Understanding Working Capital

December 15, 2014

Working capital is a financial strength indicator that is used as a starting point for a variety of industry ratios. It indicates the company’s ability to pay its bill as they come due. It is used by sureties in determining a contractor’s bonding capacity as well as by prospective buyers. When a contractor is attempting to grow, the working capital must be analyzed to see if it is sufficient for that growth spurt. While the bottom line is analyzed to see how well the company has performed for the current year, the working capital is analyzed to determine its overall financial health. With an understanding of working capital, a contractor will be better prepared to make decisions
that will affect the overall health of the company.

Calculating a Contractor’s Working Capital:

Working capital is calculated by adding all current assets and subtracting all current liabilities. Current assets include: cash, contract receivables and retentions, inventories, short-term investments, prepaid expenses and underbillings. Current liabilities include accounts payable, lines of credit, accrued liabilities, unearned revenues, and overbillings. A contractor with current assets of $6.3 million and current liabilities of $3.2 million will have a financial statement working capital of $3.1 million.

Working Capital is calculated differently between CPAs and Sureties.

The Surety will typically discount or remove completely the following items from the working capital calculation: Prepaid expenses (depending on the makeup), inventories, officer receivables and notes or other related party receivables, contract receivables aged over 90 days, and investments (depending on the volatility). Sureties will also addback cash surrender of life insurance to increase working capital. You should talk with your surety to understand how they calculate working capital as all sureties calculate this differently.

Understanding the Meaning behind the Numbers:

Working capital is an indicator of the amount of the amount of work a contractor can perform comfortably while remaining strong. This optimum amount of work usually differs according to the type of contractor.

For a Subcontractor:

A strong subcontractor could be at about a 10 times factor. Using the example above, we would take their $3.1 million in working capital, multiply by 10 and come up with $31 million in revenue. That is the 10 times factor. This strong subcontractor could comfortably perform $31 million in revenue with its $3.1 million in working capital. If it recorded revenues of only $25 million during the year, it would be an 8 times factor (even stronger). But as the factor gets lower and lower the contractor starts to have built up capital that is not performing for the company. In cases like this it would probably be best to distribute cash to the shareholders so that they could make investments on the personal side and have their money work for them. There are reasons, however, to stay at a very strong working capital level such as an 8 times factor. For example, if the company is planning to grow rapidly, it will need that excess working capital to support future growth.

How about a subcontractor that is strapped thin?

What does that look like? Assume our working capital is still $3.1 million but our revenue is $62 million. This is a 20 times factor. For a subcontractor, this will tend to be too thin. For the amount of revenue that they are performing on, they might not be able to meet the day to day cash demands. The shareholders in this instance may find themselves making cash contributions to the company or borrowing on the line of credit.

For a General Contractor:

A general contractor could remain strong at a 15 to 20 time’s factor. Think of the differences between a subcontractor and a general contractor (GC). A GC does not have to pay its payables to their subs until they are paid by the customer. The subcontractor, on the other hand, is paying its vendors for materials as the invoices become due. The GC typically does not have as high of a percentage of payroll to fund on a weekly basis that the subcontractor does. As a result, the subcontractor will find itself out on its line of credit more frequently than the GC.

How can a contractor affect his working capital?

  1. Fixed Asset purchase (equipment, machinery, vehicles) with cash vs financing: When you spend cash on a fixed asset, you are immediately reducing a current asset and creating a long-term asset. The long-term asset has no effect on a contractor’s working capital. The cash reduction, however, reduces the working capital dollar for dollar. If you finance the purchase instead, you are creating a long-term asset and a long-term note liability. The effect on a contractor’s working capital would be less in this situation.
  2. Prepaying certain expenses at year end: At the end of the year, a contractor will most likely get an insurance bill for the subsequent year. Some companies will prepay the entire insurance bill for the full policy year. By doing this, the contractor technically creates a current asset (prepaid expense) and reduces another current asset (cash) and so the working capital remains unchanged. However, sureties may discount prepaid expense or remove them all together in the working capital calculation. In that case, prepaying expenses may hurt bonding capacity. This is also true with paying health insurance which is due prior to the month it relates to.
  3. Some investments (current assets) may also be discounted by the surety: If the investment is very volatile, the surety may remove it completely from the working capital calculation. The solution here is to distribute the money to the shareholders so that they may invest on the personal level instead of the corporate level.

Working capital management is an important gauge to measure a contractor’s operational and financial efficiency. Therefore, contractors should consult their surety and CPA before making significant decisions that would have an impact on their working capital. If you have any questions or need assistance to meet working capital challenges, please do not hesitate to contact us.

About the Author:

Brandon Blackburn is a partner with Lanigan Ryan and has been with the firm since 2007.  He has provided many services to privately-owned businesses. His scope of work includes audits, reviews, compilations, income tax planning and preparation, and accounting and consulting services.  His audit experience includes working with large construction contractors and audits of qualified retirement plans.



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