Financing Construction

Cash Flows and Cash Farming

Russell Kenley

• Publisher: Routledge
• Year: 2003
• Print ISBN: 9781138414280
• eBook ISBN: 9781134573479
• Edition: 1
• Topic: Technology & Engineering
• Subtopic: Construction & Architectural Engineering
• Index: Technology & Engineering

Cash is king, not least in the construction industry. Recent government-commissioned reports have highlighted the importance of better financial management in the construction industry.

This professional text provides a considered analysis of the tools and techniques of project financial management in construction; notably it covers cash flow modelling and provides the first detailed investigation of the contentious issue of cash farming. Through use of case studies, worked examples and questions this book will appeal to practitioners and students alike.

1

Introduction

The construction industry is generally held to be fragmented, made up of a large number of relatively small firms which join together in temporary pseudo-organisations to undertake specific projects. At the crux of this organisation lies the head or management contractor, whose role, increasingly, is that of management rather than execution. This entity sits at a power locus, with all decisions and cash flow passing through their control. This is an enormously powerful position which carries a corresponding responsibility. The financial management of those firms in this position is what has created the industry as we knowit today. This is an industry characterised by brilliantly successful financial management strategies which create wonderful projects, profitably, and generate wealth through competitive infrastructure. It is also an industry which, through woeful financial management strategies, has created loss, heartache, failed projects and cascading insolvency which has gone far beyond the direct influence of one contractor’s projects.

This work aims to increase understanding of financial management issues, to help clients, contractors, subcontractors and suppliers to understand the system and to help prevent or minimise the consequences of contractor insolvency. The goal is to achieve greater understanding and support for those who manage the system well, as this will lead ultimately to a more competitive industry.

To achieve this aim, the book explores the theory behind cash flow management in construction, by introducing and comparing the various models developed by the research community to help to understand and simulate (or forecast) construction project cash flow. These models are set within a theoretical framework to assist in understanding the fundamental nature of cash flow management in construction.

Further, the issues of organisations and their strategic management are critical to understanding cash flow in practice. A lot of existing cash flow theory is based on assumptions about construction firms which simply do not hold up to practical examination. They ignore the actual behaviour of operators within the industry. So it is another aim to explore and highlight the way people behave when managing cash flow.

In part this is driven by a desire to help prevent businesses becoming insolvent due to poor organisational cash flow management. In part it is to achieve fair allocation of blame following such failures. But it is also about highlighting the opportunities which arise from strategic and careful management of cash flow.

While some of the views contained herein will be considered extreme by some, the most spectacular successes in our industry have come from mastering cash flow. Something which is so important to the industry needs to be debated and understood.

In summary, the aims are to:

• Understand the theory and the practical tools of cash flow.
• Improve the performance of industry through reduced insolvency.
• Improve the industry through improved competitive performance.

THE AIMS

Understanding the theory and the practical tools of cash flow

Cash flow has been analysed in components, but in reality they form a complete entity which should be understood holistically. It is partly through considering the components in isolation that the underlying mechanisms and behaviours become ignored. Cash flow, in construction, consists of the following layers:

• Gross cash flow—consisting of inward cash flow and outward cash flow. Founded on the relationship between time and cost, gross cash flow is closely allied with models for the time–cost relationship. Performance indicators are built on the relationship between time and cost performance, such as revising the forecast end-date and measuring the progressive value earned.
• Net cash flow—consisting of the balance between inward and outward cash flow. Founded on the interference between the component cash flow curves, and therefore not linked to the time and cost relationship. Performance measures are related to the time value of money.
• Organisational cash flow—consisting of the overlaying of the organisation’s individual project net cash flows. Founded on a portfolio approach, the performance measures are the contribution to working capital and the minimum contribution. Secondary measures are the interest cost or income.
• Strategic management of cash flow—consisting of the policy and strategic framework for managing the cash flow for the entire organisation, including non-construction projects or investments. Performance measurement is the sustainable growth or well-being of the business.

Gross cash flow and net cash flow deal with cash flow on projects. Organisational cash flow and strategic management of cash flow deal with cash flow at the level of the organisation.

Improving the industry through reduced insolvency

Reducing contractor insolvency has immediate and easily understood benefits to the industry and to society. The knock-on effects through the supply chain mean that contractor failure affects many more than those immediately responsible. Most importantly, this also reduces the risk for clients of the industry.

Building economics, as a research discipline, has always had a steady trickle of papers resulting from the international research effort, but has never been particularly significant and rarely, for example, exceeding 10% of papers in the Journal Construction Management and Economics. It seems likely that such research is considered tangential to the real problems of production efficiency and service responsiveness.

