Effective evaluation and management of working capital is a critical component of construction business management and a primary determinant of success for many contractors. In this article, we will discuss what working capital is, why it’s important for construction businesses, and ways you can evaluate and improve working capital in your own company.
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What is working capital?
Working capital is the difference between your company’s current assets and current liabilities. It is a financial measure of a company’s ability to make payments in the short term (typically one year or less). If you’ve ever wondered how you’re going to pay your bills at the end of the month, you have considered your working capital.
Your current assets are cash and other assets that can be converted to cash, typically one year or less. Examples of current assets include:
- Down payments from customers
- Raw materials
- Accounts receivable
- Marketable securities
- Any other asset that can be converted to cash within one year or less
Your current liabilities are all those bills that are due in one year or less. Current liabilities include:
- Wages due to employees and contractors for work performed but not yet paid
- Payments due to vendors and/or suppliers for materials
- Credit card debts
- Any other short-term debt obligations payable within one year or less
How to calculate working capital
Here’s the formula to calculate a contractor’s working capital:
Working Capital = Current Assets – Current Liabilities
Thus, calculating your working capital allows you to determine whether you have access to sufficient cash to pay your bills in the near term. The formula only looks at “current” assets and liabilities because these are short-term measures.
A contractor should be able to convert current assets (like accounts receivable) into cash relatively quickly in order to pay off their short-term liabilities.
Calculating working capital turnover
While working capital gives you a snapshot in time, it doesn’t tell you how effectively it’s actually working for you. Working capital turnover measures how efficiently each dollar of working capital is contributing to your company’s bottom line.
Here’s the formula to calculate a construction company’s working capital turnover:
Working capital turnover = Annual Revenue ÷ Average Working Capital
The higher the ratio, the better.
For construction businesses, working capital turnover typically falls somewhere between 3 and 7. That figure is higher for general construction businesses, while civil construction firms have the lowest working capital turnover rate.
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Why working capital matters in construction
If your construction business is an engine, working capital is the fuel that keeps the engine running. Keeping a close eye on your business’s working capital helps you evaluate the liquidity, operational efficiency, and near-term financial health of your business.
Working capital is important because a construction company may become insolvent even if it is profitable. How? By failing to keep an adequate level of current assets to pay its current liabilities.
Beyond simple survival, working capital is a key metric used by banks and surety companies when determining a contractor’s creditworthiness or bonding capacity.
Whether you are trying to grow your construction business or simply survive, working capital is essential.
Working capital vs. cash flow
Working capital is often confused with a contractor’s cash flow. But there are a few key differences. Working capital includes non-cash items, like accounts receivable and unsold inventory. While you can convert outstanding accounts to cash in theory, it is much more difficult in practice — especially in the construction industry.
The average days sales outstanding in the construction business is about 83 days. That means it takes nearly 3 months to get paid on an average account once the invoice goes out. If you have liabilities that are due within 30 days, your receivables may not be liquid enough to pay them down on time.
That said, working capital is still an important measure for construction businesses to track. Here are three scenarios that illustrate the importance of working capital and why you should pay close attention to it.
Scenario 1: Large Job
Imagine you land a large job that will earn you a 30% net margin once complete. This job is one of those kinds of jobs that doesn’t come around very often, so you want to capitalize on it.
Good news: You win the bid! However, because of the size of the job, it will take you six months before you complete the job and get paid.
That means for the next six months while you have your team working on this job, you have to float the cost of your labor — typically due every one or two weeks. You also need to cover the cost of the materials for the job, and support your general overhead expenses during the six months.
You will need to make sure you have enough cash to cover all these costs before you eventually get paid. If you don’t have other projects going on during these six months, you will need a cash infusion, or you may not be able to take on the job at all.
Scenario 2: Growing Quickly
Imagine you’ve discovered a new market segment in which you can be a first mover and capitalize on a lack of competition. The margins are healthy in this market and you want to take advantage of this.
However, to expand into this new market, your construction business needs more working capital than usual. You need to hire the staff to do the work. You also need to acquire the equipment, technology, and other assets necessary to operate in this market. If you don’t have an adequate amount of cash, you will not be able to make these investments and enter this new market.
Keeping a close eye on your business’s working capital becomes necessary not only to take on larger jobs but also to enter new markets.
Scenario 3: Poor Return on Assets
Evaluating your business’s working capital is also important in instances where you have excess cash that can be deployed for investment in the company — or elsewhere. Having a large amount of your assets tied up in cash, inventory, accounts receivable, or other current assets keeps them from being deployed in an area that can earn a larger return on investment.
