Hello - I have a F&A for those more business savvy than I am.
I currently work as a project manager for a company that supplies large mechanical systems to external customers. Each one of these systems is a project of its own, and consist of many items procured from external vendors.
I’ve encountered a situation where my project’s cash flow is very favorable (positive). Progress milestones have been hit, allowing the customer to be invoiced. Likewise, the contracts with external vendors have favorable payment terms (back loaded). Therefore, I’ve collected payment from my customer without expending much to my vendors.
Correspondingly, since I have not paid much money to the vendors, my percentage of completion (POC) is low, and my recognized revenue is low.
I’ve recently been asked by F&A to accelerate receiving invoices from the vendors. More vendor invoices = higher POC = higher recognized revenue. This comes at the expense of cash flow, which can decrease and potentially be negative.
My question is: What is the motivation behind this maneuver? It seems to me that a higher recognized revenue is intangible. The only Pro (that I can think of) is that we can claim that more work has been completed. However, it seems like a zero sum game; backlog is reduced since we’re “robbing” our future of potential revenue. Cash flow goes negative, and we have to “borrow” money to finance the project. Additionally, we incur more risk, since we’re paying vendors ahead of schedule.
On the other hand, positive cash flow seems like a very tangible benefit. The money can be used to finance other endeavors (poorly performing projects, CAPEX, investments) or can be kept as a contingency against future risk.
The amount of money that you have actually sent to vendors is not supposed to be relevant; what matters is what you’ve been billed for. If you never get billed for any services that people provide for the project, than the accounting for the project is done as if those services haven’t actually been performed. In theory, you should know how much you owe them and accrue for the unbilled amounts, but in reality the whole reason you get invoices is to know what and when exactly you owe, and it’s only things like payroll or other recurring charges that are going to actually be accrued for without invoices.
So basically, the suits want to be able to show more profit in more recent periods, and in order to show that profit, they need the project to be more completed than it already is, which means that more expenses had to be incurred, as that’s the general way you show that something is being worked on. They don’t want to pay them sooner, they just want to be billed for the work sooner.
Incidentally, the only reason I can think of for them not billing you immediately is that they’re on the accrual basis for taxes, and if they send you an invoice they have to declare it as income even if they’re not going to get the money for quite a long time. I’m not so sure about this, as I’m not an expert on cash vs. accrual basis considerations for various transactions in tax cases.
Your company’s performance evaluation could be focused more on EPS than cash, which is fairly common. Every time you hear company X missed/met/beat, they’re talking about earnings, which are driven by revenue minue expenses, not cash.
Or if you’re further down the employee food chain, your managers may be compensated on earnings in their divisions, which is again not the same as cash.
Thanks Glowacks! After reading the first paragraph several times, it finally sunk in; I was confusing receipt of invoices with payment of invoices. The former is what drives POC and revenue recognition. The latter typically follows, but is not 100% correlated. For example, we could request earlier invoices with longer Net payment terms. That would drive POC up while maintaining positive cash flow. However, it would reflect negatively on the vendor’s ability to collect invoices, so in the big picture, it is still a zero sum game.
Thank you FTM. Yes, being part of a public company, I can see the focus on [representing] positive short term results motivating some of these moves.
Taking this a bit further, is there any other rationale for these moves, other than to appease share holders? In other words, would a private company have any reason to do what I’ve described?
Compensation such as bonuses might be tied to performance in a way making this desirable for those getting the bonus, which, of course, makes it worse (first-order) for the company’s shareholders. There might be second-order benefits like retaining an employee.
Let me say up front that I did very poorly in my Accounting classes and I have thankfully forgotten half of what I learned.
However, I think that what you have there is cash flow but not *free *cash flow. You are building up cash but you are simultaneously building up liabilities, and worse, they are not recognized liabilities. The rules are designed to get the liabilities recognized as fast as possible, so that the actual balance of the project can be realized as soon as possible.
Billing your customers quickly and paying your suppliers slowly may result in large cash reserves - but you have committed obligations and incurred debts that offset that cash reserve. The bills will eventually arrive. Having $2,000 in the bank does not mean you are well off that month if you still have to pay mortgage, car payment, and insurance.