow and how to calculate operating cash flow!
Types of cash flow
There are three major sources of cash—operations (company revenue), investments, and finance (loans, lines of credit, equity raise).
Operations cash flow is all cash generated by the purchase of your company’s main service or product. Most of a typical contractor’s cash flow will come from operations, from the work you perform. When you bill your customers or submit a pay app and then get paid, that’s a primary source of cash. Consider if you have other sources as you prepare your cash flow statement.
Investment cash flow includes cash generated by investments in capital assets or other ventures. An example of this may be the interest charged on a loan to an employee or an investment made in another business, or it may be Bitcoin that you bought in the business.
Finance cash flow is the money you take in from debt or equity, less the payments you make on that debt or equity (known as “Debt Service”).
How to calculate operating cash flow
Let’s say you own a luxury baby apparel boutique and you have a goal to increase revenue by 25% as compared to the prior year. To reach that goal, you’ll want to estimate the necessary additional expenses and cash needs in order to make that goal attainable and then track against those estimates all year. You will also need a budget, but that is for another chapter. Follow the steps below on how to calculate operating cash flow or utilize a Cash Flow Calculator to streamline the process:
Step 1: Determine your cash flow starting point.
This is as simple as consulting your business cash flow report when you have one, but in the meantime, you will need to do a little work. Start with what is in your bank account(s) right now and add any additional sources of cash you have access to. Then add up all of the free cash flow from all other available Sources. This would likely be Operational cash flow. Next, you will need to choose a specific date to start from—oftentimes it makes sense to start with the end of the previous year because you should have a clean set of financials and/or a tax return that states specifically where you are at that period in time (December 31st). Then you can use that specific year as your “baseline” to project forward from.
Step 2: Estimate incoming cash flow for the next period.
Based on historical cash flow tracking of Year A (the “baseline”), you can make a rough calculation of what the expected revenue will be for Year B.
Be sure to account for any anomalies, positive or negative, in the historical data. For example, if your company was closed for several months due to the shutdowns related to the coronavirus pandemic, that will have a negative effect on your cash flow data that should not be repeated.
Similarly, if you worked on a particularly large project—something way outside your normal scope—it is best to mark it as an outlier in terms of estimating cash flow. On the other hand, if you do have one-time events that you know are typical each year then you should account for those too.
For example, you are going to purchase a truck this year or you know one of your customers is going to order in bulk at the beginning of the year versus consistently every month like in previous years. These are the kinds of things to think about when planning in this stage of the process.
Step 3: Estimate outgoing expenses for the next period.
Just like you did with your revenue, you’ll want to review and tally up all of the expenses from the baseline period in order to get a rough idea of what you will spend in Year B. In a perfect world you will estimate revenue and expenses at least on a monthly basis to start and plan for the year—then refine this down to weekly looking ahead 13 weeks at a time. Then as each week goes on you add a week to the 13 so you always have a 13-week “look ahead” of the cash needs of the business. The week you finished becomes what actually happened and you adjust the weeks coming up and add one more week to the end. This allows you to always have a line of sight to the next 13 weeks of your business.
Step 4: Subtract the estimated expenses from the estimated revenue.
This one is pretty self-explanatory. Just like when you’re creating your cash flow statement, you need to subtract your expenses from revenue in order to arrive at your estimated free cash flow. This will give you the projected cash balance to end the period of time you are planning for.
Step 5: Estimate your starting and closing cash flow for the period.
You can now see your estimated opening and closing cash flow statements for Year B. Let’s break it down in an example.
You ended Year A with an available cash flow balance of $250,000. Your Year B estimated revenue is 1,000,000. The estimated expenses for Year B are $800,000. Your estimated available cash flow is $200,000, and your closing cash balance is $450,000 ($250,000 from Year A and the additional $200,000 from Year B).
Now you have your starting point or opening balance and your estimate.
Estimating cash flow is not an exact science, especially when you are planning out an entire year. When you are looking at it yearly, that is more of a budget in our minds than a cash flow tool, but you need your budget to know where you are going to start from. Remember that these are your best guesses based on the data at hand. Stay flexible and regularly check in on your cash flow estimates as part of your cash flow management practices.
Consistently checking in on cash flow is something you want to do on a weekly basis, at a minimum, if not even daily. Again – we recommend you use a 13-week cash flow tool to manage the cash of the business. You can check out of free tool here. For more information and helpful tips, fill free to check out our Big Book of Cash Flow here and unlock your company’s potential for growth!