Builders Must Manage Cash Flow to Stay in

Business
By Ethan Butterfield

Photo by Getty Images/Phil Jason; Illustration by

Jonathan Barkat

Have you heard the rumor about the builder who can’t pay his trades, suppliers, or make payroll
and isn’t selling any houses? What about stories in your local business journal about foreclosures
on projects and bankruptcies among builders? There’s no doubt that having some cash right
about now would help keep the wolf away from the door. But coming late to the idea that “cash
is king” won’t help much now, says Steven Friedman, national director of home building
services for Ernst & Young.

“Builders should have always managed [with a focus on] cash, whether times are good or bad,”
Friedman says, adding that builders were afforded the luxury of being sloppy with their cash
flow during good times. “It’s what drives the business. Accrual earnings are nice—it’s a way to
keep score, it keeps the banks happy—but you can’t spend accrual.”

Accrual-based accounting reports income when earned and expenses when incurred, as opposed
to cash-based accounting, which measures income when it is received and expenses when they
are paid. Cash flow, a measure of a company’s financial well-being, is generally thought of as
the cash generated after expenses and repayment of principal financing.
The problem is that builders rarely have a lot of cash, says consulting guru Chuck Shinn,
president of Shinn Consulting in Littleton, Colo. “And right now, they are losing their cash pretty
fast,” he adds.

Recent builder seminars have left Shinn with a clear idea of where builders are: “The walking
dead—way too much debt, and no liquidity.”

With home sales down in most major areas, and credit tight everywhere—putting a dent in sales
even where demand is decent—businesses are hurting for revenue. And bills are mounting, says
Steve Demar, a principal at accounting firm Kaufman, Rossin & Co. in Miami. Builders still
have employee compensation to pay, as well as costs for insurance, workers’ compensation,
employee benefits, and interest on land and construction costs, as well as property taxes.

“Those all ultimately have to be paid,” Demar says.

LET'S TALK

From talking with a number of home building consultants and accountants, the most pressing
concern right now is that builders sit down and talk with their banks and creditors immediately to
air out all issues and lay out their business plan.

“The larger banks are all focused on credit management right now, and the regionals and smaller
banks aren’t far behind,” Friedman says. “If a builder hasn’t had a discussion with [his] lenders,
now’s a good time to go have it. This is one of those cases where honesty, integrity, and
proactivity are a plus.”

For builders, it’s always beneficial to meet the banks on your terms, not theirs. The benefits
might well include renegotiated terms on land, reduced interest on loans, renegotiated takedown
schedules, and extensions of land-loan terms to lengthen your time line, Shinn says. But if you
come to your creditors with a troubled business and loan payments past due, they won’t be as
forgiving and you could lose developments.
 Photo by Getty Images/Phil Jason; Illustration by
Jonathan Barkat

Despite bad housing market conditions, there’s still a chance for builders to work out a solution
with their banks that will keep them in business and the banks paid, says Shinn, who thought
banks would start pressuring builders about their operations and financial positions last June.
While many builders are in trouble, Shinn hasn’t seen creditors applying widespread pressure
yet. He thinks they’re looking to avoid setting off a panic because so many builders might be in
difficult financial straits. Of course, public builders, with their earnings statements and balance
sheets available on the Internet, can’t easily hide their business woes. But, to their advantage, if
they’re in trouble, they can get financing on Wall Street. Nobody except their consultants knows
what position many of the privately held builders are in, however. And after talking with many
home building consultants in the past month, it’s clear a lot of private builders are in serious
difficulty financially and could end up giving everything to their creditors. If they have personal
guarantees tied to their loans, even their own homes are fair game. It’s clear that builders need to
get away from recourse debt (which holds them personally liable if their companies default on
loans)—as soon as possible.

So hurry to the bank, bring your business plan for weathering the storm, and be sure to tell the
bankers how they can help your building company make it out the other side. “The banks are
going to be much more open to doing that now,” Shinn says, “[as opposed to] all of a sudden,
‘I’m in arrears on my payments, and I’m at the end of my loan; I’ve run out of interest carry.’ If
I’m in that kind of situation, I’m in trouble in being able to negotiate with the bank.”

KNOW YOUR CASH SOURCE

Something a builder could show a bank, but, more importantly, something that would help daily
and long-term operations, is a cash-flow forecast, says Steve Maltzman, president and founder of
SMA Consulting in Redlands, Calif. Demar calls it a critical path approach.
Maltzman and Demar encourage builders to view their operations on a job-by-job basis, not only
for how much profit might be left in a particular house or lot, but for how much cash might be
left after other considerations.

