Accessing Construction Working Capital As A Growing Business
Originally published on July 19, 2024
Updated on December 12th, 2024
For construction companies, working capital is the lifeblood that keeps operations flowing smoothly.
The term working capital refers to the funds a business has available to meet its short-term financial obligations and operational needs. While it applies to all industries, working capital is especially important for construction businesses. Without it, firms can struggle to pay employees, purchase materials or cover other essential costs required to complete projects successfully.
Here’s an example. Consider a construction company that lands a lucrative $15 million contract to build a new office complex. While the project promises substantial revenue, the company must front many costs for labor, materials, equipment rentals and other expenses. These up-front costs could easily reach several million dollars, and the construction company will be expected to front the majority of them.
If the company lacks sufficient working capital, or the ability to raise it, it may struggle to finance these initial expenses. This could lead to delays and strained relationships with suppliers and subcontractors.
Managing working capital effectively allows construction companies to continue winning and completing contracts. Today, we’re going to explore a series of best practices for accessing and managing construction working capital.
What Is Working Capital and How Do I Calculate It?
Working capital is more than just the cash that your business has on hand. Technically, it encompasses all your current assets, including cash, prepaid assets, inventory and accounts receivable — anything expected to be collected within twelve months. As such, it may not always reflect the money you can use to pay a bill right now.
That’s why a sophisticated understanding of your working capital is essential for planning and risk mitigation.
The formula to calculate working capital is simple:
Working Capital = (Current Assets – Current Liabilities)
But this formula doesn’t account for risk or obstacles you may face in accessing that capital. For example, a construction firm might have $500,000 in accounts receivable. But if $100,000 is in dispute due to issues with a client, it’s likely that capital won’t be readily available should the business need it.
Similarly, some assets might be difficult to liquidate. If inventory includes specialized materials unique to one project, like custom-fabricated steel beams, they might have limited value outside of that project. Items such as prepaid insurance premiums or rental deposits might be assets, but they cannot be converted to cash. Make sure to incorporate those facts into any working capital calculations too.
When assessing your company’s working capital, carefully evaluate your current assets to avoid overstating your working capital position. This might involve regular reviews of:
- Accounts receivable aging
- Inventory turnover
- The nature of prepaid expenses
Options for Accessing Construction Working Capital
Even with meticulous construction accounting practices, construction companies may need additional working capital to fund growth, take on larger projects or weather temporary cash flow challenges.
Several options are available, depending on the company’s specific circumstances, growth plans and risk tolerance. Firms with a robust set of financial statements may have more favorable options, underscoring the importance of maintaining accurate records and embracing construction accounting best practices.
Lines of Credit
Companies with strong financial statements may qualify for revolving credit facilities from banks, typically at competitive interest rates.
For example, a well-established construction firm might secure a multi-million dollar line of credit at prime plus 1%, providing flexible access to funds as needed.
Internal Funding
Well-established firms may fund working capital through equity contributions from owners. This approach avoids interest costs but may limit investments in other areas.
Debt Financing
Construction businesses may secure loans or other debt financing options to fund projects depending on project size and creditworthiness. To avoid problems later, when considering debt financing, carefully evaluate the terms and your ability to satisfy them while maintaining sufficient liquidity.
Let’s say a growing construction company takes out a $1 million term loan to finance equipment purchases and increase its working capital buffer. However, if the company fails to review the loan terms and plan accordingly—for example, by negotiating favorable payment terms—it may set itself up for financial troubles later.
Equity Investments
Companies can raise working capital by issuing new equity shares or attracting new investors. This option dilutes existing ownership but provides funds without incurring debt. For instance, a growing construction firm seeking rapid expansion might sell a 20% stake to raise $3 million in fresh capital.
Accounts Receivable Factoring
Companies can sell outstanding accounts receivable to a factoring company in exchange for immediate cash. While convenient, this can be expensive and might strain customer relationships by compromising customer service, reducing or eliminating direct interaction with customers, and potentially subjecting them to aggressive collection tactics.
For example, a company facing a short-term cash crunch might factor $200,000 in receivables, receiving $180,000 in immediate cash while paying a 10% fee. However, in addition to giving up $20,000, their customer relationships would be subject to the factoring company’s customer service and collection methods. In this scenario, the company would need to carefully consider whether the immediate cash infusion is worth the risk.
Analyzing Working Capital Ratio
At James Moore, our working capital ratio analysis mode incorporates a variety of unique ratio calculations that analyze your capital from different angles. This provides a more holistic understanding of your company’s overall financial health.
Our analysis includes:
Metric | Function | Calculation |
Current Ratio
|
Shows a company’s ability to meet short-term obligations with current assets. A ratio of 2.0 or higher is generally considered healthy for construction firms.
|
Current Assets / Current Liabilities
|
Working Capital Ratio
|
Measures the liquidity cushion available to a company. A ratio above 1.0 indicates positive working capital.
|
Current Assets – Current Liabilities
|
Accounts Receivable Turnover
|
Assesses how effectively a company collects receivables. A higher ratio indicates more efficient collection practices.
|
Net Credit Sales / Average Accounts Receivable
|
Gross Profit Margin
|
Indicates financial health and pricing strategy effectiveness. A declining margin could signal rising costs or pricing pressures.
|
(Revenue – Cost of Goods Sold) / Revenue
|
Debt-to-Equity Ratio
|
Measures financial leverage and ability to meet debt obligations. A ratio of 2.0 or lower is often considered acceptable in the construction industry.
|
Total Liabilities / Total Equity
|
Return on Net Assets
|
Evaluates how efficiently a company utilizes assets to generate profits. A higher ratio indicates better asset utilization.
|
Net Income / Total Assets
|
In addition to the above, we also measure Accounts Receivable Aging. While this isn’t a ratio, it depicts the age of outstanding invoices to identify potential collection problems or customer-specific issues. For example, if 20% of receivables are over 90 days old and your company’s policy is to bill customers on Net 45 payment terms, it’s likely you have collection problems.
Each metric is benchmarked against industry standards and analyzed in the context of each client’s specific circumstances. For instance, a company with a current ratio of 1.5 might be considered healthy if it has a strong cash position and efficient collections. Meanwhile, another firm with the same ratio but slower-paying customers might be at greater risk.
By reviewing your working capital ratio every month, you can identify potential issues promptly and take corrective action. This might involve negotiating better payment terms with suppliers, improving invoicing processes to speed up collections, or restructuring debt to improve liquidity.
Effective working capital management is essential for construction companies to maintain financial stability, fund growth initiatives, and navigate industry challenges. By closely monitoring working capital levels, calculating key ratios and implementing strategies to access additional funds when needed, construction firms can ensure they have the resources to operate efficiently, meet financial obligations and capitalize on new opportunities.
James Moore: Dedicated Construction CPAs and Advisors
Effective working capital management is crucial for construction companies’ financial stability and growth. Prioritizing this aspect of financial management allows you to enhance operational efficiency, creditworthiness, and stakeholder relationships—ultimately positioning your company for sustainable success in the competitive construction industry.
At James Moore, our expert construction CPAs provide valuable insights and guidance to help construction firms like yours assess working capital and optimize financial strategies.
To review and refine your working capital management, contact an advisor today.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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