Nowhere is the industry so well run that no financial failures occur; and the flow-on effects from such collapses resonate through the community. In 2001 in New Zealand, the industry iwas reeling from the effects of a series of major construction insolvencies, including the country’s fourth largest builder. This has highlighted the damage that can be done through one company’s mismanagement. Similar problems occurred in the early 1990s in Australia.

The gradual introduction of ‘security of payment’ legislation targeted specifically at the construction industry, originating from the UK, suggests that the industry has not solved its financial problems, with the result that the solution is being externally applied (through regulation). These solutions are in some ways bandage solutions, treating the symptoms but not the causes. It is only through improved research, education and debate that prevention may be achieved.

Improving the industry through improved competitive performance

In the UK, Sir John Egan produced the ‘Egan report’ Rethinking Construction (Egan et al., 1988). This document ignited interest in rethinking the process of construction, based as it was on the premise that the industry as a whole is underachieving.

It has low profitability and invests too little in capital, research and development and training. Too many of the industry’s clients are dissatisfied with its overall performance (Egan et al., 1988).

This has led to the development of intense research activity, primarily aimed at encouraging innovation in the industry. This focus, however desirable, has drawn attention away from research into the underlying functioning of the industry, and in particular its financial mechanisms and performance. However, an exploration of the economic contribution of the sector is important and, as we shall see in Chapter 8, essential to understanding the potential value of resources trapped and exploited within the industry.

Improved and strategic cash flow will improve the profitability of the industry. This is a good thing, as it has the potential to offer reduced costs for the client as well as providing better managed and better performing contractors. Strategic management of cash flow will be increasingly important for a firm to remain competitive in the market.

STRUCTURE OF BELIEF ABOUT CASH FLOWS

Denzin and Lincoln (1994) provide a basis for structuring thinking. While referring to the nature of paradigms, they outline a hierarchy in which paradigms¹, as basic belief systems, are based on Ontological, Epistemological, and Methodological questions:

A paradigm may be viewed as a set of basic beliefs (or metaphysics) that deals with ultimates or first principles. It represents a world view that defines, for its holder, the nature of the ‘world’, the individual’s place in it, and the range of possible relationships to that world and its parts, as, for example, cosmologies and theologies do. The beliefs are basic in the sense that they must be accepted simply on faith (however well argued); there is no way to establish their ultimate truthfulness.

The following order, quoted from Denzin and Lincoln (1994), reflects a logical (if not necessary) primacy:

1. The ontological question. What is the form and nature of reality and, therefore, what is there that can be known about it? For example, if a ‘real’ world is assumed, then what can be known about it is ‘how things really are’ and ‘how things really work’. Then only those questions that relate to matters of ‘real’ existence and ‘real’ action are admissible; other questions, such as those concerning matters of aesthetic or moral significance, fall outside the realm of legitimate scientific inquiry.

2. The epistemological question. What is the nature of the relationship between the knower or would-be knower and what can be known? The answer that can be given to this question is constrained by the answer already given to the ontological question; that is, not just any relationship can now be postulated. So if, for example, a ‘real’ reality is assumed, then the posture of the knower must be one of objective detachment or value freedom in order to be able to discover ‘how things really are’ and ‘how things really work’. (Conversely, assumption of an objectivist posture implies the existence of a ‘real’ world to be objective about.)

3. The methodological question. How can the inquirer (would-be knower) go about finding out whatever he or she believes can be known? Again, the answer that can be given to this question is constrained by answers already given to the first two questions; that is, not just any methodology is appropriate. For example, a ‘real’ reality pursued by an ‘objective’ inquirer mandates control of possible confounding factors, whether the methods are qualitative (say, observational) or quantitative (say, analysis of covariance). (Conversely, selection of a manipulative methodology—the experiment, say—implies the ability to be objective and a real world to be objective about.) The methodological question cannot be reduced to a question of methods; methods must be fitted to a predetermined methodology.

These are useful, but by no means universal, categorisations of knowledge systems. They are extremely valuable in understanding the nature of cash flow research. Understanding the epistemology and the methodology of research, and ultimately the actual methods used within that context, enables the exploration of models to be undertaken.

Ontology

Much of the research into construction project cash flows assumes that they are something which may be modelled. It is assumed that they are real and have properties. This is a challengeable assumption, and it could equally be argued that cash flows are merely a collection of discrete events. However, in this work, cash flows are accepted as having reality as a collected entity made up of connected parts which exist through the existence of the project. Furthermore, it is assumed that they are additive and interrelated at the project level and also at the organisational level.

