The construction industry is cyclical; sometimes business is good, sometimes it’s awful. Cycles run about five to seven years and I’ve been through eight cycles since I started in construction. The bottom of the last cycle was in December 2008 and January 2009.
How well you manage your money when business is good impacts how easily you’ll survive when business is tough. You need to build a cushion to land on when the economy heads south.
Most of the contractors I’ve talked with use a line of credit when they need cash. A line of credit is a loan that you can draw from as needed. It’s handy when you need the cash, but not so handy when it’s time to pay it back, especially if you still need cash when the payments are due. It also costs you money in interest. The interest charges are what make the line of credit an expensive way of doing business.
The problem with this approach is that it’s backwards. When cash is low, you borrow from the line of credit. Then you pay off the line of credit when business gets better, or when the bill is due, whichever comes first. This is a short-sighted and expensive approach to running your business. It’s also risky; what if they cut off your line of credit? What if you can’t pay it back?
There is another way you can maintain cash flow when times get tough that isn’t expensive or risky, but it requires sacrifice when times are good.
I call it an OCRA, an Operating Capital Reserve Account, and it’s free money for your business to use when times get tough. You can’t be denied the money when you need it, and you don’t have to pay it back.
You create your own OCRA. How do you get the money in the account? Start by taking 1% right off the top of every check you receive. If you can handle setting aside 1%, try to raise it to 1.5%, then 2%, all the way up to 4% of every check. You’re slowly building your own line of credit to tide you over when times get tough.
Set a goal for your OCRA by looking at your average monthly expense needs. How much money will you need in an average month to survive if you don’t make any sales?
If you’re a specialty contractor, you’ll want enough for at least five months because that’s the normal job cycle for a specialty contractor. For remodeling, you’ll want at least seven months. If your job cycles are longer or shorter, adjust accordingly. Your job cycle is the average time it takes from the day you advertise until the day you deposit the last check on a job generated by that advertising. We talk about job cycles and how to calculate yours in Markup & Profit Revisited.
With an OCRA, if your business runs into an emergency, you have funds in reserve and can tap those funds to handle the emergency. It doesn’t cost you a penny; it’s free money that you’re borrowing from yourself.
It requires discipline. You’ll be tempted to spend the money on equipment you don’t really need, or a vacation that will be forgotten. You’ll probably have to pay taxes on the funds the year they’re first set aside; that’s part of the cost of doing business. Once taxes are paid, it’s all yours.
During the last downturn, our coaching clients who had an OCRA sailed through. They were able to keep their bills paid and stay in business. If you have an OCRA now, good on you. If you don’t have an OCRA, today is a great day to get started.
Your choice: you can pay interest on a line of credit, or you can earn interest on an OCRA. When you get in the habit of setting aside these funds, you won’t even miss it. Get started while the going is good.