Dealing with Surplus Cash in your Construction Business
How to deal with surplus cash in your construction business? This is one of the more frequent questions Orlando-based accountant Sherly Ramirez gets from the small construction contractors she serves these days.
With banks paying less than 3.0 percent on 24-month certificates of deposit and around 2.25 percent on savings accounts, it’s easy to see why it’s such a common question. If only there were a common answer.
Before dispensing advice on how to deal with surplus cash in your construction business, Ramirez likes to ask a few questions of her own. One of her first is “How much have you set aside in your savings account?”
The 70/30 rule
When it comes to managing finances, Ramirez advises contractors to follow the 70/30 rule, which suggests keeping expenses to 70 percent of their income so they can pour the remaining 30 percent into three buckets: savings, investments and donations.
For purposes of illustration, let’s consider a sole proprietor who earns $80,000 annually after taxes as a carpenter and spends $56,000 on personal expenses — including housing, feeding, educating and entertaining his family. Let’s assume he has maxed out on his IRA contributions and set aside the first third of his surplus income for donations to his favorite nonprofit organizations. That would leave our prosperous carpenter roughly $16,000to split between his savings and investment buckets.
Savings vs. investments
What’s the difference between savings and investments, you ask? Well, from a financial planner’s perspective, savings refers to cash that can be accessed immediately without penalty or restriction in case of an emergency. The primary purpose of investments, on the other hand, is to increase wealth, income or both.
Ramirez advises clients to postpone pouring money into the investment bucket until they’ve built up enough savings to pay three to six months of expenses. For our carpenter, that would require keeping between $14,000 and $28,000 in savings.
Let’s assume our carpenter has already built up a balance of $12,000 in his savings account and does not anticipate any new income or expenses in the coming year. The prudent thing to do might be to sketch out three scenarios.
In a conservative scenario, he might place all his surplus cash in savings to ensure he has the full six months of living expenses set aside. In the least conservative scenario, he might deposit just $2,000 in savings and invest the rest. Or he could take a middle road by pouring half his surplus income into the savings bucket and half into the investment bucket.
Investment categories
Once he has set and met his savings goal, the carpenter can begin evaluating what investments fit his needs and preferences. As someone who prepares a lot of tax returns, Ramirez finds it useful to categorize these investments according to how the IRS taxes different types of income. They are:
Capital gains: This is income earned from buying and selling and can include profits and losses earned from flipping houses and apartments or trading used cars.
Interest income: This is income earned by investing in debt, which can include publicly traded bonds, loans to relatives and customers and even loans made to strangers through crowdfunding sites or peer-to-peer lending sites.
Residual income: This is income earned from prior works. It can include royalty payments from patents, books or other intellectual property or commission fees earned every time a life insurance policy sold decades earlier is renewed for another year.
Passive income: This is income earned when one merely owns something rather than from work performed. Examples can include income from a stock portfolio, rental income or income from limited partnerships and other pass-through entities.
Before deciding which of these income types best suits their needs when dealing with surplus cash in your construction business, Ramirez urges her clients to answer the following questions:
What is my time horizon? What’s the earliest you might need the money back? If all your personal and work vehicles are in good working order, you have at least three months of expenses socked away in savings and you don’t anticipate having to pay off any college tuition bills or divorce settlements, you might be able to go out a few years. If you think you can go out two years and are a building contractor, you might want to consider flipping a house.
What is my opportunity cost? What are you sacrificing by not spending the money elsewhere? If every dollar you invest in marketing your business returns $3.00 in sales and $1.50 in profit, that’s a 50 percent return. Can you really beat that rate of return? Or perhaps you are feeling trapped by your business and would be better off taking your spouse on a much-needed and oft-postponed vacation.
What is my risk tolerance? What kind of return are you looking for and how much of your money are you willing to lose if an investment goes sour?
“You will always have to take risks,” notes Ramirez. “So it’s critical to investigate and assess the risks before dealing with surplus cash in your construction business. Visualize a positive scenario and one that is not so positive so that your decision is as realistic as possible.”
