The Importance of Working Capital in the Construction Industry

What is working capital? What does it mean, and why is it important to your business?

Working Capital Ratio = Current Assets / Current Liabilities

Working capital is a measure of the short-term health of your business. It helps you understand whether your business can meet its obligations within the next 12 months or less. Although it is not the only measure of a contractor’s liquidity, working capital is the most important and simplest to calculate when assessing how efficiently a contractor is operating.

Working capital is a crucial metric for five reasons:

1. Cash Flow: Cash flow is one of the most important metrics for determining the health and sustainability of a business. In the construction industry, managing cash flow is especially important as the timing of costs and billings must be managed effectively to sustain projects. Doing so can be challenging as there are often considerable upfront costs, such as materials, mobilization and bonding, with a sometimes significant delay in costs being billed to the customer. Monitoring cash flows and staying on top of billings and receivables and short-term borrowings and payments of vendors is crucial to long-term success.
2. Bonding: A surety company will scrutinize a contractor’s financial statements to determine bonding capacity. Typically, bonding capacity is a function of adjusted working capital with a 10 to 20 multiple. Sureties go a step further and discount working capital to exclude any assets not readily convertible to cash, such as inventory or prepaid. By using this metric, a surety can evaluate the contractor’s ability to meet their financial obligations and complete the projects they are bonding. By having excess working capital, management can determine the suitable projects to bid on rather than being limited by bonding capacity.
3. Borrowing: Maintaining sufficient working capital allows a company to potentially reduce the need for short-term borrowings. With interest rates at a current high level, borrowing costs have significantly increased. This, in turn, has negative effects on highly leveraged companies. Even if your business decides financing is the best decision to fund current operations, a bank will review your working capital to determine your creditworthiness. It is a common covenant included in borrowing arrangements. Having healthy working capital can help your company negotiate better rates to fund projects and short-term obligations.
4. Competitiveness on Bids: Having a strong working capital allows a business to be competitive in the bidding process as it shows that the business has the necessary cash flow and capacity to complete the project successfully. If a company is heavily leveraged, the carrying costs of short-term borrowings and lines of credit should be factored into overhead rates or costs of performing work. This means it would cost a highly leveraged company more to do the same work than it would a company with fewer short-term borrowings. Working capital can also affect the ability to purchase goods and services, which is essential in determining whether your business can bid on a project or perform work within the given timeline. Therefore, understanding where your company’s liabilities stand and whether they can be supported over the next 12 months will help you determine the projects that your company can bid on and ultimately win.
5. Long-Term Plans: Not only does working capital matter in the short term, as it measures your ability to cover your current liabilities, but it also matters in the long term. This is because working capital helps you to determine your ability to make plans. A strong working capital can fund business growth, both now and in the future, while also maintaining financial stability during slower periods of business. In the event of unexpected setbacks or contract delays and issues, a business with strong working capital will be able to stay afloat, whereas a business with tighter working capital may struggle.

Working capital is one of the most important metrics of financial health in the construction industry. Maintaining a strong working capital proves that a business is reliable and capable of completing the projects it has been awarded. Monitoring your company’s working capital is even more vital as this can limit your bidding and bonding ability and your company’s ability to grow and sustain well into the future.

Contributing Author: Ryan R. Delao, CPA, is an audit manager with experience providing audit, review, compilation and consulting services to a diverse range of clients. His background includes working with clients in the construction, architectural/engineering and manufacturing industries. For more information on this topic, you may contact Ryan at rdelao@dmcpas.com or (315) 472-9127.