We’re the mechanics lien experts. It’s fast, easy, affordable, and done right.File now
Construction companies need capital to get off the ground, stay in business, and keep growing. The term capital is used across industries to represent all of a company’s financial assets, including cash, inventory, equipment, and more.
Several different types of capital — working capital, debt capital, and equity capital — are common in the construction industry. Construction companies need a solid understanding of capital to run a successful business.
In this article, we’ll explain what construction businesses need to know about the different types of capital available — and how to use them.
What is capital?
Capital is a fundamental financial concept meaning anything that is able to generate value. Money, for example, is a basic form of capital because it can be used to invest and create more wealth. But capital can take many other forms: Human capital, for instance, is labor that can build wealth. Construction businesses may have equipment, materials, or technology that function as capital, too.
However, when most construction companies think about capital, they are almost always thinking about cash. That’s because other forms of capital — like labor or equipment — can’t generate value if you don’t have enough cash to take on new jobs, acquire materials, or cover overhead.
Joshua Leyenhorst, a CPA at BasePoint who has worked with many construction companies, defines capital like this: “Capital is all of the financial resources available to start or maintain a construction company, including working capital, debt capital, and equity capital.”
Each type of capital has a specific purpose for construction businesses as they get started or look to grow.
3 types of capital for construction
Construction companies need to know the differences between the three types of capital and why each one is useful for managing and growing a business. For most businesses, working capital will be front of mind, but debt capital and equity capital serve important purposes as well.
1. Working capital
Working capital measures the difference between a construction company’s current assets and current liabilities. In other words, working capital highlights the financial prospects of a business in the short term.
Businesses whose assets (like cash, accounts receivable, inventory, or materials) exceed the value of their liabilities (like wages, debts, vendor payments, or overhead costs) have working capital to use to maintain or grow. On the other hand, companies that have liabilities exceeding their assets lack working capital and may have trouble making payments and staying afloat.
“Working capital evaluates the financial resources a company requires to operate the company,” notes Joshua Leyenhorst. “It’s something business owners need to consider over the course of the next year of operations. Many companies are only thinking in terms of the next month — the next two payroll periods or upcoming vendor payments — but stable companies typically have sufficient cash forecasts to project their working capital further out.”
Working capital is the lifeblood of a construction business. Because payment for construction jobs may be weeks or months after work is already completed, companies must manage their finances carefully to maintain cash reserves for taking on new jobs.
Learn more: How to calculate working capital in construction
In certain situations, a company’s best option is to employ debt capital to finance certain expenditures, which helps keep working capital intact.
2. Debt capital
Debt capital is funding that a construction business acquires by borrowing, typically from banks or other lending institutions. By taking on debt, construction companies can defer payment on large purchases and use cash reserves for more immediate costs, like employee payroll or purchasing materials for a new job.
“In construction, debt capital is often used to purchase so-called ‘capital assets,’ which would include equipment, vehicles, and real estate,” says Joshua Leyenhorst. “Often, the case is pretty strong to use debt financing for long-term assets, which frees up cash for operating expenses. However, companies need to be on the lookout for lender covenants or other restrictions that may make debt capital less attractive.”
Construction companies, just like individuals, need a credit history in order to borrow money. Frequently, companies start with a business credit card or another small line of credit that they pay back consistently in order to increase their creditworthiness. That way, as the need for credit increases, a business already has a demonstrated history of paying back debt.
Debt capital can be vital for managing cash flow in construction. Debt payments spread out the cost of a large purchase over time, enabling a construction company to continue to take on new jobs and bring in revenue to tackle the debt while still maintaining enough cash to pay operating costs and grow.
“Choosing debt financing is usually the right choice if your cash reserves can bring you a greater return than the debt’s interest cost,” notes Josh Leyenhorst. “For example, if you fund a $100,000 equipment purchase with a 5 percent interest loan, and your cash reserves will bring you a 10 percent return by taking on new jobs, it makes sense to finance the equipment purchase and use your cash to grow.”
Companies that have significant materials costs in order to take on new jobs may use debt capital to finance some or all of those costs. However, rising material costs and interest rates have affected construction businesses who lean on traditional lenders to cover these initial job costs. Alternative debt capital, like materials financing, presents the opportunity for businesses to defer the costs of materials without paying high-interest charges.
Get materials now, keep your cash.
Enjoy 120-day payback terms with any material supplier.
3. Equity capital
Equity capital comes from private or public investors who typically purchase shares in the company. Publicly traded construction companies can secure a large influx of cash during an initial public offering (IPO). On the other hand, most construction companies looking for equity capital will instead turn to private investors. In exchange for a percentage of the company, private funds can provide equity capital that a construction business can use to start or grow operations.
“You can use equity for initial financing or expansion,” Josh Leyenhorst points out, “but many businesses will realize that equity capital is frequently more expensive than debt capital. That’s because shareholders typically want a much greater return than whatever current interest rates are.”
Large-scale construction companies, like those who build massive apartment buildings or commercial structures, are more likely to use equity capital to finance their projects. With rising costs for construction labor and materials, many equity firms must work with the expectation of thinner margins and smaller returns, which could make this financing option more viable for construction companies.
How much capital do you need?
Capital requirements for construction companies vary widely based on the type and scale of work they do. For example, subcontractors who have significant equipment or material costs may need greater access to debt or working capital than a general contractor who has fewer upfront costs to cover for their jobs.
However, the best way to get a handle on capital requirements is through careful financial forecasting.
“Probably one of the most under-appreciated tools out there for construction business owners is a cash flow projection,” says Joshua Leyenhorst. “Cash flow is critical. If you can’t meet your payroll, can’t pay your vendors, then you’re going to run into problems. With a projection, you can see when your cash constraints are going to hit you, and you can react accordingly: Secure a line of credit, push on your accounts receivable, negotiate payment terms with your vendors.”
Learn more: How to build a cash flow projection
By understanding your cash flow and working capital requirements, you’ll be able to make more thoughtful decisions about taking on debt capital, raising money from shareholders, or cutting costs as needed.
For businesses with long-term projects, this forecasting is even more critical. Construction companies that have high margins but low volume take on a greater amount of risk, as market conditions can change between the time a project is bid, when it breaks ground, and when it is completed. Using financial projections to consider both best-case and worst-case scenarios will help a company ensure it has enough capital to stay in business.
“If you’re thinking about long-term projects,” says Josh Leyenhorst, “you may be looking out six months or more. These types of construction companies are often calculating an internal rate of return based on interest rates, but as interest rates rise, that internal rate of return can drop, and they may need supplemental funding to carry out the project.”
Construction companies that want to continue operations, grow their business, and weather economic storms need to have a firm understanding of their capital requirements. Business owners should take frequent stock of their assets, liabilities, and cash flow to foresee upcoming problems and adjust accordingly. With a clear understanding of capital — especially working capital — construction companies are poised to succeed and grow.