Keeping an eye on your working capital becomes important not only in times when working capital levels are low, but also when working capital levels may be too high. In addition to earning a poor return on current assets, certain business structures may incur an accumulated earnings tax for not distributing this excess cash to their owners. Oftentimes, accounts receivable needs the most attention.
Lack of attention over a period of years allows certain customers to take advantage of a lenient payment policy, even when defined credit terms are in place. Tightening down your accounts receivable by making sure that customers are paying on time is one of the easiest ways to improve your working capital position.
How much working capital do contractors need?
Now that we know what working capital is and why it is important, how do you assess whether your business’s working capital is sufficient?
In a perfect world, your working capital would be as low as possible. “It is important to remember that the optimum amount of working capital theoretically would be zero!” Fred Shelton, Jr. writes in the Journal of Construction Accounting and Taxation. “If a company could structure its finances so that the liquidity risk were somehow reduced to zero, there would be no need for working capital.”
However, operating without any working capital would require a situation with near instantaneous payments and zero financial risk. In reality, construction is an incredibly risky industry that suffers from insufferably slow payments. Contractors need a healthy amount of working capital just to be able to survive.
To determine how much working capital your company needs, you will need to figure out how quickly your assets and liabilities turn over — and whether your working capital is sufficient to cover any gap between them.
Questions to ask
But you may have bigger goals than simply scraping by. When setting a goal for the amount of working capital your construction business needs, there are several questions you can ask:
- Do I anticipate a large amount of growth in the near term? If so, how much cash will I need to achieve that growth? Do I currently have enough?
- What is the risk of the industry in which my business operates? Is it considered high, moderate, or low risk? Does my business or industry typically go through times of “plenty” and times of “drought”? If so, what amount of cash do I need to weather the storms?
- Do I expect immediate and/or near-term changes to the business or industry? How much cash do I need to react to these changes?
9 ways for contractors to increase working capital
After you set a working capital goal, you need to set a plan to get there. At the end of the day, there are two ways to increase it: Grow your assets, or reduce your liabilities.
Here are several strategies for construction businesses to increase their working capital.
1. Open a line of credit
A line of credit gives you access to cash when you need it without incurring interest on amounts not drawn.
2. Use progress billing
Until you generate an invoice or payment application on a project, you are only accumulating liabilities on the job. This reduces your working capital. Progress billing throughout the stages of your projects increases your cash collections and boosts working capital.
3. Finance your material purchases
The startup and mobilization costs on new construction jobs can suck up capital quickly. Materials financing allows contractors to pay suppliers directly up front.
With generous repayment terms up to 120 days, financing material purchases frees up cash that can be used to pay down other liabilities, without incurring any debt.
Get materials now, keep your cash.
Enjoy 120-day payback terms with any material supplier.
4. Request an up-front deposit
Receiving a deposit on the front end of a project helps provide the cash needed to buy materials, pay workers, and fund other working capital needs. The earlier you can start depositing cash on a construction project, the better.
This builds your asset balance and reduces the debt burden that contractors tend to carry for the first several months on a new job.
5. Apply for the Employee Retention Credit (ERC)
For construction businesses that have experienced a 20% or more decline in quarterly revenue in 2021 as compared to 2019, the Employee Retention Credit (ERC) is one of the best ways to improve your working capital situation. The credit is up to $7,000 per employee per qualifying quarter.
6. Negotiate longer payment terms with vendors
Negotiating longer payment terms is one option to keep cash on hand longer to fund other working capital needs. But keep in mind that it can put a strain on vendor relationships. This should only be used as a method of last resort.
7. Use long-term debt strategically
Because long-term debt is not considered in the calculation, construction business loans can effectively increase a contractor’s working capital.
8. Obtain a purchase card (“P Card”)
A purchase card, typically available through a bank, is like a credit card for a business where you may pay vendor invoices on credit and receive additional time to make the cash payment on the card’s balance. These purchase cards also typically earn cash back rewards, further increasing the working capital of the business.
9. Sell excess equipment
If you have fixed assets like equipment sitting idle for long periods of time, sell them to convert them into working capital. “A sin worse than having excess resources in working capital, is having excess capacity in fixed assets,” says Fred Shelton, Jr. “If the fixed asset is never used, the return on capital is zero.”
Working capital management is critical
Working capital is the lifeblood of your business. Effectively managing your working capital is critical to avoiding the pitfalls related to cash shortages and even cash overages. Managing your working capital doesn’t have to be complex. Evaluating working capital and planning for the health of your working capital can be a simple process — and one that is essential for a construction business of any size.