How can construction businesses ensure there’s enough cash in the door for seamless operations? Working capital management.
What Is Working Capital?
Working capital, or net working capital, is the amount of money you have to cover the daily operations of your construction business. It’s also money you can access instantly to pay suppliers, loans, payroll, and other financial obligations.
Working capital is made up of components including:
- Cash and cash equivalents– any money you have on-site or in easily accessible business bank accounts.
- Accounts receivable– money owed to you by clients. Payment of these is usually delayed in the construction industry
- Inventory– the material required to build your ongoing projects including any rented equipment.
- Accounts payable– debt owed for raw materials and other supplies
- Operating expenses– payroll, utilities, vehicle maintenance, licenses, permits, and other regular overhead costs.
The basic equation for working capital is:
Working capital = Current assets – current liabilities
What Is Working Capital Management?
Working capital management is the process of managing a company’s short-term assets and liabilities to ensure enough cash flow for day-to-day operations.
An effective working capital management strategy indicates short-term financial health. It helps businesses minimize costs and gives a short-term view of budgeting and forecasting.
Tracking working capital also helps businesses determine whether they have extra cash for investing. Alternatively, it tracks cash reserves needed to get through unexpected tough times.
Overall, working capital management helps your construction business stay on top of your finances. Coupled with a business environment that’s in accordance with the COSO control framework, you can ensure your construction company’s financial stability with effective working capital management strategies.
How Can Working Capital Management Streamline Construction Operations?
So, we know working capital management can help you track your finances. But how exactly can it streamline construction operations?
- It helps you prepare for seasonality– Regional economic developments can affect local construction markets. Effective working capital management ensures you have a buffer in times of need, preventing disruptions in your processes.
- It aids in improving supplier relations– You can nurture relationships with a good working capital management strategy. Your suppliers know you always pay on time so they deliver building materials promptly, ensuring your projects stay on schedule.
- It ensures debt obligation funding– Missed or late payments slow down your supply pipeline or delay permits and applications, pushing deadlines further down the road. Working capital management ensures payment compliance, allowing you to meet deadlines..
- It helps in risk management– Not every project goes according to plan. A good working capital management strategy keeps you flexible for changes in scope. It ensures you have liquid reserves to pay for additional and unforeseen costs, ensuring your processes aren’t disrupted.
Working Capital Metrics
Working capital metrics are quantifiable measurements used to determine the effectiveness of your working capital management.
Here are some working capital metrics to track:
Current Working Capital Ratio
The working capital ratio shows your ability to meet current financial obligations.
Current working capital ratio = Current assets / Current liabilities
A ratio greater than 1 signals that you can meet your current obligations. A ratio of 1.2 or greater is seen as a sign of good financial performance and a requirement for creditors. In construction, this number tends to be higher for smaller businesses and dives toward 1.2 as revenue increases.
The national average for commercial contractors with less than $25 million was 1.74 in 2023. In the same year, contractors with an annual revenue of more than $250 million operated with an average current ratio of 1.28.
Quick Working Capital Ratio
The quick ratio or quick working capital ratio is similar to the current ratio. The difference is that assets with longer cash conversion cycles are removed. This includes advance payments to obligations.
Quick ratio = (Current assets – Inventories – Prepaid expenses) / Current liabilities
The quick working capital ratio gives you a better idea of how much cash you can access right away.
Collection Ratio
A collection ratio demonstrates how well your accounts receivable process is working. It’s a pulse check on how well your credit policies and payment processing handle receivables.
Collection ratio = (365 x Average accounts receivable) / Net credit sales
Inventory Turnover Ratio
Your inventory turnover ratio measures how well you manage your inventory. It’s how well you flip inventory into sales. In the case of construction, this is mostly made up of building materials and plots (when applicable).
Inventory turnover ratio = Cost of goods sold (COGS) / Average value of inventory
A low ratio may indicate poor sales or overstocking inventory. A high ratio indicates good sales or not enough inventory levels. It’s up to you to interpret the data and weigh it against other business metrics including your working capital ratios.
Working Capital Turnover Ratio
Having free cash is great, but what are you doing with it? Working capital turnover tells you how well you generate cash with your working capital.
Working capital turnover ratio = Net annual sales / Net working capital
The higher the ratio, the more efficient your business is at generating revenue. A recent Construction Financial Management Association report found the industry average working capital turnover ratio was 6.6.
Tips to Adopt (and Improve) Working Capital Management
Now that you know the importance of working capital management, here are tips your construction business should follow to adopt and improve it:
Track Accounts Receivable
You’ll likely have some spreadsheets and/or credit notes to track accounts receivable. But there’s more you can do.
Use tools such as Handle to monitor every credit agreement with clients. With the powerful solution, you can automatically track all payment deadlines so you don’t lose payment rights. The tool can also tell you how much is left to be paid for each project. This is synced directly back to your accounting system.
