Managing Working Capital
Thomas C Schleifer, Ph.D.
As we noted last week, the primary cause of construction business failure is running out of money. Why when contractors run out of money is it so often a surprise?
American industry is addicted to growth. Industry ownership (public stockholders who make money when the stock they buy at today’s price is more valuable tomorrow) values shares based on a company’s demonstrated ability to gain market share and, by implication, generate more profit in the future; in other words – grow. In the last twenty years a good example of this capitalized growth is the tech industry. Most high growth tech companies operate in the red for many years while the investing public continues to clamor for stock valued at infinite multiples of projected growth. The capital required for these companies to grow to scale is gleefully provided by outside investors.
Contractor Capital Dilemma
The construction industry does not have access to this exuberant growth capital but must slowly accumulate capital from ongoing business activity. The unique project-by-project nature of the construction industry requires external growth to sustain ongoing business. At the same time, it is the capital accumulated from ongoing business that finances external growth. Construction is, therefore, perched on the horns of a dilemma. It needs external growth to accumulate capital, but it needs capital to finance external growth. Little wonder so many small to medium sized contractors fail from a lack adequate capital. (Reminder: Construction has the second highest failure rate in the nation)
In my opinion, this construction capital dilemma should promote Capital Management to the head of the management skills class and elevate all CFOs to top management positions. In recent years, the construction industry’s average margins have been shrinking. Rampant cost inflation and missed completion dates due to supply chain snags and labor shortages dramatically narrow those slim margins and tip many ongoing projects into losses–net users of company capital. Capital management is causing a lot of sleepless nights and is fast becoming (or should be) priority-one on the minds of construction professionals.
Working Capital Definition
Here is an unconventional definition of construction working capital represented by this formula:
(initial owner’s equity) + (current assets) + (retained earnings) + (bank lines of credit) + (front load payments) + (progress payments) + (vendor’s and supplier’s payment terms) – (cost of extras in dispute) – (retainage) – (delayed progress payments) – (net loss on recently completed projects) = working capital.
Rarely do we accurately estimate the amount of working capital available because we cling to certain assumptions about cash flow that are not necessarily accurate.
- The cash flow from the next job will cover the temporary shortfall from the current project that is wrapping up.
- Our owners will pay according to contract terms.
- Our accounting managers will bill on time and demand prompt payment.
- The cash expenditure for extras and the cost to litigate some of them is not significant.
- Retainage will only be withheld for a brief period until the job is signed off.
- Our working capital lines of credit are sufficient to cover any cash flow delay.
- Our profitable jobs make up for the occasional loser and replenish retained earnings as we go along.
Constant Professional Attention
Why does working capital management in the construction industry require the constant attention of a professional financial executive? Here’s why:
- There is no free lunch in contracting. The capital required to sustain an ongoing construction business is almost entirely generated internally, and no external equity source (like a public stock market or venture capital) is available to fund a contractor‘s growth.
- The sources of ongoing working capital are unreliable.
- “Front loading” no longer works in the long term because modern profit margins are less than the retainage front loading is intended to cover.
- Owners use slow payment to help finance the project and their designers use it to discipline the contractor. It is now almost standard in the industry. The current days sales outstanding in the construction business averages 83 days. That means it takes nearly 3 months to get paid once the invoice goes out. How many days does it take if the invoices don’t go out on time and the owner is a really slow payer in the bargain?
A Tough Business
Many years in the failure business inspired me to compose Schleifer’s first law:
A construction company may become insolvent even if it is profitable.
Next week we’ll talk about keeping a close eye on working capital status and how to resist taking large projects that won’t be financially capable of seeing through to a profitable conclusion.
For a broader view into growth, read more here: GROWTH
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