Be aware of the overtrading trap

Mark Perrin - Menzies Accountant

Mark Perrin – Strategic Advisory Partner

It is essential for construction firms, taking on long term and high budget projects, to consider long term contract accounting treatments under UK GAAP. Currently a number of construction companies struggle to comply with it.

These struggles include capturing and assigning all costs to projects/jobs, accurately evaluating suitable stages of project close and allocating profits on projects to the precise accounting period. However, it is this that may lead to inaccurate profit calculations on projects, and thus leading to poor decision making.

Cash flow conundrums

Companies may encounter cash flow issues and financial difficulties, where money is required to spend on resources before receiving payment from customers. To ensure only the most financially viable projects are accepted, it is important to maintain strong prominence of the cash-flow impact of all new tenders. So what needs to be done to avoid falling into the overtrading trap?

Cash flow modelling to decrease overtrading risks

Overtrading risks can be decreased via Cash-flow modelling. Three-way forecasting, which involves combining financial data for profit and loss, cash-flow and the company’s balance sheet, can help businesses to predict how they might perform based on a number of different scenarios. This process allows decision making and cash flow forecasting to be clearer and more precise. Other relevant data can also be fed into financial forecasts, such as if the firm is planning a recruitment drive or intends to invest in new equipment in the next few months.

What you need to consider before quoting for new work

When quoting for new work, the profit margins and cash flow effects should be considered. Both factors need to be looked at closing to avoid any cash-flow issues and overtrading. When quoting for any new job, organisations should have a clear and effective template for calculating predicted profit margins and the cash-flow impact of the project. This prototype should include a reflection of when invoices will be raised and when payments are due. Without this information in place, managers will effectively be running their business blind.

The use of long term contract accounting treatments

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This should be more widely used in the construction industry. The use of other forms of standard accounting practice is considered inadequate for measuring project profitability, where projects are large and complex. However, a lack of understanding about how to effectively monitor project profitability and cash-flow means that some businesses may be failing as a result and could be at danger of overtrading.

Some business do not use the correct accounting treatment. For example, some use a traditional accounting method and just insert a figure for ‘work in progress’ on the balance sheet. This is based on an estimation and not an accurate reflection of the business. A continuous use of this type of method could lead to the wrong decisions being made. Alongside poor cash-flow management and visibility of cash-flow on new tenders, this could place the business at serious financial risk, potentially leading to business failure and/or penalties for wrongful trading.

Becoming a credit risk can be costly

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A variety of factors could end up disrupting the business financially during the course of the project. For example, any changes to a contract can erode profit margins. These additional costs must be taken into consideration when raising invoices. If costs are going up and additional work is being done, seeking further payment from the client can be the difference between delivering profits and maintaining a healthy cash position, and making a loss.

Often, during financial difficulties, companies will take longer to pay their suppliers. However this can have a detrimental effect on supplier relations and may affect business reputation. If a business is perceived to be a credit risk, its market reputation can quickly become damaged and it could become more difficult to secure contracts or finance in the future.

How to minimise risk of overtrading

Our professional advisors can help businesses implement three-way forecasting effectively, as well as helping them identify the most profitable jobs and stress-test their cash flow cycle. If all of this is attained, accounting for projects becomes more feasible and a more successful and a sustainable future can be built. Doing all this can minimise risks of overtrading and business owners will be able to hold onto more cash for future investments.

Posted in Blog, Property & construction