Focus on recovering payments that are overdue. These are accounts that are at most risk of requiring an affidavit of nonpayment.
Re-evaluate Collection Policies
Examine your current credit and collections policies. If you don’t have a written policy, make one and send it to every client.
Your written policy can include:
- Payment reminders– Send these by email or phone on set dates such as 30, 45, and 60 days after an invoice is made.
- Early discount– A small discount of 1-3% may be worth freeing up your cash flow and avoiding late payments.
- A provision on shorter capital cycles– Shorten your payment terms, especially for newer customers or those who seem to frequently pay late.
- A provision on how to handle payment extension requests–Payment extension requests are not uncommon in your industry. Include a provision that says that approval is on a case-to-case basis and doesn’t apply automatically to all clients.
Reassess Invoicing and Payment Processing
When it comes to payment collection, you want to reduce as much friction as possible.
If you’re not already doing it, start using an invoicing solution to generate PDFs that can be sent and signed electronically. Use online payment solutions such as Handle and Stripe so that you can accept debit and credit card payments.
Make sure the payment processors you choose demonstrate SOC2 compliance. What is SOC 2 compliance? It’s adherence to the security framework that reassures customers their data–such as financial data–is safe and secure.
Optimize Inventory Management
Pay attention to what the working capital metrics are telling you. Are you constantly tying up cash in building materials? Or are projects slowed down while waiting on supplies or equipment?
Do you have idle assets such as vehicles or specialized equipment that you could turn into cash for other opportunities?
You want to free up as much cash as possible but also ensure your team can be as productive as possible. Use construction inventory management tools to help you stay on top of consumables.
Use Other Tools to Monitor and Optimize Working Capital
In addition to the tools mentioned above, use business technologies that can help you monitor and optimize your working capital.
For construction companies, these include:
- Construction project management– monitor and optimize NWC with short-term oversight of projects, tasks, and inventory.
- Enterprise resource planning (ERP)– combines financial planning with working capital management, payroll, and other business processes.
- Lien waiver solutions– exchange, collaborate, and manage lien waivers, payments, and regulatory compliance.
Just make sure you choose solutions that fit your specific construction business needs.
Negotiate Better Payment Terms
Negotiate more favorable terms for your debt obligations. You want to take an opposite approach to your receivables. Delaying payment means more working capital.
If you’re paying a supplier weekly, negotiate monthly payments. If it’s monthly, try for quarterly and so on. Of course, there are diminishing returns. Kicking the can down the road can result in huge lump sum payments you may not have the capital to fund.
Restructure or consolidate debt to reduce interest or lower the monthly payment. You can also switch to interest-only payments short-term to free up more working capital.
Another option is to negotiate waivers during the low season for your region. This is mutually beneficial as it assures any lenders that you can stay afloat and keep paying your debt in the long run.
Review Expenses
Review your expenses so you get an idea of how much money is going out. This way, you can determine how much you need to cover these expenses while freeing up working capital for your daily operations.
What are you spending on fuel for vehicles? How much rent do you pay for your office space?
Schedule a periodic review of your balance sheet and operational expenses. Look for ways to free up cash without affecting continuity. For example, you could opt for cloud services for operational infrastructure. Cloud-based apps for file storage reduce the need for hardware and equipment. They streamline operations while also saving you time and money.
Shorten Operating Cycles
Shortening business cycles can optimize your working capital. Every task you accelerate means that cash is flowing back to you quicker and projects get finished faster.
How can your construction company do this?
- Plan your projects– Better planning helps you manage unforeseen issues. It aligns your resources for greater productivity.
- Outsource-Speed up projects by outsourcing to experts who can get jobs done promptly.
- Centralize communication-Use a business communications platform to handle all communications with clients for project updates and changes. Use the same app to quickly relay instructions to on-site teams and troubleshoot issues.
There are other strategies you can follow to indirectly shorten your operating cycles.
For instance, why not leverage progress billing? Build payment around milestones, not timelines. When you do this, you’re more likely to get things done quickly. After all, you know that if you finish project phases quicker, you get paid earlier.
Streamline Construction Operations with Working Capital Management
Working capital management strategies ensure that you have enough money to use for your daily operations.
You learned how to adopt and improve your construction business’ working capital management with this article.
Just track your accounts receivable, re-evaluate your collection policy and reassess your invoicing and payment processing. Don’t forget to optimize your inventory management. Use other tools to monitor and optimize your working capital. Also, negotiate better payment terms and review your expenses. Shorten your operating cycles, too.
With an effective working capital management system, you can ensure a well-managed cash flow that helps streamline your operations. Good luck!
About the author: AuditBoard transforms how audit, risk, ESG, and InfoSec professionals manage today’s dynamic risk landscape with a modern, connected platform that engages the front lines, surfaces the risks that matter, and drives better strategic decision-making.