There are only two ingredients required to cook up a successful construction company: 1) Personnel and 2) Capital. When these two profit making assets are combined in the right proportions, construction companies thrive. In this series of messages, we have covered personnel assets and how to hire, train, and retain the construction professionals it takes to deliver construction services to a wide variety of clients. This week we will take a closer look at capital.
What do we mean by capital?
Why is it so hard to identify?
What do we need with it?
Where does it come from?
When do you have enough?
What do we mean by “flow”?
Why is capital so critical?
How do I get as much as I wan
Working Capital
The formal accounting definition of “capital” on a company’s balance sheet is the total of a company’s assets less its liabilities. But when we talk about “capital” on a construction company’s balance sheet, we’re referring to what is commonly known as “working capital”. In construction, working capital is a key management metric.
Working capital, also known as net working capital, is the amount of available capital that a company has on hand to pay for its short-term expenses. This form of capital allows companies to operate by covering the costs of inventory, short-term debt, and day-to-day operations. Working capital is the difference between the company’s current assets—any resource or goods used to generate cash flow—and current liabilities, which refers to any short-term financial obligations.
What Do Contractors Need Working Capital For?
Pretend with me for a moment that you are eavesdropping on a Q&A session I have often had with construction students. At the beginning of each class on business, I would invite the students to ask anything they needed to clear up misconceptions they may be harboring about the topics we were about to take up. Here’s a sample Q&A from those days:
Student Question #1) Why do so many construction companies suddenly fail?
My Answer #1) They run out of money.
Q #2) Why do they run out of money?
A #2) Because they are required to provide the “front” money it takes to construct large, complex building projects and often don’t have enough.
Q #3) Why do they have to put up the money for somebody else’s construction project?
A #3) Because they are legally contracted to build a project in a limited amount of time for a price fixed in advance. By contract, the owner need only make progress payments less retainage for construction completed to the owner’s satisfaction. Therefore, the contractor is required to front all the costs in advance of these progress payments.
Q #4) Where do they get this “front” money?
A #4) From their invested capital, capital they have accumulated on the balance sheet and various forms of borrowing.
Q #5) Why do they often run out?
A #5) Because they fail to accurately estimate the variables that make up the working capital required to complete a project. The multiple sources of working capital flow in and out of a contractor’s balance sheet at variable rates that are almost impossible to estimate accurately at any given point in time.
Q #6) What are these variable sources of working capital?
A #6)
The first is the progress payments themselves. Some owners pay invoices as specified in their contract. Others are contentious and chose to negotiate the amounts billed. Others simply pay slow. Just a few days of unpaid invoices on a big job can add up to a substantial sum.
The second is the contractor’s working capital line of credit at their bank. The total amount varies based on the asset value of the construction company and the contractor’s personal net equity. The available balance varies on how much the contractor has used on other projects in progress and the rate the contractor is repaying his working capital line (based on progress payments from other jobs). CFOs must estimate available cash flow (in and out of the working capital line) on multiple simultaneous projects.
Pace of the work. As a project proceeds varying costs are incurred. On big complex projects there are costs that may not be able to be invoiced in the current period. These can be substantial and require working capital financing.
Accounts payable aging. Another source of working capital is the aging of accounts payable. A contractor’s vendors expect to be paid net 30 days, but if you can convince vendors (and/or subs) to accept payment later, say in 45 days, you have just raised a substantial amount of working capital. 60 days; even more.
The complexity of working capital in construction stems from the complexity of the industry’s model payment system. Progress payments over a long and often contentious period of time do not bode well for solid cash flow management. Next week we’ll discuss cash flow management techniques that might save your company’s future.
For more information financial management, read more at: FINANCIAL
For a broader view on working capital, read more here: WORKING CAPITAL
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