Financial management in simple words is the process of accounting for the resources, primarily monetary and managing them in a way that would ensure their proper utilization.
Construction is an inherently risky endeavor that needs proper financial management even more desperately than other businesses and as research studies have found many of the failures of construction companies can be attributed to poor financial management.
Financial management for construction projects.
- What is Financial Management?
- Role of FM in construction management
- Importance of FM in Construction
- Financial Planning in construction management
Financial management in the construction industry is a bit different from financial management in other industries as the dynamic and complex nature of the sector makes it difficult for the concepts to work without some modification.
It is beyond the scope of this article to discuss the subject of Construction Financial Management in detail, we will, however; delve briefly, into some of its aspects.
What is Financial Management?
Financial management is the diligent use and distribution of financial resources to achieve organizational goals.
It includes the use of cash and management of other assets— such as machinery and equipment, etc.
Chung and Chuang (2009) categorized the practice of financial into five areas:
Capital structure management
Capital structure is the total equity and total debt of a company. It makes up the funds that are available for disposal to a company. It is important to manage the ratio of each i.e. debt and equity for maintaining the balance. Having more debt can give leverage but that is risky too, therefore, proper management of capital structure is important.
Working capital management
Working Capital is the money required to operate the business. To keep things going, you need the money and without adequate working capital, nothing works. There are a lot of expenses that need to be incurred every day beside the capital expenditure that a construction project warrants like wages of laborers (if they are daily wagers), fuel, repairs food, etc.
The importance of maintaining the right levels of working capital, especially for a construction company, cannot be exaggerated. One of the main reasons for failures in construction projects is poor working capital management.
Various studies have found a positive correlation between proper working capital management and profitability.
Working capital management in itself is a vast field but we will briefly discuss a few of the tools and techniques used in working capital management
Forecasting Cash flows is one method used in WCM. It simply means predicting the cash flows both out-flow and in-flows that are likely going to transpire in the future. There are various tools used to do that from simple estimates from historical data and past experience to highly sophisticated statistical techniques like time series analysis.
Many factors determine the working capital requirements in construction projects. Some of them include:
- Nature of the construction project.
- Size of the construction project.
- Price fluctuations
- Changes in seasons.
- Credit policy.
- Construction process and procedures employed by the construction company.
Financial reporting and analysis
Financial reporting is the practice of communicating the company’s financial information, including revenues, profits, expenses, capital, liabilities, and assets. It includes the preparation of various statements like Profit and Loss Statement, Balance sheet, etc.
Financial reporting is legally mandatory but it serves a greater purpose too.
Financial analysis, as the name suggests, is simply the analysis of various financial aspects of a business or a project. A typical construction project may involve the use of various techniques of financial analysis like
- Trend analysis
- Ratio analysis
- Cash flow analysis etc.
Financial reporting and analysis give an idea of the financial position of the company, which is important for making bidding and other decisions.
Capital is the total investment or expenditure of the project and budgeting is the process or practice of drafting budgets for capital expenditure.
In the execution of a project, a company might require to invest in some capital assets like machinery and equipment, which are often expensive and capital intensive. Therefore, budgeting i.e. allocating funds for assets that need t to be purchased up-front is important. This process is used to provide a rational ground for basing these decisions.
Capital Budgeting Methods
Some of the ubiquitously used methods include:
- Net present value analysis – It is used to find the present value of future cash flows. It is an important method that is used extensively in capital investment projects.
- Avoidance analysis – It is used to determine if the life of equipment or machinery could be extended by increasing its maintenance? This could help reduce capital investment.
- Break-even analysis – It is used to figure the time it takes to recover the investment to the point where the profits and losses are zero.
The magnitude of resources required for those capital expenditures can be huge enough to lead to bankruptcy if the investment fails. Therefore, capital budgeting should be a necessary part of the planning process for any project.
It is more important for larger capital expenditures like the purchase of land and building. Smaller investments should be streamlined so that the decisions don’t get delayed, which can cause other problems.
Accounting information system.
It is used by businesses to collect, store, and analyze financial data to aid their decision-makers in making better financial decisions.
Various studies like these have found that “accounting information system leads to good financial reports and also leading to better decision- making”.
Role of FM in construction management
Financial management plays an important role in construction project management.
It would be impossible for any construction company to survive without proper financial management and since the competition in the sector has grown rapidly and the profit margins are often slim, it plays a pivotal role.
Financial management involves decision making regarding various aspects of the business or project. There are many decisions to be taken every day and each decision can have a significant impact on the project and the company involved.
If we take an example of an important decision of bidding, it requires immense managerial foresight and needs analysis of many factors involved.
It may require an analysis of the financial resources of the company to determine whether the company should finance the project externally or use internal resources.
It may also require a thorough analysis of the human resources available to determine whether the labor is outsourced or not.
In addition, leasing or buying decisions are to be made for the construction equipment and machinery, since the construction machinery is a capital expenditure and is often very expensive. And if the purchase decision is taken the route of financing the purchase has to be figured out.
Some projects may require the company to increase its expenditure on other things not directly related to the project itself like its office expenditure. And, finally, deciding the percentage of profits to be added into the bid needs to be taken very carefully.
The decisions taken will have a significant impact on the company’s finances and the project’s success. Even one of those decisions can change the feasibility of the project. For example, if the machinery is decided to be bought, it would require the allocation of significant resources, which may leave the company with inadequate resources for other activities.
Importance of FM in Construction
The inherently complex nature of construction projects and the fiercely competitive environment makes it exceedingly important for the construction companies to employ the practices of financial management.
One of the major reasons for failure for a construction company is poor financial management. Companies fail to install proper accounting procedures and systems in place, leading to legal and compliance issues along with other issues like ignorance of their financial position, poor cash flow management, etc.
Some of the benefits that proper financial management ensues include:
- Accurate tracking of expenditures.
- Reduction in excessive and unnecessary expenditures.
- Planning for acceptable profit margins becomes easy.
- Sound financial data helps in taking better financial decisions, thus reducing the risk associated with them.
Without proper financial management, any construction project is likely to fail.
A study concluded that efficient financial management practices can lead to higher profitability.
It is therefore important to allocate resources to properly manage and plan the financials of a project. The cost of doing so outweighs the cost of failure.
Financial Planning in construction management
It is an important part of construction management. Financial planning takes significant time and has a great impact on the success of a project; hence it is important to do it properly.
It is the process of estimating the total investment required for a particular project and involves determining the efficient sources of capital that may be used for financing the project.
It involves planning for costs, working capital, capital expenditure, etc. each of which has been briefly touched upon in this article.
Financial management is no doubt a tedious activity but the rewards that one can get by applying the principles of financial management can justify the efforts involved in it.
Many Construction companies go bankrupt primarily because of their inefficient financial management. Therefore, understanding the methodology is important for success.
In a risky and uncertain environment such as construction, allocating resources for proper planning and management of finances is important.
Research studies have shown that proper financial management can be a major factor in the failure of projects.
Diligent construction financial management hence becomes a priority for any project planning activity.