Epistemology

Epistemology is the philosophical theory of knowledge, of how we know what we know. It seeks to define knowledge, to distinguish its principal varieties, identify its sources, and establish its limits. The various sorts of knowledge seem to be reducible either to knowing-how (for example knowing how to speak Italian) or to knowing- that (for example knowing that Italy exists). Of these, knowledge-that is the prime concern of epistemologists, who differentiate between empirical and a priori knowledge. A priori knowledge is derived from its self evident axiomatic bases by deduction; empirical knowledge is derived from uninferred observation statements by induction. The usual sources of empirical knowledge are sense perception, while a priori knowledge is said to come from reason.

Accordingly, epistemology is generally characterized by a division between two competing schools of thought:

1. Rationalism (apriorism—or before experience, by deduction); and
2. Empiricism (from experience, by induction).

Rationalists insist that knowledge requires a direct insight or a demonstration, for which our faculty of reason is indispensable. The empiricists hold that all our knowledge must ultimately be derived, as it is in the sciences, from our sense experience.

So far the definition deals with how knowing-that is achieved, whether by deduction or induction. Epistemology is also concerned with the question of what it is for someone to know that something is so. The traditional assumption was that a person knows that P, if and only if (1) he believes that P, (2) P is true, and (3) he has good grounds for the belief. An alternative view is that knowledge is simply the ability, based on some non-accidental means, to provide the right answers.

Warnke (1987) casts further light on epistemology with an essay on Rorty’s views:

Rorty characterizes ‘epistemologically-centered philosophy’ as the search for a neutral foundation upon which to justify our beliefs and adjudicate between existing theories or interpretations. Since the seventeenth century this form of philosophy has defined knowledge as the correct depiction of reality, a mirror of the way things ‘really’ are with regard to the physical universe, the social world or the constituents of moral action. Accordingly the epistemological project has been that of showing the possibility of such accurate representation. The question it asks has been how the ideas and images within the human mind can be shown to correspond to an external world.

Epistemology is a term rarely but loosely used in the construction project cash flow literature. The bulk of cash flow research is empirical, being based on analysis of observed data. However, there is an increasing tendency to move beyond such analysis, to deduction, with the development of models for projects which do not arise directly from observation. Epistemology is not limited to rationalism and empiricism. Goldman introduces the division between the individual and grouped (social):

Epistemology as I conceive it, divides into two parts: individual epistemology and social epistemology. Individual epistemology—at least primary individual epistemology—needs help from the cognitive sciences. Cognitive science tries to delineate the architecture of the human mind-brain, and an understanding of this architecture is essential for primary epistemology. Social epistemology needs help from various of the social sciences and humanities, which jointly provide models, facts, and insights into social systems of science, learning, and culture (Goldman, 1986: 1).

This second division of belief, borrowed here from the study of the human mind, introduces ‘what is valid’ in the understanding of cash flow models, which can be classified by methodologies following two epistemological categories:

• Empirical or rational;
• Idiographic or nomothetic.

These are neither mutually exclusive nor corresponding. Particularly, empirical studies may be idiographic or nomothetic, as may studies constructed on deduction. In this book, idiographic and nomothetic will be most often described as methodologies.

Methodology

Within construction cash flow research, the methodology is dictated by the epistemology. The basic forms taken are for empirical, post hoc, studies the (idiographic) analysis of individual project data, and the (nomothetic) analysis of grouped project data.

When forecasting or modelling future projects, another useful division emerges. This once again follows the idiographic–nomothetic division, and divides the research into:

• Deterministic: those methods which allow a deterministic model (usually from an average of past projects) to be held as a fixed model for future projects, from which forecast cash flows can be calculated.
• Stochastic: those methods which allow for the probability of variation in the forecast (sometimes for convenience from an average of past projects) by calculating future cash flows as an assembly of a trend and probabilistic variation about that trend.

Method

There are many methods used in cash flow research, whether empirical or rational, idiographic or nomothetic. They may however be broadly grouped, for convenience, into schedule-based or cost-profile methods. The former use the construction sequence, costed, to generate an originating cash flow profile. The latter utilises knowledge about the inherent properties of cash flow profiles to generate cash flow profiles for projects. These methods rely, to some extent, on the use of models to generate a representation of reality. Whether this be for schedule-based methods, which rely on the construction schedule as a model of the real project, or the cost-profile based methods, which rely on a model of the cash flow profile.

Modelling

A model is constructed to facilitate understanding and enhance prediction, and is an abstract description of the real world (Rubenstein, 1975). ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Preface
• Acknowledgements
• Permissions
• Glossary
• 1
• 2
• 3
• 4
• 5
• 6
• 7
• 8