“Where is your cash coming from?” Maltzman asks. “It is either coming from draws from your
customer, less what you have to pay out, [or] sometimes, if you’re ahead of the customer or your
construction loans, you can take from another job, but it will catch up to you, so you have to be
careful.”

Knowing when the cash will come in, when it needs to be paid out, in roughly what amounts, in
order to avoid penalties and ultimately default, is a crucial piece of the accounting process and
should be a by-product of the company’s overall operating budget, say Demar and Maltzman.

A builder must develop a process for obtaining company financial information in a timely way to
help guide decisions, Demar says. Our experts are split on the use of technology for this process.
Some say adding new technology applications is a good idea if the cash is available; others say
builders’ attention should be elsewhere right now.

“If you are looking at what your accounting department is providing you six months after the
fact, it may be too late to make good decisions, and it may cost you an enormous amount of
money or even, ultimately, your business,” Demar says.

BOOSTING EFFICIENCIES

One piece of advice nearly all consultants offer is not unlike talking and working with banks:
Builders must confer with their vendors and subcontractors. Talk to them, find out where they
see inefficiencies, and then make changes that will take costs out of your building and business
processes.

“[Subs] are working my inefficiencies all day long,” says Shinn, assuming the builder’s
perspective. “I’ve got to reduce my construction schedules. I’ve got to get more efficient in what
I do, and what I need to do is bring the trades in and work with them to become more efficient.”

Builders—and virtually every one of them needs cash right now—have to sell house and lot
inventory, Shinn says. He suggests discounting all old product, but not new product, which needs
to be re-engineered for value. He also sees builders who need to give in to market prices for land,
and sell. “[Acquiring] cash and getting out of debt are the two things you’ve got to do,” he says.

Builders also should constantly evaluate their production. Starts will fall further still, and
builders generally shouldn’t be starting projects where there is already plenty of inventory.

Toll Brothers, based in Horsham, Pa., is a public luxury home builder that has managed to ride
the relatively strong high-end market. Through the first three quarters of 2007, Toll reduced its
debt-to-capital ratio to 28.6 percent from 36.8 percent in the summer of 2006. Toll has also cut
its owned and optioned lots by nearly one-third and has reduced its production, mothballing
several communities, says CFO Joel Rassman.
“We have either canceled or delayed 35 communities that would have been open that are not,”
Rassman says. “That’s a result of the market conditions. There are places where I already own
the ground that it makes more sense for me not to open the community. In this market, it’s just
too costly. You just can’t sell enough homes to justify [a presence], so it’s better for me to wait
six months.”

AN AWAKENING

Photo by Getty Images/Phil Jason; Illustration by

Jonathan Barkat

Toll can afford to hold land and developments and not build them in part due to the debt it holds,
more than $1.17 billion available, maturing between 2011 and 2015, Rassman says. The
company has also pulled back on buying land to replace the homes it sells, a move that’s
generating even more cash. Most builders don’t have Toll’s financial backing. But if they can
negotiate with their banks for longer terms on their land loans and for longer takedown schedules
with developers; they could also get longer payable cycles with their subcontractors, says Ernst
& Young’s Friedman.

“When things slow down, subcontractors lose some of their leverage, because you now have a
pool of subcontractors fighting for the same contracts, whereas before you had a shortage of
labor,” Friedman says. “Maybe subcontractors are willing to take a longer receipt cycle.”

Small builders are being asked to think in more complex ways than ever before, mapping and
planning out each part of their company, each step of the building and billing processes. For
many builders, it’s an awakening of sorts, Friedman says.

“This is really a question of sophistication,” says Friedman. “The smaller builders are getting
more sophisticated, because they’re having a ‘holy crap’ moment [now]. They’re becoming more
aware of [cash management].”
Another strategy builders might consider comes from the Lee Evans building management
doctrine, says Emma Shinn, an accountant with Shinn Consulting. Builders should think about
having a rainy-day fund, she says. Only about 5 percent of builders have some type of
emergency fund, Shinn says. Such funds should consist of at least six months of operating
expenses and be held in an investment that can be easily converted to cash.

“When hard times roll, cash disappears very quickly,” says Shinn. “This cycle is probably going
to be three to four years long. You probably don’t need to have extra cash for full operating
expenses, because you’re still generating some cash, but it can help pull you through that period
of time; and you can be in a much better position as you come out of the downturn.”

The bottom line? Builders need to hit the pavement and generate cash, because it’s going to be a
long winter, and maintaining operations and keeping the heat turned on is going to be expensive.